[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2019 Edition]
[From the U.S. Government Publishing Office]



[[Page i]]

          
          
          Title 26

Internal Revenue


________________________

Part 1 (Sec. Sec.  1.140 to 1.169)

                         Revised as of April 1, 2019

          Containing a codification of documents of general 
          applicability and future effect

          As of April 1, 2019
                    Published by the Office of the Federal Register 
                    National Archives and Records Administration as a 
                    Special Edition of the Federal Register

[[Page ii]]

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[[Page iii]]




                            Table of Contents



                                                                    Page
  Explanation.................................................       v

  Title 26:
          Chapter I--Internal Revenue Service, Department of 
          the Treasury (Continued)                                   3
  Finding Aids:
      Table of CFR Titles and Chapters........................     623
      Alphabetical List of Agencies Appearing in the CFR......     643
      Table of OMB Control Numbers............................     653
      List of CFR Sections Affected...........................     671

[[Page iv]]





                     ----------------------------

                     Cite this Code: CFR
                     To cite the regulations in 
                       this volume use title, 
                       part and section number. 
                       Thus, 26 CFR 1.141-0 
                       refers to title 26, part 
                       1, section 141-0.

                     ----------------------------

[[Page v]]



                               EXPLANATION

    The Code of Federal Regulations is a codification of the general and 
permanent rules published in the Federal Register by the Executive 
departments and agencies of the Federal Government. The Code is divided 
into 50 titles which represent broad areas subject to Federal 
regulation. Each title is divided into chapters which usually bear the 
name of the issuing agency. Each chapter is further subdivided into 
parts covering specific regulatory areas.
    Each volume of the Code is revised at least once each calendar year 
and issued on a quarterly basis approximately as follows:

Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1

    The appropriate revision date is printed on the cover of each 
volume.

LEGAL STATUS

    The contents of the Federal Register are required to be judicially 
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie 
evidence of the text of the original documents (44 U.S.C. 1510).

HOW TO USE THE CODE OF FEDERAL REGULATIONS

    The Code of Federal Regulations is kept up to date by the individual 
issues of the Federal Register. These two publications must be used 
together to determine the latest version of any given rule.
    To determine whether a Code volume has been amended since its 
revision date (in this case, April 1, 2019), consult the ``List of CFR 
Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative 
List of Parts Affected,'' which appears in the Reader Aids section of 
the daily Federal Register. These two lists will identify the Federal 
Register page number of the latest amendment of any given rule.

EFFECTIVE AND EXPIRATION DATES

    Each volume of the Code contains amendments published in the Federal 
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citations for the regulations are referred to by volume number and page 
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inserted following the text.

OMB CONTROL NUMBERS

    The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires 
Federal agencies to display an OMB control number with their information 
collection request.

[[Page vi]]

Many agencies have begun publishing numerous OMB control numbers as 
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PAST PROVISIONS OF THE CODE

    Provisions of the Code that are no longer in force and effect as of 
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for 1949-1963, 1964-1972, 1973-1985, and 1986-2000.

``[RESERVED]'' TERMINOLOGY

    The term ``[Reserved]'' is used as a place holder within the Code of 
Federal Regulations. An agency may add regulatory information at a 
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INCORPORATION BY REFERENCE

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This material, like any other properly issued regulation, has the force 
of law.
    What is a proper incorporation by reference? The Director of the 
Federal Register will approve an incorporation by reference only when 
the requirements of 1 CFR part 51 are met. Some of the elements on which 
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    (a) The incorporation will substantially reduce the volume of 
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    (b) The matter incorporated is in fact available to the extent 
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CFR INDEXES AND TABULAR GUIDES

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and Finding Aids. This volume contains the Parallel Table of Authorities 
and Rules. A list of CFR titles, chapters, subchapters, and parts and an 
alphabetical list of agencies publishing in the CFR are also included in 
this volume.

[[Page vii]]

    An index to the text of ``Title 3--The President'' is carried within 
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This index is based on a consolidation of the ``Contents'' entries in 
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the revision dates of the 50 CFR titles.

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in the Code of Federal Regulations.

INQUIRIES

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or write to the Director, Office of the Federal Register, National 
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    The e-CFR is a regularly updated, unofficial editorial compilation 
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of the Federal Register and the Government Publishing Office. It is 
available at www.ecfr.gov.

    Oliver A. Potts,
    Director,
    Office of the Federal Register
    April 1, 2019.







[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of twenty-two volumes. The 
contents of these volumes represent all current regulations issued by 
the Internal Revenue Service, Department of the Treasury, as of April 1, 
2019. The first fifteen volumes comprise part 1 (Subchapter A--Income 
Tax) and are arranged by sections as follows: Sec. Sec.  1.0-1.60; 
Sec. Sec.  1.61-1.139; Sec. Sec.  1.140-1.169; Sec. Sec.  1.170-1.300; 
Sec. Sec.  1.301-1.400; Sec. Sec.  1.401-1.409; Sec. Sec.  1.410-1.440; 
Sec. Sec.  1.441-1.500; Sec. Sec.  1.501-1.640; Sec. Sec.  1.641-1.850; 
Sec. Sec.  1.851-1.907; Sec. Sec.  1.908-1.1000; Sec. Sec.  1.1001-
1.1400; Sec. Sec.  1.1401-1.1550; and Sec.  1.1551 to end of part 1. The 
sixteenth volume containing parts 2-29, includes the remainder of 
subchapter A and all of Subchapter B--Estate and Gift Taxes. The last 
six volumes contain parts 30-39 (Subchapter C--Employment Taxes and 
Collection of Income Tax at Source); parts 40-49; parts 50-299 
(Subchapter D--Miscellaneous Excise Taxes); parts 300-499 (Subchapter 
F--Procedure and Administration); parts 500-599 (Subchapter G--
Regulations under Tax Conventions); and part 600 to end (Subchapter H--
Internal Revenue Practice).

    The OMB control numbers for title 26 appear in Sec.  602.101 of this 
chapter. For the convenience of the user, Sec.  602.101 appears in the 
Finding Aids section of the volumes containing parts 1 to 599.

    For this volume, Cheryl E. Sirofchuck was Chief Editor. The Code of 
Federal Regulations publication program is under the direction of John 
Hyrum Martinez, assisted by Stephen J. Frattini.

[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




         (This book contains part 1, Sec. Sec.  1.140 to 1.169)

  --------------------------------------------------------------------
                                                                    Part

chapter i--Internal Revenue Service, Department of the 
  Treasury (Continued)......................................           1

[[Page 3]]



    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)




  --------------------------------------------------------------------


  Editorial Note: IRS published a document at 45 FR 6088, Jan. 25, 1980, 
deleting statutory sections from their regulations. In Chapter I cross-
references to the deleted material have been changed to the 
corresponding sections of the IRS Code of 1954 or to the appropriate 
regulations sections. When either such change produced a redundancy, the 
cross-reference has been deleted. For further explanation, see 45 FR 
20795, Mar. 31, 1980.

                  SUBCHAPTER A--INCOME TAX (CONTINUED)
Part                                                                Page
1               Income taxes (Continued)....................           5

Supplementary Publications: Internal Revenue Service Looseleaf 
  Regulations System, Alcohol and Tobacco Tax Regulations, and 
  Regulations Under Tax Conventions.

  Editorial Note: Treasury Decision 6091, 19 FR 5167, Aug. 17, 1954, 
provides in part as follows:

  Paragraph 1. All regulations (including all Treasury decisions) 
prescribed by, or under authority duly delegated by, the Secretary of 
the Treasury, or jointly by the Secretary and the Commissioner of 
Internal Revenue, or by the Commissioner of Internal Revenue with the 
approval of the Secretary of the Treasury, or jointly by the 
Commissioner of Internal Revenue and the Commissioner of Customs or the 
Commissioner of Narcotics with the approval of the Secretary of the 
Treasury, applicable under any provision of law in effect on the date of 
enactment of the Code, to the extent such provision of law is repealed 
by the Code, are hereby prescribed under and made applicable to the 
provisions of the Code corresponding to the provision of law so repealed 
insofar as any such regulation is not inconsistent with the Code. Such 
regulations shall become effective as regulations under the various 
provisions of the Code as of the dates the corresponding provisions of 
law are repealed by the Code, until superseded by regulations issued 
under the Code.

  Par. 2. With respect to any provision of the Code which depends for 
its application upon the promulgation of regulations or which is to be 
applied in such manner as may be prescribed by regulations, all 
instructions or rules in effect immediately prior to the enactment of 
the Code, to the extent such instructions or rules could be prescribed 
as regulations under authority of such provision of the Code, shall be 
applied as regulations under such provision insofar as such instructions 
or rules are not inconsistent with the Code. Such instructions or rules 
shall be applied as regulations under the applicable provision of the 
Code as of the date such provision takes effect.

  Par. 3. If any election made or other act done pursuant to any 
provision of the Internal Revenue Code of 1939 or prior internal revenue 
laws would (except for the enactment of the Code) be effective for any 
period subsequent to such enactment, and if corresponding provisions are 
contained in the Code, such election or other act shall be given the 
same effect under the corresponding provisions of the Code to the extent 
not inconsistent therewith. The term ``act'' includes, but is not 
limited to, an allocation, identification, declaration, agreement, 
option, waiver, relinquishment, or renunciation.

  Par. 4. The limits of the various internal revenue districts have not 
been changed by the enactment of the Code. Furthermore, delegations of 
authority made pursuant to the provisions of Reorganization Plan No. 26 
of 1950 and Reorganization Plan No. 1 of 1952 (as well as redelegations 
thereunder), including those governing the authority of the Commissioner 
of Internal Revenue, the Regional Commissioners of Internal Revenue, or 
the District Directors of Internal Revenue, are applicable to the 
provisions of the Code to the extent consistent therewith.

[[Page 5]]



                   SUBCHAPTER A_INCOME TAX (CONTINUED)





PART 1_INCOME TAXES (CONTINUED)--Table of Contents



Sec.
1.141-0 Table of contents.

          Tax Exemption Requirements for State and Local Bonds

1.141-1 Definitions and rules of general application.
1.141-2 Private activity bond tests.
1.141-3 Definition of private business use.
1.141-4 Private security or payment test.
1.141-5 Private loan financing test.
1.141-6 Allocation and accounting rules.
1.141-7 Special rules for output facilities.
1.141-8 $15 million limitation for output facilities.
1.141-9 Unrelated or disproportionate use test.
1.141-10 Coordination with volume cap. [Reserved]
1.141-11 Acquisition of nongovernmental output property. [Reserved]
1.141-12 Remedial actions.
1.141-13 Refunding issues.
1.141-14 Anti-abuse rules.
1.141-15 Effective/applicability dates.
1.141-16 Effective dates for qualified private activity bond provisions.
1.142-0 Table of contents.
1.142-1 Exempt facility bonds.
1.142-2 Remedial actions.
1.142-3 Refunding issues. [Reserved]
1.142-4 Use of proceeds to provide a facility.
1.142(a)(5)-1 Exempt facility bonds: Sewage facilities.
1.142(a)(6)-1 Exempt facility bonds: solid waste disposal facilities.
1.142(f)(4)-1 Manner of making election to terminate tax-exempt bond 
          financing.
1.143(g)-1 Requirements related to arbitrage.
1.144-0 Table of contents.
1.144-1 Qualified small issue bonds, qualified student loan bonds, and 
          qualified redevelopment bonds.
1.144-2 Remedial actions.
1.144-3 Standard deduction for individuals choosing income averaging. 
          [Reserved]
1.145-0 Table of contents.
1.145-1 Qualified 501(c)(3) bonds.
1.145-2 Application of private activity bond regulations.
1.147-0 Table of contents.
1.147-1 Other requirements applicable to certain private activity bonds.
1.147-2 Remedial actions.
1.147(b)-1 Bond maturity limitation--treatment of working capital.
1.147(f)-1 Public approval of private activity bonds.
1.148-0 Scope and table of contents.
1.148-1 Definitions and elections.
1.148-2 General arbitrage yield restriction rules.
1.148-3 General arbitrage rebate rules.
1.148-4 Yield on an issue of bonds.
1.148-5 Yield and valuation of investments.
1.148-6 General allocation and accounting rules.
1.148-7 Spending exceptions to the rebate requirement.
1.148-8 Small issuer exception to rebate requirement.
1.148-9 Arbitrage rules for refunding issues.
1.148-10 Anti-abuse rules and authority of Commissioner.
1.148-11 Effective/applicability dates.
1.149(b)-1 Federally guaranteed bonds.
1.149(d)-1 Limitations on advance refundings.
1.149(e)-1 Information reporting requirements for tax-exempt bonds.
1.149(g)-1 Hedge bonds.
1.150-1 Definitions.
1.150-2 Proceeds of bonds used for reimbursement.
1.150-4 Change in use of facilities financed with tax-exempt private 
          activity bonds.
1.150-5 Filing notices and elections.

   Regulations Applicable to Certain Bonds Sold Prior to July 8, 1997

1.148-1A--1.148-6A [Reserved]
1.148-9A--1.148-10A [Reserved]
1.148-11A Effective dates.

                   Deductions for Personal Exemptions

1.151-1 Deductions for personal exemptions.
1.151-2 Additional exemptions for dependents.
1.151-3 Definitions.
1.151-4 Amount of deduction for each exemption under section 151.
1.152-1 General definition of a dependent.
1.152-2 Rules relating to general definition of dependent.
1.152-3 Multiple support agreements.
1.152-4 Special rule for a child of divorced or separated parents or 
          parents who live apart.
1.153-1 Determination of marital status.
1.154 Statutory provisions; cross references.

          Itemized Deductions for Individuals and Corporations

1.161-1 Allowance of deductions.
1.162-1 Business expenses.
1.162-2 Traveling expenses.
1.162-3 Materials and supplies.
1.162-4 Repairs.
1.162-5 Expenses for education.
1.162-7 Compensation for personal services.

[[Page 6]]

1.162-8 Treatment of excessive compensation.
1.162-9 Bonuses to employees.
1.162-10 Certain employee benefits.
1.162-10T Questions and answers relating to the deduction of employee 
          benefits under the Tax Reform Act of 1984; certain limits on 
          amounts deductible (temporary).
1.162-11 Rentals.
1.162-12 Expenses of farmers.
1.162-13 Depositors' guaranty fund.
1.162-14 Expenditures for advertising or promotion of good will.
1.162-15 Contributions, dues, etc.
1.162-16 Cross reference.
1.162-17 Reporting and substantiation of certain business expenses of 
          employees.
1.162-18 Illegal bribes and kickbacks.
1.162-19 Capital contributions to Federal National Mortgage Association.
1.162-20 Expenditures attributable to lobbying, political campaigns, 
          attempts to influence legislation, etc., and certain 
          advertising.
1.162-21 Fines and penalties.
1.162-22 Treble damage payments under the antitrust laws.
1.162-24 Travel expenses of state legislators.
1.162-25 Deductions with respect to noncash fringe benefits.
1.162-25T Deductions with respect to noncash fringe benefits 
          (temporary).
1.162-27 Certain employee remuneration in excess of $1,000,000.
1.162-28 Allocation of costs to lobbying activities.
1.162-29 Influencing legislation.
1.162-31 The $500,000 deduction limitation for remuneration provided by 
          certain health insurance providers.
1.162-32 Expenses paid or incurred for lodging when not traveling away 
          from home.
1.162(k)-1 Disallowance of deduction for reacquisition payments.
1.162(l)-0 Table of Contents.
1.162(l)-1 Deduction for health insurance costs of self-employed 
          individuals.
1.163-1 Interest deduction in general.
1.163-2 Installment purchases where interest charge is not separately 
          stated.
1.163-3 Deduction for discount on bond issued on or before May 27, 1969.
1.163-4 Deduction for original issue discount on certain obligations 
          issued after May 27, 1969. 1
1.163-5 Denial of interest deduction on certain obligations issued after 
          December 31, 1982, unless issued in registered form.
1.163-5T Denial of interest deduction on certain obligations issued 
          after December 31, 1982, unless issued in registered form 
          (temporary).
1.163-6T Reduction of deduction where section 25 credit taken 
          (temporary).
1.163-7 Deduction for OID on certain debt instruments.
1.163-8T Allocation of interest expense among expenditures (temporary).
1.163-9T Personal interest (temporary).
1.163-10T Qualified residence interest (temporary).
1.163-11 Allocation of certain prepaid qualified mortgage insurance 
          premiums.
1.163-12 Deduction of original issue discount on instrument held by 
          related foreign person.
1.163-13 Treatment of bond issuance premium.
1.163(d)-1 Time and manner for making elections under the Omnibus Budget 
          Reconciliation Act of 1993 and the Jobs and Growth Tax Relief 
          Reconciliation Act of 2003.
1.164-1 Deduction for taxes.
1.164-2 Deduction denied in case of certain taxes.
1.164-3 Definitions and special rules.
1.164-4 Taxes for local benefits.
1.164-5 Certain retail sales taxes and gasoline taxes.
1.164-6 Apportionment of taxes on real property between seller and 
          purchaser.
1.164-7 Taxes of shareholder paid by corporation.
1.164-8 Payments for municipal services in atomic energy communities.
1.165-1 Losses.
1.165-2 Obsolescence of nondepreciable property.
1.165-3 Demolition of buildings.
1.165-4 Decline in value of stock.
1.165-5 Worthless securities.
1.165-6 Farming losses.
1.165-7 Casualty losses.
1.165-8 Theft losses.
1.165-9 Sale of residential property.
1.165-10 Wagering losses.
1.165-11 Election in respect of losses attributable to a disaster.
1.165-12 Denial of deduction for losses on registration-required 
          obligations not in registered form.
1.166-1 Bad debts.
1.166-2 Evidence of worthlessness.
1.166-3 Partial or total worthlessness.
1.166-4 Reserve for bad debts.
1.166-5 Nonbusiness debts.
1.166-6 Sale of mortgaged or pledged property.
1.166-7 Worthless bonds issued by an individual.
1.166-8 Losses of guarantors, endorsers, and indemnitors incurred on 
          agreements made before January 1, 1976.
1.166-9 Losses of guarantors, endorsers, and indemnitors incurred, on 
          agreements made after December 31, 1975, in taxable years 
          beginning after such date.
1.166-10 Reserve for guaranteed debt obligations.
1.167(a)-1 Depreciation in general.
1.167(a)-2 Tangible property.
1.167(a)-3 Intangibles.

[[Page 7]]

1.167(a)-4 Leased property.
1.167(a)-5 Apportionment of basis.
1.167(a)-5T Application of section 1060 to section 167 (temporary).
1.167(a)-6 Depreciation in special cases.
1.167(a)-7 Accounting for depreciable property.
1.167(a)-8 Retirements.
1.167(a)-9 Obsolescence.
1.167(a)-10 When depreciation deduction is allowable.
1.167(a)-11 Depreciation based on class lives and asset depreciation 
          ranges for property placed in service after December 31, 1970.
1.167(a)-12 Depreciation based on class lives for property first placed 
          in service before January 1, 1971.
1.167(a)-13T Certain elections for intangible property (temporary).
1.167(a)-14 Treatment of certain intangible property excluded from 
          section 197.
1.167(b)-0 Methods of computing depreciation.
1.167(b)-1 Straight line method.
1.167(b)-2 Declining balance method.
1.167(b)-3 Sum of the years-digits method.
1.167(b)-4 Other methods.
1.167(c)-1 Limitations on methods of computing depreciation under 
          section 167(b) (2), (3), and (4).
1.167(d)-1 Agreement as to useful life and rates of depreciation.
1.167(e)-1 Change in method.
1.167(f)-1 Reduction of salvage value taken into account for certain 
          personal property.
1.167(g)-1 Basis for depreciation.
1.167(h)-1 Life tenants and beneficiaries of trusts and estates.
1.167(i)-1 Depreciation of improvements in the case of mines, etc.
1.167(l)-1 Limitations on reasonable allowance in case of property of 
          certain public utilities.
1.167(l)-2 Public utility property; election as to post-1969 property 
          representing growth in capacity.
1.167(l)-3 Multiple regulation, asset acquisitions, reorganizations, 
          etc.
1.167(l)-4 Public utility property; election to use asset depreciation 
          range system.
1.167(m)-1 Class lives.
1.168-5 Special rules.
1.168(a)-1 Modified accelerated cost recovery system.
1.168(b)-1 Definitions.
1.168(d)-0 Table of contents for the applicable convention rules.
1.168(d)-1 Applicable conventions--half-year and mid-quarter 
          conventions.
1.168(h)-1 Like-kind exchanges involving tax-exempt use property.
1.168(i)-0 Table of contents for the general asset account rules.
1.168(i)-1 General asset accounts.
1.168(i)-2 Lease term.
1.168(i)-3 Treatment of excess deferred income tax reserve upon 
          disposition of deregulated public utility property.
1.168(i)-4 Changes in use.
1.168(i)-5 Table of contents.
1.168(i)-6 Like-kind exchanges and involuntary conversions.
1.168(i)-7 Accounting for MACRS property.
1.168(i)-8 Dispositions of MACRS property.
1.168(j)-1T Questions and answers concerning tax-exempt entity leasing 
          rules (temporary).
1.168(k)-0 Table of contents.
1.168(k)-1 Additional first year depreciation deduction.
1.168A-1 Amortization of emergency facilities; general rule.
1.168A-2 Election of amortization.
1.168A-3 Election to discontinue amortization.
1.168A-4 Definitions.
1.168A-5 Adjusted basis of emergency facility.
1.168A-6 Depreciation of portion of emergency facility not subject to 
          amortization.
1.168A-7 Payment by United States of unamortized cost of facility.
1.169-1 Amortization of pollution control facilities.
1.169-2 Definitions.
1.169-3 Amortizable basis.
1.169-4 Time and manner of making elections

    Authority: 26 U.S.C. 7805, unless otherwise noted.
    Section 1.148-0 through 1.148-11 also issued under 26 U.S.C. 148(i).
    Section 1.148-6 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(d)-1 also issued under 26 U.S.C. 149(d)(7).
    Section 1.149(e)-1 also issued under 26 U.S.C. 149(e).
    Section 1.149(g)-1 also issued under 26 U.S.C. 149(g)(5).
    Section 1.150-4 also issued under 26 U.S.C. 150 (c)(5).
    Section 1.152-4 also issued under 26 U.S.C. 152(e).
    Section 1.162-24 also issued under 26 U.S.C. 162(h).
    Section 1.162(k)-1 is also issued under section 26 U.S.C. 162(k).
    Section 1.163-8T also issued under 26 U.S.C. 469(k)(4).
    Section 1.163-9T also issued under 26 U.S.C. 163(h)(3)(D).
    Section 1.165-12 also issued under 26 U.S.C. 165(j)(3).
    Section 1.166-10 also issued under 26 U.S.C. 166(f).
    Section 1.168(d)-1 also issued under 26 U.S.C. 168(d)(3).

[[Page 8]]

    Section 1.168(f)(8)-1T also added under sec. 112(c), Black Lung 
Benefits Revenue Act of 1981 (Pub. L. 97-119).
    Section 1.168(h)-1 also issued under 26 U.S.C. 168.
    Section 1.168(i)-1 also issued under 26 U.S.C. 168(i)(4).
    Section 1.168(i)-1T also issued under 26 U.S.C. 168(i)(4).
    Section 1.168(i)-2 also issued under 26 U.S.C. 168.
    Section 1.168(i)-4 also issued under 26 U.S.C. 168(i)(5).
    Section 1.168(j)-1T also added under 26 U.S.C. 168(j)(10).

    Source: T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 
1960, unless otherwise noted.



Sec.  1.141-0  Table of contents.

    This section lists the captioned paragraphs contained in Sec. Sec.  
1.141-1 through 1.141-16.

       Sec.  1.141-1 Definitions and rules of general application.

    (a) In general.
    (b) Certain general definitions.
    (c) Elections.
    (d) Related parties.
    (e) Partnerships.

               Sec.  1.141-2 Private activity bond tests.

    (a) Overview.
    (b) Scope.
    (c) General definition of private activity bond.
    (d) Reasonable expectations and deliberate actions.
    (1) In general.
    (2) Reasonable expectations test.
    (3) Deliberate action defined.
    (4) Special rule for dispositions of personal property in the 
ordinary course of an established governmental program.
    (5) Special rule for general obligation bond programs that finance a 
large number of separate purposes.
    (e) When a deliberate action occurs.
    (f) Certain remedial actions.
    (g) Examples.

            Sec.  1.141-3 Definition of private business use.

    (a) General rule.
    (1) In general.
    (2) Indirect use.
    (3) Aggregation of private business use.
    (b) Types of private business use arrangements.
    (1) In general.
    (2) Ownership.
    (3) Leases.
    (4) Management contracts.
    (5) Output contracts.
    (6) Research agreements.
    (7) Other actual or beneficial use.
    (c) Exception for general public use.
    (1) In general.
    (2) Use on the same basis.
    (3) Long-term arrangements not treated as general public use.
    (4) Relation to other use.
    (d) Other exceptions.
    (1) Agents.
    (2) Use incidental to financing arrangements.
    (3) Exceptions for arrangements other than arrangements resulting in 
ownership of financed property by a nongovernmental person.
    (4) Temporary use by developers.
    (5) Incidental use.
    (6) Qualified improvements.
    (e) Special rule for tax assessment bonds.
    (f) Examples.
    (g) Measurement of private business use.
    (1) In general.
    (2) Measurement period.
    (3) Determining average percentage of private business use.
    (4) Determining the average amount of private business use for a 1-
year period.
    (5) Common areas.
    (6) Allocation of neutral costs.
    (7) Commencement of measurement of private business use.
    (8) Examples.

             Sec.  1.141-4 Private security or payment test.

    (a) General rule.
    (1) Private security or payment.
    (2) Aggregation of private payments and security.
    (3) Underlying arrangement.
    (b) Measurement of private payments and security.
    (1) Scope.
    (2) Present value measurement.
    (c) Private payments.
    (1) In general.
    (2) Payments taken into account.
    (3) Allocation of payments.
    (d) Private security.
    (1) In general.
    (2) Security taken into account.
    (3) Pledge of unexpended proceeds.
    (4) Secured by any interest in property or payments.
    (5) Payments in respect of property.
    (6) Allocation of security among issues.
    (e) Generally applicable taxes.
    (1) General rule.
    (2) Definition of generally applicable taxes.
    (3) Special charges.
    (4) Manner of determination and collection.
    (5) Payments in lieu of taxes.
    (f) Certain waste remediation bonds.
    (1) Scope.
    (2) Persons that are not private users.
    (3) Persons that are private users.
    (g) Examples.

[[Page 9]]

               Sec.  1.141-5 Private loan financing test.

    (a) In general.
    (b) Measurement of test.
    (c) Definition of private loan.
    (1) In general.
    (2) Application only to purpose investments.
    (3) Grants.
    (4) Hazardous waste remediation bonds.
    (d) Tax assessment loan exception.
    (1) General rule.
    (2) Tax assessment loan defined.
    (3) Mandatory tax or other assessment.
    (4) Specific essential governmental function.
    (5) Equal basis requirement.
    (6) Coordination with private business tests.
    (e) Examples.

             Sec.  1.141-6 Allocation and accounting rules.

    (a) Allocation of proceeds to expenditures, projects, and uses in 
general.
    (1) Allocations to expenditures.
    (2) Allocations of sources to a project and its uses.
    (3) Definition of project.
    (b) Special allocation rules for eligible mixed-use projects.
    (1) In general.
    (2) Definition of eligible mixed-use project.
    (3) Definition of qualified equity.
    (4) Same plan of financing.
    (c) Allocations of private payments.
    (d) Allocations of proceeds to common costs of an issue.
    (e) Allocations of proceeds to bonds.
    (f) Examples.

           Sec.  1.141-7 Special rules for output facilities.

    (a) Overview.
    (b) Definitions.
    (1) Available output.
    (2) Measurement period.
    (3) Sale at wholesale.
    (4) Take contract and take or pay contract.
    (5) Requirements contract.
    (6) Nonqualified amount.
    (c) Output contracts.
    (1) General rule.
    (2) Take contract or take or pay contract.
    (3) Requirements contract.
    (4) Output contract properly characterized as a lease.
    (d) Measurement of private business use.
    (e) Measurement of private security or payment.
    (f) Exceptions for certain contracts.
    (1) Small purchases of output.
    (2) Swapping and pooling arrangements.
    (3) Short-term output contracts.
    (4) Certain conduit parties disregarded.
    (g) Special rules for electric output facilities used to provide 
open access.
    (1) Operation of transmission facilities by nongovernmental persons.
    (2) Certain use by nongovernmental persons under output contracts.
    (3) Ancillary services.
    (4) Exceptions to deliberate action rules.
    (5) Additional transactions as permitted by the Commissioner.
    (h) Allocations of output facilities and systems.
    (1) Facts and circumstances analysis.
    (2) Illustrations.
    (3) Transmission and distribution contracts.
    (4) Allocation of payments.
    (i) Examples.

       Sec.  1.141-8 $15 million limitation for output facilities.

    (a) In general.
    (1) General rule.
    (2) Reduction in $15 million output limitation for outstanding 
issues.
    (3) Benefits and burdens test applicable.
    (b) Definition of project.
    (1) General rule.
    (2) Separate ownership.
    (3) Generating property.
    (4) Transmission and distribution.
    (5) Subsequent improvements.
    (6) Replacement property.
    (c) Examples.

          Sec.  1.141-9 Unrelated or disproportionate use test.

    (a) General rules.
    (1) Description of test.
    (2) Application of unrelated or disproportionate use test.
    (b) Unrelated use.
    (1) In general.
    (2) Use for the same purpose as government use.
    (c) Disproportionate use.
    (1) Definition of disproportionate use.
    (2) Aggregation of related uses.
    (3) Allocation rule.
    (d) Maximum use taken into account.
    (e) Examples.

         Sec.  1.141-10 Coordination with volume cap. [Reserved]

     Sec.  1.141-11 Acquisition of nongovernmental output property. 
                               [Reserved]

                    Sec.  1.141-12 Remedial actions.

    (a) Conditions to taking remedial action.
    (1) Reasonable expectations test met.
    (2) Maturity not unreasonably long.
    (3) Fair market value consideration.
    (4) Disposition proceeds treated as gross proceeds for arbitrage 
purposes.
    (5) Proceeds expended on a governmental purpose.
    (b) Effect of a remedial action.
    (1) In general.
    (2) Effect on bonds that have been advance refunded.
    (c) Disposition proceeds.

[[Page 10]]

    (1) Definition.
    (2) Allocating disposition proceeds to an issue.
    (3) Allocating disposition proceeds to different sources of funding.
    (d) Redemption or defeasance of nonqualified bonds.
    (1) In general.
    (2) Special rule for dispositions for cash.
    (3) Anticipatory remedial action.
    (4) Notice of defeasance.
    (5) Special limitation.
    (6) Defeasance escrow defined.
    (e) Alternative use of disposition proceeds.
    (1) In general.
    (2) Special rule for use by 501(c)(3) organizations.
    (f) Alternative use of facility.
    (g) Rules for deemed reissuance.
    (h) Authority of Commissioner to provide for additional remedial 
actions.
    (i) Effect of remedial action on continuing compliance.
    (j) Nonqualified bonds.
    (1) Amount of nonqualified bonds.
    (2) Allocation of nonqualified bonds.
    (k) Examples.

                    Sec.  1.141-13 Refunding issues.

    (a) In general.
    (b) Application of private business use test and private loan 
financing test.
    (1) Allocation of proceeds.
    (2) Determination of amount of private business use.
    (c) Application of private security or payment test.
    (1) Separate issue treatment.
    (2) Combined issue treatment.
    (3) Special rule for arrangements not entered into in contemplation 
of the refunding issue.
    (d) Multipurpose issue allocations.
    (1) In general.
    (2) Exceptions.
    (e) Application of reasonable expectations test to certain refunding 
bonds.
    (f) Special rule for refundings of certain general obligation bonds.
    (g) Examples.

                    Sec.  1.141-14 Anti-abuse rules.

    (a) Authority of Commissioner to reflect substance of transactions.
    (b) Examples.

              Sec.  1.141-15 Effective/applicability dates.

    (a) Scope.
    (b) Effective dates.
    (1) In general.
    (2) Certain short-term arrangements.
    (3) Certain prepayments.
    (4) Certain remedial actions.
    (c) Refunding bonds.
    (d) Permissive application of regulations.
    (e) Permissive retroactive application of certain sections.
    (1) In general.
    (2) Transition rule for pre-effective date bonds.
    (f) Effective dates for certain regulations relating to output 
facilities.
    (1) General rule.
    (2) Transition rule for requirements contracts.
    (g) Refunding bonds for output facilities.
    (h) Permissive retroactive application.
    (i) Permissive application of certain regulations relating to output 
facilities.
    (j) Effective dates for certain regulations relating to refundings.
    (k) Effective/applicability dates for certain regulations relating 
to generally applicable taxes and payments in lieu of tax.
    (l) Applicability date for certain regulations related to allocation 
and accounting.
    (1) In general.
    (2) Refunding bonds.
    (3) Permissive application.
    (m) Permissive retroactive application of certain regulations.
    (n) Effective/applicability dates for certain regulations relating 
to certain definitions.

   Sec.  1.141-16 Effective dates for qualified private activity bond 
                               provisions.

    (a) Scope.
    (b) Effective dates.
    (c) Permissive application.
    (d) Certain remedial actions.
    (1) General rule.
    (2) Special rule for allocations of nonqualified bonds.

[T.D. 8712, 62 FR 2283, Jan. 16, 1997, as amended by T.D. 8757, 63 FR 
3259, Jan. 22, 1998; T.D. 8941, 66 FR 4664, Jan. 18, 2001; T.D. 9016, 67 
FR 59759, Sept. 23, 2002; T.D. 9085, 68 FR 45775, Aug. 4, 2003; T.D. 
9150, 69 FR 50066, Aug. 13, 2004; T.D. 9234, 70 FR 75031, Dec. 19, 2005; 
T.D. 9429, 73 FR 63374, Oct. 24, 2008; T.D. 9741, 80 FR 65642, Oct. 27, 
2015; T.D. 9777, 81 FR 46591, July 18, 2016]

          Tax Exemption Requirements for State and Local Bonds



Sec.  1.141-1  Definitions and rules of general application.

    (a) In general. For purposes of Sec. Sec.  1.141-0 through 1.141-16, 
the following definitions and rules apply: The definitions in this 
section, the definitions in Sec.  1.150-1, the definition of placed in 
service in Sec.  1.150-2(c), the definition of reasonably required 
reserve or replacement fund in Sec.  1.148-2(f), and the definitions in 
Sec.  1.148-1 of bond year, commingled fund, fixed yield issue, higher 
yielding investments, investment, investment proceeds, issue price, 
issuer,

[[Page 11]]

nonpurpose investment, purpose investment, qualified guarantee, 
qualified hedge, reasonable expectations or reasonableness, rebate 
amount, replacement proceeds, sale proceeds, variable yield issue and 
yield.
    (b) Certain general definitions.
    Common areas means portions of a facility that are equally available 
to all users of a facility on the same basis for uses that are 
incidental to the primary use of the facility. For example, hallways and 
elevators generally are treated as common areas if they are used by the 
different lessees of a facility in connection with the primary use of 
that facility.
    Consistently applied means applied uniformly to account for proceeds 
and other amounts.
    Deliberate action is defined in Sec.  1.141-2(d)(3).
    Discrete portion means a portion of a facility that consists of any 
separate and discrete portion of a facility to which use is limited, 
other than common areas. A floor of a building and a portion of a 
building separated by walls, partitions, or other physical barriers are 
examples of a discrete portion.
    Disposition is defined in Sec.  1.141-12(c)(1).
    Disposition proceeds is defined in Sec.  1.141-12(c)(1).
    Essential governmental function is defined in Sec.  1.141-
5(d)(4)(ii).
    Financed means constructed, reconstructed, or acquired with proceeds 
of an issue.
    Governmental bond has the same meaning as in Sec.  1.150-1(b), 
except that, for purposes of Sec.  1.141-13, governmental bond is 
defined in Sec.  1.141-13(b)(2)(iv).
    Governmental person means a state or local governmental unit as 
defined in Sec.  1.103-1 or any instrumentality thereof. It does not 
include the United States or any agency or instrumentality thereof.
    Hazardous waste remediation bonds is defined in Sec.  1.141-4(f)(1).
    Measurement period is defined in Sec.  1.141-3(g)(2).
    Nongovernmental person means a person other than a governmental 
person.
    Output facility means electric and gas generation, transmission, 
distribution, and related facilities, and water collection, storage, and 
distribution facilities.
    Private business tests means the private business use test and the 
private security or payment test of section 141(b).
    Proceeds means the sale proceeds of an issue (other than those sale 
proceeds used to retire bonds of the issue that are not deposited in a 
reasonably required reserve or replacement fund). Proceeds also include 
any investment proceeds from investments that accrue during the project 
period (net of rebate amounts attributable to the project period). 
Disposition proceeds of an issue are treated as proceeds to the extent 
provided in Sec.  1.141-12. The Commissioner may treat any replaced 
amounts as proceeds.
    Project period means the period beginning on the issue date and 
ending on the date that the project is placed in service. In the case of 
a multipurpose issue, the issuer may elect to treat the project period 
for the entire issue as ending on either the expiration of the temporary 
period described in Sec.  1.148-2(e)(2) or the end of the fifth bond 
year after the issue date.
    Public utility property means public utility property as defined in 
section 168(i)(10).
    Qualified bond means a qualified bond as defined in section 141(e).
    Renewal option means a provision under which either party has a 
legally enforceable right to renew the contract. Thus, for example, a 
provision under which a contract is automatically renewed for 1-year 
periods absent cancellation by either party is not a renewal option 
(even if it is expected to be renewed).
    Replaced amounts means replacement proceeds other than amounts that 
are treated as replacement proceeds solely because they are sinking 
funds or pledged funds.
    Weighted average maturity is determined under section 147(b).
    Weighted average reasonably expected economic life is determined 
under section 147(b). The reasonably expected economic life of property 
may be determined by reference to the class life of the property under 
section 168.
    (c) Elections. Elections must be made in writing on or before the 
issue date

[[Page 12]]

and retained as part of the bond documents, and, once made, may not be 
revoked without the permission of the Commissioner.
    (d) Related parties. Except as otherwise provided, all related 
parties are treated as one person and any reference to ``person'' 
includes any related party.
    (e) Partnerships. A partnership (as defined in section 7701(a)(2)) 
is treated as an aggregate of its partners, rather than as an entity.

[T.D. 8712, 62 FR 2284, Jan. 16, 1997, as amended by T.D. 9234, 70 FR 
75032, Dec. 19, 2005; T.D. 9741, 80 FR 65643, Oct. 27, 2015; T.D. 9777, 
81 FR 46592, July 18, 2016]



Sec.  1.141-2  Private activity bond tests.

    (a) Overview. Interest on a private activity bond is not excludable 
from gross income under section 103(a) unless the bond is a qualified 
bond. The purpose of the private activity bond tests of section 141 is 
to limit the volume of tax-exempt bonds that finance the activities of 
nongovernmental persons, without regard to whether a financing actually 
transfers benefits of tax-exempt financing to a nongovernmental person. 
The private activity bond tests serve to identify arrangements that have 
the potential to transfer the benefits of tax-exempt financing, as well 
as arrangements that actually transfer these benefits. The regulations 
under section 141 may not be applied in a manner that is inconsistent 
with these purposes.
    (b) Scope. Sections 1.141-0 through 1.141-16 apply generally for 
purposes of the private activity bond limitations under section 141.
    (c) General definition of private activity bond. Under section 141, 
bonds are private activity bonds if they meet either the private 
business use test and private security or payment test of section 141(b) 
or the private loan financing test of section 141(c). The private 
business use and private security or payment tests are described in 
Sec. Sec.  1.141-3 and 1.141-4. The private loan financing test is 
described in Sec.  1.141-5.
    (d) Reasonable expectations and deliberate actions--(1) In general. 
An issue is an issue of private activity bonds if the issuer reasonably 
expects, as of the issue date, that the issue will meet either the 
private business tests or the private loan financing test. An issue is 
also an issue of private activity bonds if the issuer takes a deliberate 
action, subsequent to the issue date, that causes the conditions of 
either the private business tests or the private loan financing test to 
be met.
    (2) Reasonable expectations test--(i) In general. In general, the 
reasonable expectations test must take into account reasonable 
expectations about events and actions over the entire stated term of an 
issue.
    (ii) Special rule for issues with mandatory redemption provisions. 
An action that is reasonably expected, as of the issue date, to occur 
after the issue date and to cause either the private business tests or 
the private loan financing test to be met may be disregarded for 
purposes of those tests if--
    (A) The issuer reasonably expects, as of the issue date, that the 
financed property will be used for a governmental purpose for a 
substantial period before the action;
    (B) The issuer is required to redeem all nonqualifying bonds 
(regardless of the amount of disposition proceeds actually received) 
within 6 months of the date of the action;
    (C) The issuer does not enter into any arrangement with a 
nongovernmental person, as of the issue date, with respect to that 
specific action; and
    (D) The mandatory redemption of bonds meets all of the conditions 
for remedial action under Sec.  1.141-12(a).
    (3) Deliberate action defined--(i) In general. Except as otherwise 
provided in this paragraph (d)(3), a deliberate action is any action 
taken by the issuer that is within its control. An intent to violate the 
requirements of section 141 is not necessary for an action to be 
deliberate.
    (ii) Safe harbor exceptions. An action is not treated as a 
deliberate action if--
    (A) It would be treated as an involuntary or compulsory conversion 
under section 1033; or
    (B) It is taken in response to a regulatory directive made by the 
federal government. See Sec.  1.141-7(g)(4).
    (4) Special rule for dispositions of personal property in the 
ordinary course of an established governmental program--(i) In general. 
Dispositions of personal

[[Page 13]]

property in the ordinary course of an established governmental program 
are not treated as deliberate actions if--
    (A) The weighted average maturity of the bonds financing that 
personal property is not greater than 120 percent of the reasonably 
expected actual use of that property for governmental purposes;
    (B) The issuer reasonably expects on the issue date that the fair 
market value of that property on the date of disposition will be not 
greater than 25 percent of its cost; and
    (C) The property is no longer suitable for its governmental purposes 
on the date of disposition.
    (ii) Reasonable expectations test. The reasonable expectation that a 
disposition described in paragraph (d)(4)(i) of this section may occur 
in the ordinary course while the bonds are outstanding will not cause 
the issue to meet the private activity bond tests if the issuer is 
required to deposit amounts received from the disposition in a 
commingled fund with substantial tax or other governmental revenues and 
the issuer reasonably expects to spend the amounts on governmental 
programs within 6 months from the date of commingling.
    (iii) Separate issue treatment. An issuer may treat the bonds 
properly allocable to the personal property eligible for this exception 
as a separate issue under Sec.  1.150-1(c)(3).
    (5) Special rule for general obligation bond programs that finance a 
large number of separate purposes. The determination of whether bonds of 
an issue are private activity bonds may be based solely on the issuer's 
reasonable expectations as of the issue date if all of the requirements 
of paragraphs (d)(5)(i) through (vii) of this section are met.
    (i) The issue is an issue of general obligation bonds of a general 
purpose governmental unit that finances at least 25 separate purposes 
(as defined in Sec.  1.150-1(c)(3)) and does not predominantly finance 
fewer than 4 separate purposes.
    (ii) The issuer has adopted a fund method of accounting for its 
general governmental purposes that makes tracing the bond proceeds to 
specific expenditures unreasonably burdensome.
    (iii) The issuer reasonably expects on the issue date to allocate 
all of the net proceeds of the issue to capital expenditures within 6 
months of the issue date and adopts reasonable procedures to verify that 
net proceeds are in fact so expended. A program to randomly spot check 
that 10 percent of the net proceeds were so expended generally is a 
reasonable verification procedure for this purpose.
    (iv) The issuer reasonably expects on the issue date to expend all 
of the net proceeds of the issue before expending proceeds of a 
subsequent issue of similar general obligation bonds.
    (v) The issuer reasonably expects on the issue date that it will not 
make any loans to nongovernmental persons with the proceeds of the 
issue.
    (vi) The issuer reasonably expects on the issue date that the 
capital expenditures that it could make during the 6-month period 
beginning on the issue date with the net proceeds of the issue that 
would not meet the private business tests are not less than 125 percent 
of the capital expenditures to be financed with the net proceeds of the 
issue.
    (vii) The issuer reasonably expects on the issue date that the 
weighted average maturity of the issue is not greater than 120 percent 
of the weighted average reasonably expected economic life of the capital 
expenditures financed with the issue. To determine reasonably expected 
economic life for this purpose an issuer may use reasonable estimates 
based on the type of expenditures made from a fund.
    (e) When a deliberate action occurs. A deliberate action occurs on 
the date the issuer enters into a binding contract with a 
nongovernmental person for use of the financed property that is not 
subject to any material contingencies.
    (f) Certain remedial actions. See Sec.  1.141-12 for certain 
remedial actions that prevent a deliberate action with respect to 
property financed by an issue from causing that issue to meet the 
private business use test or the private loan financing test.
    (g) Examples. The following examples illustrate the application of 
this section:


[[Page 14]]


    Example 1 Involuntary action. City B issues bonds to finance the 
purchase of land. On the issue date, B reasonably expects that it will 
be the sole user of the land for the entire term of the bonds. 
Subsequently, the federal government acquires the land in a condemnation 
action. B sets aside the condemnation proceeds to pay debt service on 
the bonds but does not redeem them on their first call date. The bonds 
are not private activity bonds because B has not taken a deliberate 
action after the issue date. See, however, Sec.  1.141-14(b), Example 2.
    Example 2 Reasonable expectations test--involuntary action. The 
facts are the same as in Example 1, except that, on the issue date, B 
reasonably expects that the federal government will acquire the land in 
a condemnation action during the term of the bonds. On the issue date, 
the present value of the amount that B reasonably expects to receive 
from the federal government is greater than 10 percent of the present 
value of the debt service on the bonds. The terms of the bonds do not 
require that the bonds be redeemed within 6 months of the acquisition by 
the federal government. The bonds are private activity bonds because the 
issuer expects as of the issue date that the private business tests will 
be met.
    Example 3 Reasonable expectations test--mandatory redemption. City C 
issues bonds to rehabilitate an existing hospital that it currently 
owns. On the issue date of the bonds, C reasonably expects that the 
hospital will be used for a governmental purpose for a substantial 
period. On the issue date, C also plans to construct a new hospital, but 
the placed in service date of that new hospital is uncertain. C 
reasonably expects that, when the new hospital is placed in service, it 
will sell or lease the rehabilitated hospital to a private hospital 
corporation. The bond documents require that the bonds must be redeemed 
within 6 months of the sale or lease of the rehabilitated hospital 
(regardless of the amount actually received from the sale). The bonds 
meet the reasonable expectations requirement of the private activity 
bond tests if the mandatory redemption of bonds meets all of the 
conditions for a remedial action under Sec.  1.141-12(a).
    Example 4 Dispositions in the ordinary course of an established 
governmental program. City D issues bonds with a weighted average 
maturity of 6 years for the acquisition of police cars. D reasonably 
expects on the issue date that the police cars will be used solely by 
its police department, except that, in the ordinary course of its police 
operations, D sells its police cars to a taxicab corporation after 5 
years of use because they are no longer suitable for police use. 
Further, D reasonably expects that the value of the police cars when 
they are no longer suitable for police use will be no more than 25 
percent of cost. D subsequently sells 20 percent of the police cars 
after only 3 years of actual use. At that time, D deposits the proceeds 
from the sale of the police cars in a commingled fund with substantial 
tax revenues and reasonably expects to spend the proceeds on 
governmental programs within 6 months of the date of deposit. D does not 
trace the actual use of these commingled amounts. The sale of the police 
cars does not cause the private activity bond tests to be met because 
the requirements of paragraph (d)(4) of this section are met.

[T.D. 8712, 62 FR 2284, Jan. 16, 1997, as amended by T.D. 8757, 63 FR 
3260, Jan. 22, 1998; T.D. 9016, 67 FR 59759, Sept. 23, 2002]



Sec.  1.141-3  Definition of private business use.

    (a) General rule--(1) In general. The private business use test 
relates to the use of the proceeds of an issue. The 10 percent private 
business use test of section 141(b)(1) is met if more than 10 percent of 
the proceeds of an issue is used in a trade or business of a 
nongovernmental person. For this purpose, the use of financed property 
is treated as the direct use of proceeds. Any activity carried on by a 
person other than a natural person is treated as a trade or business. 
Unless the context or a provision clearly requires otherwise, this 
section also applies to the private business use test under sections 
141(b)(3) (unrelated or disproportionate use), 141(b)(4) ($15 million 
limitation for certain output facilities), and 141(b)(5) (the 
coordination with the volume cap where the nonqualified amount exceeds 
$15 million).
    (2) Indirect use. In determining whether an issue meets the private 
business use test, it is necessary to look to both the indirect and 
direct uses of proceeds. For example, a facility is treated as being 
used for a private business use if it is leased to a nongovernmental 
person and subleased to a governmental person or if it is leased to a 
governmental person and then subleased to a nongovernmental person, 
provided that in each case the nongovernmental person's use is in a 
trade or business. Similarly, the issuer's use of the proceeds to engage 
in a series of financing transactions for property to be used by 
nongovernmental persons in their trades or businesses may cause the 
private business

[[Page 15]]

use test to be met. In addition, proceeds are treated as used in the 
trade or business of a nongovernmental person if a nongovernmental 
person, as a result of a single transaction or a series of related 
transactions, uses property acquired with the proceeds of an issue.
    (3) Aggregation of private business use. The use of proceeds by all 
nongovernmental persons is aggregated to determine whether the private 
business use test is met.
    (b) Types of private business use arrangements--(1) In general. Both 
actual and beneficial use by a nongovernmental person may be treated as 
private business use. In most cases, the private business use test is 
met only if a nongovernmental person has special legal entitlements to 
use the financed property under an arrangement with the issuer. In 
general, a nongovernmental person is treated as a private business user 
of proceeds and financed property as a result of ownership; actual or 
beneficial use of property pursuant to a lease, or a management or 
incentive payment contract; or certain other arrangements such as a take 
or pay or other output-type contract.
    (2) Ownership. Except as provided in paragraph (d)(1) or (d)(2) of 
this section, ownership by a nongovernmental person of financed property 
is private business use of that property. For this purpose, ownership 
refers to ownership for federal income tax purposes.
    (3) Leases. Except as provided in paragraph (d) of this section, the 
lease of financed property to a nongovernmental person is private 
business use of that property. For this purpose, any arrangement that is 
properly characterized as a lease for federal income tax purposes is 
treated as a lease. In determining whether a management contract is 
properly characterized as a lease, it is necessary to consider all of 
the facts and circumstances, including the following factors--
    (i) The degree of control over the property that is exercised by a 
nongovernmental person; and
    (ii) Whether a nongovernmental person bears risk of loss of the 
financed property.
    (4) Management contracts--(i) Facts and circumstances test. Except 
as provided in paragraph (d) of this section, a management contract 
(within the meaning of paragraph (b)(4)(ii) of this section) with 
respect to financed property may result in private business use of that 
property, based on all of the facts and circumstances. A management 
contract with respect to financed property generally results in private 
business use of that property if the contract provides for compensation 
for services rendered with compensation based, in whole or in part, on a 
share of net profits from the operation of the facility.
    (ii) Management contract defined. For purposes of this section, a 
management contract is a management, service, or incentive payment 
contract between a governmental person and a service provider under 
which the service provider provides services involving all, a portion 
of, or any function of, a facility. For example, a contract for the 
provision of management services for an entire hospital, a contract for 
management services for a specific department of a hospital, and an 
incentive payment contract for physician services to patients of a 
hospital are each treated as a management contract.
    (iii) Arrangements generally not treated as management contracts. 
The arrangements described in paragraphs (b)(4)(iii)(A) through (D) of 
this section generally are not treated as management contracts that give 
rise to private business use.
    (A) Contracts for services that are solely incidental to the primary 
governmental function or functions of a financed facility (for example, 
contracts for janitorial, office equipment repair, hospital billing, or 
similar services).
    (B) The mere granting of admitting privileges by a hospital to a 
doctor, even if those privileges are conditioned on the provision of de 
minimis services, if those privileges are available to all qualified 
physicians in the area, consistent with the size and nature of its 
facilities.
    (C) A contract to provide for the operation of a facility or system 
of facilities that consists predominantly of public utility property, if 
the only compensation is the reimbursement of

[[Page 16]]

actual and direct expenses of the service provider and reasonable 
administrative overhead expenses of the service provider.
    (D) A contract to provide for services, if the only compensation is 
the reimbursement of the service provider for actual and direct expenses 
paid by the service provider to unrelated parties.
    (iv) Management contracts that are properly treated as other types 
of private business use. A management contract with respect to financed 
property results in private business use of that property if the service 
provider is treated as the lessee or owner of financed property for 
federal income tax purposes, unless an exception under paragraph (d) of 
this section applies to the arrangement.
    (5) Output contracts. See Sec.  1.141-7 for special rules for 
contracts for the purchase of output of output facilities.
    (6) Research agreements--(i) Facts and circumstances test. Except as 
provided in paragraph (d) of this section, an agreement by a 
nongovernmental person to sponsor research performed by a governmental 
person may result in private business use of the property used for the 
research, based on all of the facts and circumstances.
    (ii) Research agreements that are properly treated as other types of 
private business use. A research agreement with respect to financed 
property results in private business use of that property if the sponsor 
is treated as the lessee or owner of financed property for federal 
income tax purposes, unless an exception under paragraph (d) of this 
section applies to the arrangement.
    (7) Other actual or beneficial use--(i) In general. Any other 
arrangement that conveys special legal entitlements for beneficial use 
of bond proceeds or of financed property that are comparable to special 
legal entitlements described in paragraphs (b)(2), (3), (4), (5), or (6) 
of this section results in private business use. For example, an 
arrangement that conveys priority rights to the use or capacity of a 
facility generally results in private business use.
    (ii) Special rule for facilities not used by the general public. In 
the case of financed property that is not available for use by the 
general public (within the meaning of paragraph (c) of this section), 
private business use may be established solely on the basis of a special 
economic benefit to one or more nongovernmental persons, even if those 
nongovernmental persons have no special legal entitlements to use of the 
property. In determining whether special economic benefit gives rise to 
private business use it is necessary to consider all of the facts and 
circumstances, including one or more of the following factors--
    (A) Whether the financed property is functionally related or 
physically proximate to property used in the trade or business of a 
nongovernmental person;
    (B) Whether only a small number of nongovernmental persons receive 
the special economic benefit; and
    (C) Whether the cost of the financed property is treated as 
depreciable by any nongovernmental person.
    (c) Exception for general public use--(1) In general. Use as a 
member of the general public (general public use) is not private 
business use. Use of financed property by nongovernmental persons in 
their trades or businesses is treated as general public use only if the 
property is intended to be available and in fact is reasonably available 
for use on the same basis by natural persons not engaged in a trade or 
business.
    (2) Use on the same basis. In general, use under an arrangement that 
conveys priority rights or other preferential benefits is not use on the 
same basis as the general public. Arrangements providing for use that is 
available to the general public at no charge or on the basis of rates 
that are generally applicable and uniformly applied do not convey 
priority rights or other preferential benefits. For this purpose, rates 
may be treated as generally applicable and uniformly applied even if--
    (i) Different rates apply to different classes of users, such as 
volume purchasers, if the differences in rates are customary and 
reasonable; or
    (ii) A specially negotiated rate arrangement is entered into, but 
only if the user is prohibited by federal law from paying the generally 
applicable rates, and the rates established are as comparable as 
reasonably possible to the generally applicable rates.

[[Page 17]]

    (3) Long-term arrangements not treated as general public use. An 
arrangement is not treated as general public use if the term of the use 
under the arrangement, including all renewal options, is greater than 
200 days. For this purpose, a right of first refusal to renew use under 
the arrangement is not treated as a renewal option if--
    (i) The compensation for the use under the arrangement is 
redetermined at generally applicable, fair market value rates that are 
in effect at the time of renewal; and
    (ii) The use of the financed property under the same or similar 
arrangements is predominantly by natural persons who are not engaged in 
a trade or business.
    (4) Relation to other use. Use of financed property by the general 
public does not prevent the proceeds from being used for a private 
business use because of other use under this section.
    (d) Other exceptions--(1) Agents. Use of proceeds by nongovernmental 
persons solely in their capacity as agents of a governmental person is 
not private business use. For example, use by a nongovernmental person 
that issues obligations on behalf of a governmental person is not 
private business use to the extent the nongovernmental person's use of 
proceeds is in its capacity as an agent of the governmental person.
    (2) Use incidental to financing arrangements. Use by a 
nongovernmental person that is solely incidental to a financing 
arrangement is not private business use. A use is solely incidental to a 
financing arrangement only if the nongovernmental person has no 
substantial rights to use bond proceeds or financed property other than 
as an agent of the bondholders. For example, a nongovernmental person 
that acts solely as an owner of title in a sale and leaseback financing 
transaction with a city generally is not a private business user of the 
property leased to the city, provided that the nongovernmental person 
has assigned all of its rights to use the leased facility to the trustee 
for the bondholders upon default by the city. Similarly, bond trustees, 
servicers, and guarantors are generally not treated as private business 
users.
    (3) Exceptions for arrangements other than arrangements resulting in 
ownership of financed property by a nongovernmental person--(i) 
Arrangements not available for use on the same basis by natural persons 
not engaged in a trade or business. Use by a nongovernmental person 
pursuant to an arrangement, other than an arrangement resulting in 
ownership of financed property by a nongovernmental person, is not 
private business use if--
    (A) The term of the use under the arrangement, including all renewal 
options, is not longer than 100 days;
    (B) The arrangement would be treated as general public use, except 
that it is not available for use on the same basis by natural persons 
not engaged in a trade or business because generally applicable and 
uniformly applied rates are not reasonably available to natural persons 
not engaged in a trade or business; and
    (C) The property is not financed for a principal purpose of 
providing that property for use by that nongovernmental person.
    (ii) Negotiated arm's-length arrangements. Use by a nongovernmental 
person pursuant to an arrangement, other than an arrangement resulting 
in ownership of financed property by a nongovernmental person, is not 
private business use if--
    (A) The term of the use under the arrangement, including all renewal 
options, is not longer than 50 days;
    (B) The arrangement is a negotiated arm's-length arrangement, and 
compensation under the arrangement is at fair market value; and
    (C) The property is not financed for a principal purpose of 
providing that property for use by that nongovernmental person.
    (4) Temporary use by developers. Use during an initial development 
period by a developer of an improvement that carries out an essential 
governmental function is not private business use if the issuer and the 
developer reasonably expect on the issue date to proceed with all 
reasonable speed to develop the improvement and property benefited by 
that improvement and to transfer the improvement to a governmental 
person, and if the improvement is in fact transferred to a governmental

[[Page 18]]

person promptly after the property benefited by the improvement is 
developed.
    (5) Incidental use--(i) General rule. Incidental uses of a financed 
facility are disregarded, to the extent that those uses do not exceed 
2.5 percent of the proceeds of the issue used to finance the facility. A 
use of a facility by a nongovernmental person is incidental if--
    (A) Except for vending machines, pay telephones, kiosks, and similar 
uses, the use does not involve the transfer to the nongovernmental 
person of possession and control of space that is separated from other 
areas of the facility by walls, partitions, or other physical barriers, 
such as a night gate affixed to a structural component of a building (a 
nonpossessory use);
    (B) The nonpossessory use is not functionally related to any other 
use of the facility by the same person (other than a different 
nonpossessory use); and
    (C) All nonpossessory uses of the facility do not, in the aggregate, 
involve the use of more than 2.5 percent of the facility.
    (ii) Illustrations. Incidental uses may include pay telephones, 
vending machines, advertising displays, and use for television cameras, 
but incidental uses may not include output purchases.
    (6) Qualified improvements. Proceeds that provide a governmentally 
owned improvement to a governmentally owned building (including its 
structural components and land functionally related and subordinate to 
the building) are not used for a private business use if--
    (i) The building was placed in service more than 1 year before the 
construction or acquisition of the improvement is begun;
    (ii) The improvement is not an enlargement of the building or an 
improvement of interior space occupied exclusively for any private 
business use;
    (iii) No portion of the improved building or any payments in respect 
of the improved building are taken into account under section 
141(b)(2)(A) (the private security test); and
    (iv) No more than 15 percent of the improved building is used for a 
private business use.
    (e) Special rule for tax assessment bonds. In the case of a tax 
assessment bond that satisfies the requirements of Sec.  1.141-5(d), the 
loan (or deemed loan) of the proceeds to the borrower paying the 
assessment is disregarded in determining whether the private business 
use test is met. However, the use of the loan proceeds is not 
disregarded in determining whether the private business use test is met.
    (f) Examples. The following examples illustrate the application of 
paragraphs (a) through (e) of this section. In each example, assume that 
the arrangements described are the only arrangements with 
nongovernmental persons for use of the financed property.

    Example 1. Nongovernmental ownership. State A issues 20-year bonds 
to purchase land and equip and construct a factory. A then enters into 
an arrangement with Corporation X to sell the factory to X on an 
installment basis while the bonds are outstanding. The issue meets the 
private business use test because a nongovernmental person owns the 
financed facility. See also Sec.  1.141-2 (relating to the private 
activity bond tests), and Sec.  1.141-5 (relating to the private loan 
financing test).
    Example 2 Lease to a nongovernmental person. (i) The facts are the 
same as in Example 1, except that A enters into an arrangement with X to 
lease the factory to X for 3 years rather than to sell it to X. The 
lease payments will be made annually and will be based on the tax-exempt 
interest rate on the bonds. The issue meets the private business use 
test because a nongovernmental person leases the financed facility. See 
also Sec.  1.141-14 (relating to anti-abuse rules).
    (ii) The facts are the same as in Example 2(i), except that the 
annual payments made by X will equal fair rental value of the facility 
and exceed the amount necessary to pay debt service on the bonds for the 
3 years of the lease. The issue meets the private business use test 
because a nongovernmental person leases the financed facility and the 
test does not require that the benefits of tax-exempt financing be 
passed through to the nongovernmental person.
    Example 3. Management contract in substance a lease. City L issues 
30-year bonds to finance the construction of a city hospital. L enters 
into a 15-year contract with M, a nongovernmental person that operates a 
health maintenance organization relating to the treatment of M's members 
at L's hospital. The

[[Page 19]]

contract provides for reasonable fixed compensation to M for services 
rendered with no compensation based, in whole or in part, on a share of 
net profits from the operation of the hospital. However, the contract 
also provides that 30 percent of the capacity of the hospital will be 
exclusively available to M's members and M will bear the risk of loss of 
that portion of the capacity of the hospital so that, under all of the 
facts and circumstances, the contract is properly characterized as a 
lease for federal income tax purposes. The issue meets the private 
business use test because a nongovernmental person leases the financed 
facility.
    Example 4. Ownership of title in substance a leasehold interest. 
Nonprofit Corporation R issues bonds on behalf of City P to finance the 
construction of a hospital. R will own legal title to the hospital. In 
addition, R will operate the hospital, but R is not treated as an agent 
of P in its capacity as operator of the hospital. P has certain rights 
to the hospital that establish that it is properly treated as the owner 
of the property for federal income tax purposes. P does not have rights, 
however, to directly control operation of the hospital while R owns 
legal title to it and operates it. The issue meets the private business 
use test because the arrangement provides a nongovernmental person an 
interest in the financed facility that is comparable to a leasehold 
interest. See paragraphs (a)(2) and (b)(7)(i) of this section.
    Example 5. Rights to control use of property treated as private 
business use--parking lot. Corporation C and City D enter into a plan to 
finance the construction of a parking lot adjacent to C's factory. 
Pursuant to the plan, C conveys the site for the parking lot to D for a 
nominal amount, subject to a covenant running with the land that the 
property be used only for a parking lot. In addition, D agrees that C 
will have the right to approve rates charged by D for use of the parking 
lot. D issues bonds to finance construction of the parking lot on the 
site. The parking lot will be available for use by the general public on 
the basis of rates that are generally applicable and uniformly applied. 
The issue meets the private business use test because a nongovernmental 
person has special legal entitlements for beneficial use of the financed 
facility that are comparable to an ownership interest. See paragraph 
(b)(7)(i) of this section.
    Example 6. Other actual or beneficial use--hydroelectric 
enhancements. J, a political subdivision, owns and operates a 
hydroelectric generation plant and related facilities. Pursuant to a 
take or pay contract, J sells 15 percent of the output of the plant to 
Corporation K, an investor-owned utility. K is treated as a private 
business user of the plant. Under the license issued to J for operation 
of the plant, J is required by federal regulations to construct and 
operate various facilities for the preservation of fish and for public 
recreation. J issues its obligations to finance the fish preservation 
and public recreation facilities. K has no special legal entitlements 
for beneficial use of the financed facilities. The fish preservation 
facilities are functionally related to the operation of the plant. The 
recreation facilities are available to natural persons on a short-term 
basis according to generally applicable and uniformly applied rates. 
Under paragraph (c) of this section, the recreation facilities are 
treated as used by the general public. Under paragraph (b)(7) of this 
section, K's use is not treated as private business use of the 
recreation facilities because K has no special legal entitlements for 
beneficial use of the recreation facilities. The fish preservation 
facilities are not of a type reasonably available for use on the same 
basis by natural persons not engaged in a trade or business. Under all 
of the facts and circumstances (including the functional relationship of 
the fish preservation facilities to property used in K's trade or 
business) under paragraph (b)(7)(ii) of this section, K derives a 
special economic benefit from the fish preservation facilities. 
Therefore, K's private business use may be established solely on the 
basis of that special economic benefit, and K's use of the fish 
preservation facilities is treated as private business use.
    Example 7. Other actual or beneficial use--pollution control 
facilities. City B issues obligations to finance construction of a 
specialized pollution control facility on land that it owns adjacent to 
a factory owned by Corporation N. B will own and operate the pollution 
control facility, and N will have no special legal entitlements to use 
the facility. B, however, reasonably expects that N will be the only 
user of the facility. The facility will not be reasonably available for 
use on the same basis by natural persons not engaged in a trade or 
business. Under paragraph (b)(7)(ii) of this section, because under all 
of the facts and circumstances the facility is functionally related and 
is physically proximate to property used in N's trade or business, N 
derives a special economic benefit from the facility. Therefore, N's 
private business use may be established solely on the basis of that 
special economic benefit, and N's use is treated as private business use 
of the facility. See paragraph (b)(7)(ii) of this section.
    Example 8. General public use--airport runway. (i) City I issues 
bonds and uses all of the proceeds to finance construction of a runway 
at a new city-owned airport. The runway will be available for take-off 
and landing by any operator of an aircraft desiring to use the airport, 
including general aviation operators who are natural persons not engaged 
in a trade or business. It is reasonably expected that most of the 
actual use of the runway will be by private air carriers

[[Page 20]]

(both charter airlines and commercial airlines) in connection with their 
use of the airport terminals leased by those carriers. These leases for 
the use of terminal space provide no priority rights or other 
preferential benefits to the air carriers for use of the runway. 
Moreover, under the leases the lease payments are determined without 
taking into account the revenues generated by runway landing fees (that 
is, the lease payments are not determined on a ``residual'' basis). 
Although the lessee air carriers receive a special economic benefit from 
the use of the runway, this economic benefit is not sufficient to cause 
the air carriers to be private business users, because the runway is 
available for general public use. The issue does not meet the private 
business use test. See paragraphs (b)(7)(ii) and (c) of this section.
    (ii) The facts are the same as in Example 8(i), except that the 
runway will be available for use only by private air carriers. The use 
by these private air carriers is not for general public use, because the 
runway is not reasonably available for use on the same basis by natural 
persons not engaged in a trade or business. Depending on all of the 
facts and circumstances, including whether there are only a small number 
of lessee private air carriers, the issue may meet the private business 
use test solely because the private air carriers receive a special 
economic benefit from the runway. See paragraph (b)(7)(ii) of this 
section.
    (iii) The facts are the same as in Example 8(i), except that the 
lease payments under the leases with the private air carriers are 
determined on a residual basis by taking into account the net revenues 
generated by runway landing fees. These leases cause the private 
business use test to be met with respect to the runway because they are 
arrangements that convey special legal entitlements to the financed 
facility to nongovernmental persons. See paragraph (b)(7)(i) of this 
section.
    Example 9. General public use--airport parking garage. City S issues 
bonds and uses all of the proceeds to finance construction of a city-
owned parking garage at the city-owned airport. S reasonably expects 
that more than 10 percent of the actual use of the parking garage will 
be by employees of private air carriers (both charter airlines and 
commercial airlines) in connection with their use of the airport 
terminals leased by those carriers. The air carriers' use of the parking 
garage, however, will be on the same basis as passengers and other 
members of the general public using the airport. The leases for the use 
of the terminal space provide no priority rights to the air carriers for 
use of the parking garage, and the lease payments are determined without 
taking into account the revenues generated by the parking garage. 
Although the lessee air carriers receive a special economic benefit from 
the use of the parking garage, this economic benefit is not sufficient 
to cause the air carriers to be private business users, because the 
parking garage is available for general public use. The issue does not 
meet the private business use test. See paragraphs (b)(7)(ii) and (c) of 
this section.
    Example 10. Long-term arrangements not treated as general public 
use--insurance fund. Authority T deposits all of the proceeds of its 
bonds in its insurance fund and invests all of those proceeds in tax-
exempt bonds. The insurance fund provides insurance to a large number of 
businesses and natural persons not engaged in a trade or business. Each 
participant receives insurance for a term of 1 year. The use by the 
participants, other than participants that are natural persons not 
engaged in a trade or business, is treated as private business use of 
the proceeds of the bonds because the participants have special legal 
entitlements to the use of bond proceeds, even though the contractual 
rights are not necessarily properly characterized as ownership, 
leasehold, or similar interests listed in paragraph (b) of this section. 
Use of the bond proceeds is not treated as general public use because 
the term of the insurance is greater than 200 days. See paragraphs 
(b)(7)(i) and (c)(3) of this section.
    Example 11. General public use--port road. Highway Authority W uses 
all of the proceeds of its bonds to construct a 25-mile road to connect 
an industrial port owned by Corporation Y with existing roads owned and 
operated by W. Other than the port, the nearest residential or 
commercial development to the new road is 12 miles away. There is no 
reasonable expectation that development will occur in the area 
surrounding the new road. W and Y enter into no arrangement (either by 
contract or ordinance) that conveys special legal entitlements to Y for 
the use of the road. Use of the road will be available without 
restriction to all users, including natural persons who are not engaged 
in a trade or business. The issue does not meet the private business use 
test because the road is treated as used only by the general public.
    Example 12. General public use of governmentally owned hotel. State 
Q issues bonds to purchase land and construct a hotel for use by the 
general public (that is, tourists, visitors, and business travelers). 
The bond documents provide that Q will own and operate the project for 
the term of the bonds. Q will not enter into a lease or license with any 
user for use of rooms for a period longer than 200 days (although users 
may actually use rooms for consecutive periods in excess of 200 days). 
Use of the hotel by hotel guests who are travelling in connection with 
trades or businesses of nongovernmental persons is not a private 
business use of the hotel by these persons because the hotel is intended

[[Page 21]]

to be available and in fact is reasonably available for use on the same 
basis by natural persons not engaged in a trade or business. See 
paragraph (c)(1) of this section.
    Example 13. General public use with rights of first refusal. 
Authority V uses all of the proceeds of its bonds to construct a parking 
garage. At least 90 percent of the spaces in the garage will be 
available to the general public on a monthly first-come, first-served 
basis. V reasonably expects that the spaces will be predominantly leased 
to natural persons not engaged in a trade or business who have priority 
rights to renew their spaces at then current fair market value rates. 
More than 10 percent of the spaces will be leased to nongovernmental 
persons acting in a trade or business. These leases are not treated as 
arrangements with a term of use greater than 200 days. The rights to 
renew are not treated as renewal options because the compensation for 
the spaces is redetermined at generally applicable, fair market value 
rates that will be in effect at the time of renewal and the use of the 
spaces under similar arrangements is predominantly by natural persons 
who are not engaged in a trade or business. The issue does not meet the 
private business use test because at least 90 percent of the use of the 
parking garage is general public use. See paragraph (c)(3) of this 
section.
    Example 14. General public use with a specially negotiated rate 
agreement with agency of United States. G, a sewage collection and 
treatment district, operates facilities that were financed with its 
bonds. F, an agency of the United States, has a base located within G. 
Approximately 20 percent of G's facilities are used to treat sewage 
produced by F under a specially negotiated rate agreement. Under the 
specially negotiated rate agreement, G uses its best efforts to charge F 
as closely as possible the same amount for its use of G's services as 
its other customers pay for the same amount of services, although those 
other customers pay for services based on standard district charges and 
tax levies. F is prohibited by federal law from paying for the services 
based on those standard district charges and tax levies. The use of G's 
facilities by F is on the same basis as the general public. See 
paragraph (c)(2)(ii) of this section.
    Example 15. Arrangements not available for use by natural persons 
not engaged in a trade or business--federal use of prisons. Authority E 
uses all of the proceeds of its bonds to construct a prison. E contracts 
with federal agency F to house federal prisoners on a space-available, 
first-come, first-served basis, pursuant to which F will be charged 
approximately the same amount for each prisoner as other persons that 
enter into similar transfer agreements. It is reasonably expected that 
other persons will enter into similar agreements. The term of the use 
under the contract is not longer than 100 days, and F has no right to 
renew, although E reasonably expects to renew the contract indefinitely. 
The prison is not financed for a principal purpose of providing the 
prison for use by F. It is reasonably expected that during the term of 
the bonds, more than 10 percent of the prisoners at the prison will be 
federal prisoners. F's use of the facility is not general public use 
because this type of use (leasing space for prisoners) is not available 
for use on the same basis by natural persons not engaged in a trade or 
business. The issue does not meet the private business use test, 
however, because the leases satisfy the exception of paragraph (d)(3)(i) 
of this section.
    Example 16. Negotiated arm's-length arrangements--auditorium 
reserved in advance. (i) City Z issues obligations to finance the 
construction of a municipal auditorium that it will own and operate. The 
use of the auditorium will be open to anyone who wishes to use it for a 
short period of time on a rate-scale basis. Z reasonably expects that 
the auditorium will be used by schools, church groups, sororities, and 
numerous commercial organizations. Corporation H, a nongovernmental 
person, enters into an arm's-length arrangement with Z to use the 
auditorium for 1 week for each year for a 10-year period (a total of 70 
days), pursuant to which H will be charged a specific price reflecting 
fair market value. On the date the contract is entered into, Z has not 
established generally applicable rates for future years. Even though the 
auditorium is not financed for a principal purpose of providing use of 
the auditorium to H, H is not treated as using the auditorium as a 
member of the general public because its use is not on the same basis as 
the general public. Because the term of H's use of the auditorium is 
longer than 50 days, the arrangement does not meet the exception under 
paragraph (d)(3)(ii) of this section.
    (ii) The facts are the same as in Example 16(i), except that H will 
enter into an arm's-length arrangement with Z to use the auditorium for 
1 week for each year for a 4-year period (a total of 28 days), pursuant 
to which H will be charged a specific price reflecting fair market 
value. H is not treated as a private business user of the auditorium 
because its contract satisfies the exception of paragraph (d)(3)(ii) of 
this section for negotiated arm's-length arrangements.

    (g) Measurement of private business use--(1) In general. In general, 
the private business use of proceeds is allocated to property under 
Sec.  1.141-6. The amount of private business use of that property is 
determined according to the average percentage of private business use 
of that property during the measurement period.

[[Page 22]]

    (2) Measurement period--(i) General rule. Except as provided in this 
paragraph (g)(2), the measurement period of property financed by an 
issue begins on the later of the issue date of that issue or the date 
the property is placed in service and ends on the earlier of the last 
date of the reasonably expected economic life of the property or the 
latest maturity date of any bond of the issue financing the property 
(determined without regard to any optional redemption dates). In 
general, the period of reasonably expected economic life of the property 
for this purpose is based on reasonable expectations as of the issue 
date.
    (ii) Special rule for refundings of short-term obligations. For an 
issue of short-term obligations that the issuer reasonably expects to 
refund with a long-term financing (such as bond anticipation notes), the 
measurement period is based on the latest maturity date of any bond of 
the last refunding issue with respect to the financed property 
(determined without regard to any optional redemption dates).
    (iii) Special rule for reasonably expected mandatory redemptions. If 
an issuer reasonably expects on the issue date that an action will occur 
during the term of the bonds to cause either the private business tests 
or the private loan financing test to be met and is required to redeem 
bonds to meet the reasonable expectations test of Sec.  1.141-2(d)(2), 
the measurement period ends on the reasonably expected redemption date.
    (iv) Special rule for ownership by a nongovernmental person. The 
amount of private business use resulting from ownership by a 
nongovernmental person is the greatest percentage of private business 
use in any 1-year period.
    (v) Special rule for partners that are nongovernmental persons--(A) 
The amount of private business use by a nongovernmental person resulting 
from the use of property by a partnership in which that nongovernmental 
person is a partner is that nongovernmental partner's share of the 
amount of use of the property by the partnership. For this purpose, 
except as otherwise provided in paragraph (g)(2)(v)(B) of this section, 
a nongovernmental partner's share of the partnership's use of the 
property is the nongovernmental partner's greatest percentage share 
under section 704(b) of any partnership item of income, gain, loss, 
deduction, or credit attributable to the period that the partnership 
uses the property during the measurement period. For example, if a 
partnership has a nongovernmental partner and that partner's share of 
partnership items varies, with the greatest share being 25 percent, then 
that nongovernmental partner's share of the partnership's use of 
property is 25 percent.
    (B) An issuer may determine a nongovernmental partner's share of the 
partnership's use of the property under guidance published in the 
Internal Revenue Bulletin (see Sec.  601.601(d)(2)(ii)(b) of this 
chapter).
    (vi) Anti-abuse rule. If an issuer establishes the term of an issue 
for a period that is longer than is reasonably necessary for the 
governmental purposes of the issue for a principal purpose of increasing 
the permitted amount of private business use, the Commissioner may 
determine the amount of private business use according to the greatest 
percentage of private business use in any 1-year period.
    (3) Determining average percentage of private business use. The 
average percentage of private business use is the average of the 
percentages of private business use during the 1-year periods within the 
measurement period. Appropriate adjustments must be made for beginning 
and ending periods of less than 1 year.
    (4) Determining the average amount of private business use for a 1-
year period--(i) In general. The percentage of private business use of 
property for any 1-year period is the average private business use 
during that year. This average is determined by comparing the amount of 
private business use during the year to the total amount of private 
business use and use that is not private business use (government use) 
during that year. Paragraphs (g)(4) (ii) through (v) of this section 
apply to determine the average amount of private business use for a 1-
year period.
    (ii) Uses at different times. For a facility in which actual 
government use and private business use occur at different times (for 
example, different

[[Page 23]]

days), the average amount of private business use generally is based on 
the amount of time that the facility is used for private business use as 
a percentage of the total time for all actual use. In determining the 
total amount of actual use, periods during which the facility is not in 
use are disregarded.
    (iii) Simultaneous use. In general, for a facility in which 
government use and private business use occur simultaneously, the entire 
facility is treated as having private business use. For example, a 
governmentally owned facility that is leased or managed by a 
nongovernmental person in a manner that results in private business use 
is treated as entirely used for a private business use. If, however, 
there is also private business use and actual government use on the same 
basis, the average amount of private business use may be determined on a 
reasonable basis that properly reflects the proportionate benefit to be 
derived by the various users of the facility (for example, reasonably 
expected fair market value of use). For example, the average amount of 
private business use of a garage with unassigned spaces that is used for 
government use and private business use is generally based on the number 
of spaces used for private business use as a percentage of the total 
number of spaces.
    (iv) Discrete portion. For purposes of this paragraph (g), 
measurement of the use of proceeds allocated to a discrete portion of a 
facility is determined by treating that discrete portion as a separate 
facility.
    (v) Relationship to fair market value. For purposes of paragraphs 
(g)(4) (ii) through (iv) of this section, if private business use is 
reasonably expected as of the issue date to have a significantly greater 
fair market value than government use, the average amount of private 
business use must be determined according to the relative reasonably 
expected fair market values of use rather than another measure, such as 
average time of use. This determination of relative fair market value 
may be made as of the date the property is acquired or placed in service 
if making this determination as of the issue date is not reasonably 
possible (for example, if the financed property is not identified on the 
issue date). In general, the relative reasonably expected fair market 
value for a period must be determined by taking into account the amount 
of reasonably expected payments for private business use for the period 
in a manner that properly reflects the proportionate benefit to be 
derived from the private business use.
    (5) Common areas. The amount of private business use of common areas 
within a facility is based on a reasonable method that properly reflects 
the proportionate benefit to be derived by the users of the facility. 
For example, in general, a method that is based on the average amount of 
private business use of the remainder of the entire facility reflects 
proportionate benefit.
    (6) Allocation of neutral costs. Proceeds that are used to pay costs 
of issuance, invested in a reserve or replacement fund, or paid as fees 
for a qualified guarantee or a qualified hedge must be allocated ratably 
among the other purposes for which the proceeds are used.
    (7) Commencement of measurement of private business use. Generally, 
private business use commences on the first date on which there is a 
right to actual use by the nongovernmental person. However, if an issuer 
enters into an arrangement for private business use a substantial period 
before the right to actual private business use commences and the 
arrangement transfers ownership or is an arrangement for other long-term 
use (such as a lease for a significant portion of the remaining economic 
life of financed property), private business use commences on the date 
the arrangement is entered into, even if the right to actual use 
commences after the measurement period. For this purpose, 10 percent of 
the measurement period is generally treated as a substantial period.
    (8) Examples. The following examples illustrate the application of 
this paragraph (g):

    Example 1. Research facility. University U, a state owned and 
operated university, owns and operates a research facility. U proposes 
to finance general improvements to the facility with the proceeds of an 
issue of bonds. U enters into sponsored research agreements with 
nongovernmental persons that result in private business use because the 
sponsors will own title to any patents resulting from the research. The 
governmental research

[[Page 24]]

conducted by U and the research U conducts for the sponsors take place 
simultaneously in all laboratories within the research facility. All 
laboratory equipment is available continuously for use by workers who 
perform both types of research. Because it is not possible to predict 
which research projects will be successful, it is not reasonably 
practicable to estimate the relative revenues expected to result from 
the governmental and nongovernmental research. U contributed 90 percent 
of the cost of the facility and the nongovernmental persons contributed 
10 percent of the cost. Under this section, the nongovernmental persons 
are using the facility for a private business use on the same basis as 
the government use of the facility. The portions of the costs 
contributed by the various users of the facility provide a reasonable 
basis that properly reflects the proportionate benefit to be derived by 
the users of the facility. The nongovernmental persons are treated as 
using 10 percent of the proceeds of the issue.
    Example 2. Stadium. (i) City L issues bonds and uses all of the 
proceeds to construct a stadium. L enters into a long-term contract with 
a professional sports team T under which T will use the stadium 20 times 
during each year. These uses will occur on nights and weekends. L 
reasonably expects that the stadium will be used more than 180 other 
times each year, none of which will give rise to private business use. 
This expectation is based on a feasibility study and historical use of 
the old stadium that is being replaced by the new stadium. There is no 
significant difference in the value of T's uses when compared to the 
other uses of the stadium, taking into account the payments that T is 
reasonably expected to make for its use. Assuming no other private 
business use, the issue does not meet the private business use test 
because not more than 10 percent of the use of the facility is for a 
private business use.
    (ii) The facts are the same as in Example 2(i), except that L 
reasonably expects that the stadium will be used not more than 60 other 
times each year, none of which will give rise to private business use. 
The issue meets the private business use test because 25 percent of the 
proceeds are used for a private business use.
    Example 3. Airport terminal areas treated as common areas. City N 
issues bonds to finance the construction of an airport terminal. Eighty 
percent of the leasable space of the terminal will be leased to private 
air carriers. The remaining 20 percent of the leasable space will be 
used for the term of the bonds by N for its administrative purposes. The 
common areas of the terminal, including waiting areas, lobbies, and 
hallways are treated as 80 percent used by the air carriers for purposes 
of the private business use test.

[T.D. 8712, 62 FR 2286, Jan. 16, 1997, as amended by T.D. 8967, 66 FR 
58062, Nov. 20, 2001; T.D. 9741, 80 FR 65643, Oct. 27, 2015]



Sec.  1.141-4  Private security or payment test.

    (a) General rule--(1) Private security or payment. The private 
security or payment test relates to the nature of the security for, and 
the source of, the payment of debt service on an issue. The private 
payment portion of the test takes into account the payment of the debt 
service on the issue that is directly or indirectly to be derived from 
payments (whether or not to the issuer or any related party) in respect 
of property, or borrowed money, used or to be used for a private 
business use. The private security portion of the test takes into 
account the payment of the debt service on the issue that is directly or 
indirectly secured by any interest in property used or to be used for a 
private business use or payments in respect of property used or to be 
used for a private business use. For additional rules for output 
facilities, see Sec.  1.141-7.
    (2) Aggregation of private payments and security. For purposes of 
the private security or payment test, payments taken into account as 
private payments and payments or property taken into account as private 
security are aggregated. However, the same payments are not taken into 
account as both private security and private payments.
    (3) Underlying arrangement. The security for, and payment of debt 
service on, an issue is determined from both the terms of the bond 
documents and on the basis of any underlying arrangement. An underlying 
arrangement may result from separate agreements between the parties or 
may be determined on the basis of all of the facts and circumstances 
surrounding the issuance of the bonds. For example, if the payment of 
debt service on an issue is secured by both a pledge of the full faith 
and credit of a state or local governmental unit and any interest in 
property used or to be used in a private business use, the issue meets 
the private security or payment test.

[[Page 25]]

    (b) Measurement of private payments and security--(1) Scope. This 
paragraph (b) contains rules that apply to both private security and 
private payments.
    (2) Present value measurement--(i) Use of present value. In 
determining whether an issue meets the private security or payment test, 
the present value of the payments or property taken into account is 
compared to the present value of the debt service to be paid over the 
term of the issue.
    (ii) Debt service--(A) Debt service paid from proceeds. Debt service 
does not include any amount paid or to be paid from sale proceeds or 
investment proceeds. For example, debt service does not include payments 
of capitalized interest funded with proceeds.
    (B) Adjustments to debt service. Debt service is adjusted to take 
into account payments and receipts that adjust the yield on an issue for 
purposes of section 148(f). For example, debt service includes fees paid 
for qualified guarantees under Sec.  1.148-4(f) and is adjusted to take 
into account payments and receipts on qualified hedges under Sec.  
1.148-4(h).
    (iii) Computation of present value--(A) In general. Present values 
are determined by using the yield on the issue as the discount rate and 
by discounting all amounts to the issue date. See, however, Sec.  1.141-
13 for special rules for refunding bonds.
    (B) Fixed yield issues. For a fixed yield issue, yield is determined 
on the issue date and is not adjusted to take into account subsequent 
events.
    (C) Variable yield issues. The yield on a variable yield issue is 
determined over the term of the issue. To determine the reasonably 
expected yield as of any date, the issuer may assume that the future 
interest rate on a variable yield bond will be the then-current interest 
rate on the bonds determined under the formula prescribed in the bond 
documents. A deliberate action requires a recomputation of the yield on 
the variable yield issue to determine the present value of payments 
under that arrangement. In that case, the issuer must use the yield 
determined as of the date of the deliberate action for purposes of 
determining the present value of payments under the arrangement causing 
the deliberate action. See paragraph (g) of this section, Example 3.
    (iv) Application to private security. For purposes of determining 
the present value of debt service that is secured by property, the 
property is valued at fair market value as of the first date on which 
the property secures bonds of the issue.
    (c) Private payments--(1) In general. This paragraph (c) contains 
rules that apply to private payments.
    (2) Payments taken into account--(i) Payments for use--(A) In 
general. Both direct and indirect payments made by any nongovernmental 
person that is treated as using proceeds of the issue are taken into 
account as private payments to the extent allocable to the proceeds used 
by that person. Payments are taken into account as private payments only 
to the extent that they are made for the period of time that proceeds 
are used for a private business use. Payments for a use of proceeds 
include payments (whether or not to the issuer) in respect of property 
financed (directly or indirectly) with those proceeds, even if not made 
by a private business user. Payments are not made in respect of financed 
property if those payments are directly allocable to other property 
being directly used by the person making the payment and those payments 
represent fair market value compensation for that other use. See 
paragraph (g) of this section, Example 4 and Example 5. See also 
paragraph (c)(3) of this section for rules relating to allocation of 
payments to the source or sources of funding of property.
    (B) Payments not to exceed use. Payments with respect to proceeds 
that are used for a private business use are not taken into account to 
the extent that the present value of those payments exceeds the present 
value of debt service on those proceeds. Payments need not be directly 
derived from a private business user, however, to be taken into account. 
Thus, if 7 percent of the proceeds of an issue is used by a person over 
the measurement period, payments with respect to the property financed 
with those proceeds are taken into account as private payments only to 
the extent that the present value of those payments does not exceed the

[[Page 26]]

present value of 7 percent of the debt service on the issue.
    (C) Payments for operating expenses. Payments by a person for a use 
of proceeds do not include the portion of any payment that is properly 
allocable to the payment of ordinary and necessary expenses (as defined 
under section 162) directly attributable to the operation and 
maintenance of the financed property used by that person. For this 
purpose, general overhead and administrative expenses are not directly 
attributable to those operations and maintenance. For example, if an 
issuer receives $5,000 rent during the year for use of space in a 
financed facility and during the year pays $500 for ordinary and 
necessary expenses properly allocable to the operation and maintenance 
of that space and $400 for general overhead and general administrative 
expenses properly allocable to that space, $500 of the $5,000 received 
would not be considered a payment for the use of the proceeds allocable 
to that space (regardless of the manner in which that $500 is actually 
used).
    (ii) Refinanced debt service. Payments of debt service on an issue 
to be made from proceeds of a refunding issue are taken into account as 
private payments in the same proportion that the present value of the 
payments taken into account as private payments for the refunding issue 
bears to the present value of the debt service to be paid on the 
refunding issue. For example, if all the debt service on a note is paid 
with proceeds of a refunding issue, the note meets the private security 
or payment test if (and to the same extent that) the refunding issue 
meets the private security or payment test. This paragraph (c)(2)(ii) 
does not apply to payments that arise from deliberate actions that occur 
more than 3 years after the retirement of the prior issue that are not 
reasonably expected on the issue date of the refunding issue. For 
purposes of this paragraph (c)(2)(ii), whether an issue is a refunding 
issue is determined without regard to Sec.  1.150-1(d)(2)(i) (relating 
to certain payments of interest).
    (3) Allocation of payments--(i) In general. Private payments for the 
use of property are allocated to the source or different sources of 
funding of property. The allocation to the source or different sources 
of funding is based on all of the facts and circumstances, including 
whether an allocation is consistent with the purposes of section 141. In 
general, a private payment for the use of property is allocated to a 
source of funding based upon the nexus between the payment and both the 
financed property and the source of funding. For this purpose, different 
sources of funding may include different tax-exempt issues, taxable 
issues, and amounts that are not derived from a borrowing, such as 
revenues of an issuer (equity).
    (ii) Payments for use of discrete property. Payments for the use of 
a discrete facility (or a discrete portion of a facility) are allocated 
to the source or different sources of funding of that discrete property.
    (iii) Allocations among two or more sources of funding. In general, 
except as provided in paragraphs (c)(3)(iv) and (v) of this section, if 
a payment is made for the use of property financed with two or more 
sources of funding (for example, equity and a tax-exempt issue), that 
payment must be allocated to those sources of funding in a manner that 
reasonably corresponds to the relative amounts of those sources of 
funding that are expended on that property. If an issuer has not 
retained records of amounts expended on the property (for example, 
records of costs of a building that was built 30 years before the 
allocation), an issuer may use reasonable estimates of those 
expenditures. For this purpose, costs of issuance and other similar 
neutral costs are allocated ratably among expenditures in the same 
manner as in Sec.  1.141-3(g)(6). A payment for the use of property may 
be allocated to two or more issues that finance property according to 
the relative amounts of debt service (both paid and accrued) on the 
issues during the annual period for which the payment is made, if that 
allocation reasonably reflects the economic substance of the 
arrangement. In general, allocations of payments according to relative 
debt service reasonably reflect the economic substance of the 
arrangement if the maturity of the bonds reasonably corresponds to the 
reasonably expected economic life of the property

[[Page 27]]

and debt service payments on the bonds are approximately level from year 
to year.
    (iv) Payments made under an arrangement entered into in connection 
with issuance of bonds. A private payment for the use of property made 
under an arrangement that is entered into in connection with the 
issuance of the issue that finances that property generally is allocated 
to that issue. Whether an arrangement is entered into in connection with 
the issuance of an issue is determined on the basis of all of the facts 
and circumstances. An arrangement is ordinarily treated as entered into 
in connection with the issuance of an issue if--
    (A) The issuer enters into the arrangement during the 3-year period 
beginning 18 months before the issue date; and
    (B) The amount of payments reflects all or a portion of debt service 
on the issue.
    (v) Allocations to equity. A private payment for the use of property 
may be allocated to equity before payments are allocated to an issue 
only if--
    (A) Not later than 60 days after the date of the expenditure of 
those amounts, the issuer adopts an official intent (in a manner 
comparable to Sec.  1.150-2(e)) indicating that the issuer reasonably 
expects to be repaid for the expenditure from a specific arrangement; 
and
    (B) The private payment is made not later than 18 months after the 
later of the date the expenditure is made or the date the project is 
placed in service.
    (d) Private security--(1) In general. This paragraph (d) contains 
rules that relate to private security.
    (2) Security taken into account. The property that is the security 
for, or the source of, the payment of debt service on an issue need not 
be property financed with proceeds. For example, unimproved land or 
investment securities used, directly or indirectly, in a private 
business use that secures an issue provides private security. Private 
security (other than financed property and private payments) for an 
issue is taken into account under section 141(b), however, only to the 
extent it is provided, directly or indirectly, by a user of proceeds of 
the issue.
    (3) Pledge of unexpended proceeds. Proceeds qualifying for an 
initial temporary period under Sec.  1.148-2(e)(2) or (3) or deposited 
in a reasonably required reserve or replacement fund (as defined in 
Sec.  1.148-2(f)(2)(i)) are not taken into account under this paragraph 
(d) before the date on which those amounts are either expended or loaned 
by the issuer to an unrelated party.
    (4) Secured by any interest in property or payments. Property used 
or to be used for a private business use and payments in respect of that 
property are treated as private security if any interest in that 
property or payments secures the payment of debt service on the bonds. 
For this purpose, the phrase any interest in is to be interpreted 
broadly and includes, for example, any right, claim, title, or legal 
share in property or payments.
    (5) Payments in respect of property. The payments taken into account 
as private security are payments in respect of property used or to be 
used for a private business use. Except as otherwise provided in this 
paragraph (d)(5) and paragraph (d)(6) of this section, the rules in 
paragraphs (c)(2)(i)(A) and (B) and (c)(2)(ii) of this section apply to 
determine the amount of payments treated as payments in respect of 
property used or to be used for a private business use. Thus, payments 
made by members of the general public for use of a facility used for a 
private business use (for example, a facility that is the subject of a 
management contract that results in private business use) are taken into 
account as private security to the extent that they are made for the 
period of time that property is used by a private business user.
    (6) Allocation of security among issues. In general, property or 
payments from the disposition of that property that are taken into 
account as private security are allocated to each issue secured by the 
property or payments on a reasonable basis that takes into account 
bondholders' rights to the payments or property upon default.
    (e) Generally applicable taxes--(1) General rule. For purposes of 
the private security or payment test, generally applicable taxes are not 
taken into account (that is, are not payments from a nongovernmental 
person and are not

[[Page 28]]

payments in respect of property used for a private business use).
    (2) Definition of generally applicable taxes. A generally applicable 
tax is an enforced contribution exacted pursuant to legislative 
authority in the exercise of the taxing power that is imposed and 
collected for the purpose of raising revenue to be used for governmental 
or public purposes. A generally applicable tax must have a uniform tax 
rate that is applied to all persons of the same classification in the 
appropriate jurisdiction and a generally applicable manner of 
determination and collection.
    (3) Special charges. A special charge (as defined in this paragraph 
(e)(3)) is not a generally applicable tax. For this purpose, a special 
charge means a payment for a special privilege granted or regulatory 
function (for example, a license fee), a service rendered (for example, 
a sanitation services fee), a use of property (for example, rent), or a 
payment in the nature of a special assessment to finance capital 
improvements that is imposed on a limited class of persons based on 
benefits received from the capital improvements financed with the 
assessment. Thus, a special assessment to finance infrastructure 
improvements in a new industrial park (such as sidewalks, streets, 
streetlights, and utility infrastructure improvements) that is imposed 
on a limited class of persons composed of property owners within the 
industrial park who benefit from those improvements is a special charge. 
By contrast, an otherwise qualified generally applicable tax (such as a 
generally applicable ad valorem tax on all real property within a 
governmental taxing jurisdiction) or an eligible PILOT under paragraph 
(e)(5) of this section that is based on such a generally applicable tax 
is not treated as a special charge merely because the taxes or PILOTs 
received are used for governmental or public purposes in a manner which 
benefits particular property owners.
    (4) Manner of determination and collection--(i) In general. A tax 
does not have a generally applicable manner of determination and 
collection to the extent that one or more taxpayers make any 
impermissible agreements relating to payment of those taxes. An 
impermissible agreement relating to the payment of a tax is taken into 
account whether or not it is reasonably expected to result in any 
payments that would not otherwise have been made. For example, if an 
issuer uses proceeds to make a grant to a taxpayer to improve property, 
agreements that impose reasonable conditions on the use of the grant do 
not cause a tax on that property to fail to be a generally applicable 
tax. If an agreement by a taxpayer causes the tax imposed on that 
taxpayer not to be treated as a generally applicable tax, the entire tax 
paid by that taxpayer is treated as a special charge, unless the 
agreement is limited to a specific portion of the tax.
    (ii) Impermissible agreements. The following are examples of 
agreements that cause a tax to fail to have a generally applicable 
manner of determination and collection: an agreement to be personally 
liable on a tax that does not generally impose personal liability, to 
provide additional credit support such as a third party guarantee, or to 
pay unanticipated shortfalls; an agreement regarding the minimum market 
value of property subject to property tax; and an agreement not to 
challenge or seek deferral of the tax.
    (iii) Permissible agreements. The following are examples of 
agreements that do not cause a tax to fail to have a generally 
applicable manner of determination and collection: an agreement to use a 
grant for specified purposes (whether or not that agreement is secured); 
a representation regarding the expected value of the property following 
the improvement; an agreement to insure the property and, if damaged, to 
restore the property; a right of a grantor to rescind the grant if 
property taxes are not paid; and an agreement to reduce or limit the 
amount of taxes collected to further a bona fide governmental purpose. 
For example, an agreement to abate taxes to encourage a property owner 
to rehabilitate property in a distressed area is a permissible 
agreement.
    (5) Payments in lieu of taxes. A tax equivalency payment or other 
payment in lieu of a tax (``PILOT'') is treated as a generally 
applicable tax if it meets the requirements of paragraphs (e)(5)(i) 
through (iv) of this section--

[[Page 29]]

    (i) Maximum amount limited by underlying generally applicable tax. 
The PILOT is not greater than the amount imposed by a statute for a 
generally applicable tax in each year.
    (ii) Commensurate with a generally applicable tax. The PILOT is 
commensurate with the amount imposed by a statute for a generally 
applicable tax in each year under the commensurate standard set forth in 
this paragraph (e)(5)(ii). For this purpose, except as otherwise 
provided in this paragraph (e)(5)(ii), a PILOT is commensurate with a 
generally applicable tax only if it is equal to a fixed percentage of 
the generally applicable tax that would otherwise apply in each year or 
it reflects a fixed adjustment to the generally applicable tax that 
would otherwise apply in each year. A PILOT based on a property tax does 
not fail to be commensurate with the property tax as a result of changes 
in the level of the percentage of or adjustment to that property tax for 
a reasonable phase-in period ending when the subject property is placed 
in service (as defined in Sec.  1.150-2(c)). A PILOT based on a property 
tax must take into account the current assessed value of the property 
for property tax purposes for each year in which the PILOT is paid and 
that assessed value must be determined in the same manner and with the 
same frequency as property subject to the property tax. A PILOT is not 
commensurate with a generally applicable tax, however, if the PILOT is 
set at a fixed dollar amount (for example, fixed debt service on a bond 
issue) that cannot vary with changes in the level of the generally 
applicable tax on which it is based.
    (iii) Use of PILOTs for governmental or public purposes. The PILOT 
is to be used for governmental or public purposes for which the 
generally applicable tax on which it is based may be used.
    (iv) No special charges. The PILOT is not a special charge under 
paragraph (e)(3) of this section.
    (f) Certain waste remediation bonds--(1) Scope. This paragraph (f) 
applies to bonds issued to finance hazardous waste clean-up activities 
on privately owned land (hazardous waste remediation bonds).
    (2) Persons that are not private users. Payments from 
nongovernmental persons who are not (other than coincidentally) either 
users of the site being remediated or persons potentially responsible 
for disposing of hazardous waste on that site are not taken into account 
as private security. This paragraph (f)(2) applies to payments that 
secure (directly or indirectly) the payment of principal of, or interest 
on, the bonds under the terms of the bonds. This paragraph (f)(2) 
applies only if the payments are made pursuant to either a generally 
applicable state or local taxing statute or a state or local statute 
that regulates or restrains activities on an industry-wide basis of 
persons who are engaged in generating or handling hazardous waste, or in 
refining, producing, or transporting petroleum, provided that those 
payments do not represent, in substance, payment for the use of 
proceeds. For this purpose, a state or local statute that imposes 
payments that have substantially the same character as those described 
in Chapter 38 of the Code are treated as generally applicable taxes.
    (3) Persons that are private users. If payments from nongovernmental 
persons who are either users of the site being remediated or persons 
potentially responsible for disposing of hazardous waste on that site do 
not secure (directly or indirectly) the payment of principal of, or 
interest on, the bonds under the terms of the bonds, the payments are 
not taken into account as private payments. This paragraph (f)(3) 
applies only if at the time the bonds are issued the payments from those 
nongovernmental persons are not material to the security for the bonds. 
For this purpose, payments are not material to the security for the 
bonds if--
    (i) The payments are not required for the payment of debt service on 
the bonds;
    (ii) The amount and timing of the payments are not structured or 
designed to reflect the payment of debt service on the bonds;
    (iii) The receipt or the amount of the payment is uncertain (for 
example, as of the issue date, no final judgment has been entered into 
against the nongovernmental person);

[[Page 30]]

    (iv) The payments from those nongovernmental persons, when and if 
received, are used either to redeem bonds of the issuer or to pay for 
costs of any hazardous waste remediation project; and
    (v) In the case when a judgment (but not a final judgment) has been 
entered by the issue date against a nongovernmental person, there are, 
as of the issue date, costs of hazardous waste remediation other than 
those financed with the bonds that may be financed with the payments.
    (g) Examples. The following examples illustrate the application of 
this section:

    Example 1. Aggregation of payments. State B issues bonds with 
proceeds of $10 million. B uses $9.7 million of the proceeds to 
construct a 10-story office building. B uses the remaining $300,000 of 
proceeds to make a loan to Corporation Y. In addition, Corporation X 
leases 1 floor of the building for the term of the bonds. Under all of 
the facts and circumstances, it is reasonable to allocate 10 percent of 
the proceeds to that 1 floor. As a percentage of the present value of 
the debt service on the bonds, the present value of Y's loan repayments 
is 3 percent and the present value of X's lease payments is 8 percent. 
The bonds meet the private security or payment test because the private 
payments taken into account are more than 10 percent of the present 
value of the debt service on the bonds.
    Example 2. Indirect private payments. J, a political subdivision of 
a state, will issue several series of bonds from time to time and will 
use the proceeds to rehabilitate urban areas. Under all of the facts and 
circumstances, the private business use test will be met with respect to 
each issue that will be used for the rehabilitation and construction of 
buildings that will be leased or sold to nongovernmental persons for use 
in their trades or businesses. Nongovernmental persons will make 
payments for these sales and leases. There is no limitation either on 
the number of issues or the aggregate amount of bonds that may be 
outstanding. No group of bondholders has any legal claim prior to any 
other bondholders or creditors with respect to specific revenues of J, 
and there is no arrangement whereby revenues from a particular project 
are paid into a trust or constructive trust, or sinking fund, or are 
otherwise segregated or restricted for the benefit of any group of 
bondholders. There is, however, an unconditional obligation by J to pay 
the principal of, and the interest on, each issue. Although not directly 
pledged under the terms of the bond documents, the leases and sales are 
underlying arrangements. The payments relating to these leases and sales 
are taken into account as private payments to determine whether each 
issue of bonds meets the private security or payment test.
    Example 3. Computation of payment in variable yield issues. (i) City 
M issues general obligation bonds with proceeds of $10 million to 
finance a 5-story office building. The bonds bear interest at a variable 
rate that is recomputed monthly according to an index that reflects 
current market yields. The yield that the interest index would produce 
on the issue date is 6 percent. M leases 1 floor of the office building 
to Corporation T, a nongovernmental person, for the term of the bonds. 
Under all of the facts and circumstances, T is treated as using more 
than 10 percent of the proceeds. Using the 6 percent yield as the 
discount rate, M reasonably expects on the issue date that the present 
value of lease payments to be made by T will be 8 percent of the present 
value of the total debt service on the bonds. After the issue date of 
the bonds, interest rates decline significantly, so that the yield on 
the bonds over their entire term is 4 percent. Using this actual 4 
percent yield as the discount rate, the present value of lease payments 
made by T is 12 percent of the present value of the actual total debt 
service on the bonds. The bonds are not private activity bonds because M 
reasonably expected on the issue date that the bonds would not meet the 
private security or payment test and because M did not take any 
subsequent deliberate action to meet the private security or payment 
test.
    (ii) The facts are the same as Example 3(i), except that 5 years 
after the issue date M leases a second floor to Corporation S, a 
nongovernmental person, under a long-term lease. Because M has taken a 
deliberate action, the present value of the lease payments must be 
computed. On the date this lease is entered into, M reasonably expects 
that the yield on the bonds over their entire term will be 5.5 percent, 
based on actual interest rates to date and the then-current rate on the 
variable yield bonds. M uses this 5.5 percent yield as the discount 
rate. Using this 5.5 percent yield as the discount rate, as a percentage 
of the present value of the debt service on the bonds, the present value 
of the lease payments made by S is 3 percent. The bonds are private 
activity bonds because the present value of the aggregate private 
payments is greater than 10 percent of the present value of debt 
service.
    Example 4. Payments not in respect of financed property. In order to 
further public safety, City Y issues tax assessment bonds the proceeds 
of which are used to move existing electric utility lines underground. 
Although the utility lines are owned by a nongovernmental utility 
company, that company is under no obligation to move the

[[Page 31]]

lines. The debt service on the bonds will be paid using assessments 
levied by City Y on the customers of the utility. Although the utility 
lines are privately owned and the utility customers make payments to the 
utility company for the use of those lines, the assessments are payments 
in respect of the cost of relocating the utility line. Thus, the 
assessment payments are not made in respect of property used for a 
private business use. Any direct or indirect payments to Y by the 
utility company for the undergrounding are, however, taken into account 
as private payments.
    Example 5. Payments from users of proceeds that are not private 
business users taken into account. City P issues general obligation 
bonds to finance the renovation of a hospital that it owns. The hospital 
is operated for P by D, a nongovernmental person, under a management 
contract that results in private business use under Sec.  1.141-3. P 
will use the revenues from the hospital (after the required payments to 
D and the payment of operation and maintenance expenses) to pay the debt 
service on the bonds. The bonds meet the private security or payment 
test because the revenues from the hospital are payments in respect of 
property used for a private business use.
    Example 6. Limitation of amount of payments to amount of private 
business use not determined annually. City Q issues bonds with a term of 
15 years and uses the proceeds to construct an office building. The debt 
service on the bonds is level throughout the 15-year term. Q enters into 
a 5-year lease with Corporation R under which R is treated as a user of 
11 percent of the proceeds. R will make lease payments equal to 20 
percent of the annual debt service on the bonds for each year of the 
lease. The present value of R's lease payments is equal to 12 percent of 
the present value of the debt service over the entire 15-year term of 
the bonds. If, however, the lease payments taken into account as private 
payments were limited to 11 percent of debt service paid in each year of 
the lease, the present value of these payments would be only 8 percent 
of the debt service on the bonds over the entire term of the bonds. The 
bonds meet the private security or payment test, because R's lease 
payments are taken into account as private payments in an amount not to 
exceed 11 percent of the debt service of the bonds.
    Example 7. Allocation of payments to funds not derived from a 
borrowing. City Z purchases property for $1,250,000 using $1,000,000 of 
proceeds of its tax increment bonds and $250,000 of other revenues that 
are in its redevelopment fund. Within 60 days of the date of purchase, Z 
declared its intent to sell the property pursuant to a redevelopment 
plan and to use that amount to reimburse its redevelopment fund. The 
bonds are secured only by the incremental property taxes attributable to 
the increase in value of the property from the planned redevelopment of 
the property. Within 18 months after the issue date, Z sells the 
financed property to Developer M for $250,000, which Z uses to reimburse 
the redevelopment fund. The property that M uses is financed both with 
the proceeds of the bonds and Z's redevelopment fund. The payments by M 
are properly allocable to the costs of property financed with the 
amounts in Z's redevelopment fund. See paragraphs (c)(3) (i) and (v) of 
this section.
    Example 8. Allocation of payments to different sources of funding--
improvements. In 1997, City L issues bonds with proceeds of $8 million 
to finance the acquisition of a building. In 2002, L spends $2 million 
of its general revenues to improve the heating system and roof of the 
building. At that time, L enters into a 10-year lease with Corporation M 
for the building providing for annual payments of $1 million to L. The 
lease payments are at fair market value, and the lease payments do not 
otherwise have a significant nexus to either the issue or to the 
expenditure of general revenues. Eighty percent of each lease payment is 
allocated to the issue and is taken into account under the private 
payment test because each lease payment is properly allocated to the 
sources of funding in a manner that reasonably corresponds to the 
relative amounts of the sources of funding that are expended on the 
building.
    Example 9. Security not provided by users of proceeds not taken into 
account. County W issues certificates of participation in a lease of a 
building that W owns and covenants to appropriate annual payments for 
the lease. A portion of each payment is specified as interest. More than 
10 percent of the building is used for private business use. None of the 
proceeds of the obligations are used with respect to the building. W 
uses the proceeds of the obligations to make a grant to Corporation Y 
for the construction of a factory that Y will own. Y makes no payments 
to W, directly or indirectly, for its use of proceeds, and Y has no 
relationship to the users of the leased building. If W defaults under 
the lease, the trustee for the holders of the certificates of 
participation has a limited right of repossession under which the 
trustee may not foreclose but may lease the property to a new tenant at 
fair market value. The obligations are secured by an interest in 
property used for a private business use. However, because the property 
is not provided by a private business user and is not financed property, 
the obligations do not meet the private security or payment test.
    Example 10. Allocation of payments among issues. University L, a 
political subdivision, issued three separate series of revenue bonds 
during 1989, 1991, and 1993 under the same bond resolution. L used the 
proceeds to construct facilities exclusively for its own use.

[[Page 32]]

Bonds issued under the resolution are equally and ratably secured and 
payable solely from the income derived by L from rates, fees, and 
charges imposed by L for the use of the facilities. The bonds issued in 
1989, 1991, and 1993 are not private activity bonds. In 1997, L issues 
another series of bonds under the resolution to finance additional 
facilities. L leases 20 percent of the new facilities for the term of 
the 1997 bonds to nongovernmental persons who will use the facilities in 
their trades or businesses. The present value of the lease payments from 
the nongovernmental users will equal 15 percent of the present value of 
the debt service on the 1997 bonds. L will commingle all of the revenues 
from all its bond-financed facilities in its revenue fund. The present 
value of the portion of the lease payments from nongovernmental lessees 
of the new facilities allocable to the 1997 bonds under paragraph (d) of 
this section is less than 10 percent of the present value of the debt 
service on the 1997 bonds because the bond documents provide that the 
bonds are equally and ratably secured. Accordingly, the 1997 bonds do 
not meet the private security test. The 1997 bonds meet the private 
payment test, however, because the private lease payments for the new 
facility are properly allocated to those bonds (that is, because none of 
the proceeds of the prior issues were used for the new facilities). See 
paragraph (c) of this section.
    Example 11. Generally applicable tax. (i) Authority N issues bonds 
to finance the construction of a stadium. Under a long-term lease, 
Corporation X, a professional sports team, will use more than 10 percent 
of the stadium. X will not, however, make any payments for this private 
business use. The security for the bonds will be a ticket tax imposed on 
each person purchasing a ticket for an event at the stadium. The portion 
of the ticket tax attributable to tickets purchased by persons attending 
X's events will, on a present value basis, exceed 10 percent of the 
present value of the debt service on N's bonds. The bonds meet the 
private security or payment test. The ticket tax is not a generally 
applicable tax and, to the extent that the tax receipts relate to X's 
events, the taxes are payments in respect of property used for a private 
business use.
    (ii) The facts are the same as Example 11(i), except that the ticket 
tax is imposed by N on tickets purchased for events at a number of large 
entertainment facilities within the N's jurisdiction (for example, other 
stadiums, arenas, and concert halls), some of which were not financed 
with tax-exempt bonds. The ticket tax is a generally applicable tax and 
therefore the revenues from this tax are not payments in respect of 
property used for a private business use. The receipt of the ticket tax 
does not cause the bonds to meet the private security or payment test.

[T.D. 8712, 62 FR 2291, Jan. 16, 1997, as amended by T.D. 9429, 73 FR 
63374, Oct. 24, 2008]



Sec.  1.141-5  Private loan financing test.

    (a) In general. Bonds of an issue are private activity bonds if more 
than the lesser of 5 percent or $5 million of the proceeds of the issue 
is to be used (directly or indirectly) to make or finance loans to 
persons other than governmental persons. Section 1.141-2(d) applies in 
determining whether the private loan financing test is met. In 
determining whether the proceeds of an issue are used to make or finance 
loans, indirect, as well as direct, use of the proceeds is taken into 
account.
    (b) Measurement of test. In determining whether the private loan 
financing test is met, the amount actually loaned to a nongovernmental 
person is not discounted to reflect the present value of the loan 
repayments.
    (c) Definition of private loan--(1) In general. Any transaction that 
is generally characterized as a loan for federal income tax purposes is 
a loan for purposes of this section. In addition, a loan may arise from 
the direct lending of bond proceeds or may arise from transactions in 
which indirect benefits that are the economic equivalent of a loan are 
conveyed. Thus, the determination of whether a loan is made depends on 
the substance of a transaction rather than its form. For example, a 
lease or other contractual arrangement (for example, a management 
contract or an output contract) may in substance constitute a loan if 
the arrangement transfers tax ownership of the facility to a 
nongovernmental person. Similarly, an output contract or a management 
contract with respect to a financed facility generally is not treated as 
a loan of proceeds unless the agreement in substance shifts significant 
burdens and benefits of ownership to the nongovernmental purchaser or 
manager of the facility.
    (2) Application only to purpose investments--(i) In general. A loan 
may be either a purpose investment or a nonpurpose investment. A loan 
that is a nonpurpose investment does not cause the private loan 
financing test to be met. For example, proceeds invested in

[[Page 33]]

loans, such as obligations of the United States, during a temporary 
period, as part of a reasonably required reserve or replacement fund, as 
part of a refunding escrow, or as part of a minor portion (as each of 
those terms are defined in Sec.  1.148-1 or Sec.  1.148-2) are generally 
not treated as loans under the private loan financing test.
    (ii) Certain prepayments treated as loans. Except as otherwise 
provided, a prepayment for property or services, including a prepayment 
for property or services that is made after the date that the contract 
to buy the property or services is entered into, is treated as a loan 
for purposes of the private loan financing test if a principal purpose 
for prepaying is to provide a benefit of tax-exempt financing to the 
seller. A prepayment is not treated as a loan for purposes of the 
private loan financing test if--
    (A) 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;
    (B) The prepayment is made within 90 days of the reasonably expected 
date of delivery to the issuer of all of the property or services for 
which the prepayment is made; or
    (C) The prepayment meets the requirements of Sec.  1.148-
1(e)(2)(iii)(A) or (B) (relating to certain prepayments to acquire a 
supply of natural gas or electricity).
    (iii) Customary prepayments. The determination of whether a 
prepayment satisfies paragraph (c)(2)(ii)(A) of this section is 
generally made based on all the facts and circumstances. In addition, a 
prepayment is deemed to satisfy paragraph (c)(2)(ii)(A) of this section 
if--
    (A) The prepayment is made for--
    (1) Maintenance, repair, or an extended warranty with respect to 
personal property (for example, automobiles or electronic equipment); or
    (2) Updates or maintenance or support services with respect to 
computer software; and
    (B) The same maintenance, repair, extended warranty, updates or 
maintenance or support services, as applicable, are regularly provided 
to nongovernmental persons on the same terms.
    (iv) Additional prepayments as permitted by the Commissioner. The 
Commissioner may, by published guidance, set forth additional 
circumstances in which a prepayment is not treated as a loan for 
purposes of the private loan financing test.
    (3) Grants--(i) In general. A grant of proceeds is not a loan. 
Whether a transaction may be treated as a grant or a loan depends on all 
of the facts and circumstances.
    (ii) Tax increment financing--(A) In general. Generally, a grant 
using proceeds of an issue that is secured by generally applicable taxes 
attributable to the improvements to be made with the grant is not 
treated as a loan, unless the grantee makes any impermissible agreements 
relating to the payment that results in the taxes imposed on that 
taxpayer not to be treated as generally applicable taxes under Sec.  
1.141-4(e).
    (B) Amount of loan. If a grant is treated as a loan under this 
paragraph (c)(3), the entire grant is treated as a loan unless the 
impermissible agreement is limited to a specific portion of the tax. For 
this purpose, an arrangement with each unrelated grantee is treated as a 
separate grant.
    (4) Hazardous waste remediation bonds. In the case of an issue of 
hazardous waste remediation bonds, payments from nongovernmental persons 
that are either users of the site being remediated or persons 
potentially responsible for disposing of hazardous waste on that site do 
not establish that the transaction is a loan for purposes of this 
section. This paragraph (c)(4) applies only if those payments do not 
secure the payment of principal of, or interest on, the bonds (directly 
or indirectly), under the terms of the bonds and those payments are not 
taken into account under the private payment test pursuant to Sec.  
1.141-4(f)(3).
    (d) Tax assessment loan exception--(1) General rule. For purposes of 
this section, a tax assessment loan that satisfies the requirements of 
this paragraph (d) is not a loan for purposes of the private loan 
financing test.
    (2) Tax assessment loan defined. A tax assessment loan is a loan 
that arises

[[Page 34]]

when a governmental person permits or requires property owners to 
finance any governmental tax or assessment of general application for an 
essential governmental function that satisfies each of the requirements 
of paragraphs (d) (3) through (5) of this section.
    (3) Mandatory tax or other assessment. The tax or assessment must be 
an enforced contribution that is imposed and collected for the purpose 
of raising revenue to be used for a specific purpose (that is, to defray 
the capital cost of an improvement). Taxes and assessments do not 
include fees for services. The tax or assessment must be imposed 
pursuant to a state law of general application that can be applied 
equally to natural persons not acting in a trade or business and persons 
acting in a trade or business. For this purpose, taxes and assessments 
that are imposed subject to protest procedures are treated as enforced 
contributions.
    (4) Specific essential governmental function--(i) In general. A 
mandatory tax or assessment that gives rise to a tax assessment loan 
must be imposed for one or more specific, essential governmental 
functions.
    (ii) Essential governmental functions. For purposes of paragraph (d) 
of this section, improvements to utilities and systems that are owned by 
a governmental person and that are available for use by the general 
public (such as sidewalks, streets and street-lights; electric, 
telephone, and cable television systems; sewage treatment and disposal 
systems; and municipal water facilities) serve essential governmental 
functions. For other types of facilities, the extent to which the 
service provided by the facility is customarily performed (and financed 
with governmental bonds) by governments with general taxing powers is a 
primary factor in determining whether the facility serves an essential 
governmental function. For example, parks that are owned by a 
governmental person and that are available for use by the general public 
serve an essential governmental function. Except as otherwise provided 
in this paragraph (d)(4)(ii), commercial or industrial facilities and 
improvements to property owned by a nongovernmental person do not serve 
an essential governmental

function. Permitting installment payments of property taxes or other 
taxes is not an essential governmental function.
    (5) Equal basis requirement--(i) In general. Owners of both business 
and nonbusiness property benefiting from the financed improvements must 
be eligible, or required, to make deferred payments of the tax or 
assessment giving rise to a tax assessment loan on an equal basis (the 
equal basis requirement). A tax or assessment does not satisfy the equal 
basis requirement if the terms for payment of the tax or assessment are 
not the same for all taxed or assessed persons. For example, the equal 
basis requirement is not met if certain property owners are permitted to 
pay the tax or assessment over a period of years while others must pay 
the entire tax or assessment immediately or if only certain property 
owners are required to prepay the tax or assessment when the property is 
sold.
    (ii) General rule for guarantees. A guarantee of debt service on 
bonds, or of taxes or assessments, by a person that is treated as a 
borrower of bond proceeds violates the equal basis requirement if it is 
reasonable to expect on the date the guarantee is entered into that 
payments will be made under the guarantee.
    (6) Coordination with private business tests. See Sec. Sec.  1.141-3 
and 1.141-4 for rules for determining whether tax assessment loans cause 
the bonds financing those loans to be private activity bonds under the 
private business use and the private security or payment tests.
    (e) Examples. The following examples illustrate the application of 
this section:

    Example 1. Turnkey contract not treated as a loan. State agency Z 
and federal agency H will each contribute to rehabilitate a project 
owned by Z. H can only provide its funds through a contribution to Z to 
be used to acquire the rehabilitated project on a turnkey basis from an 
approved developer. Under H's turnkey program, the developer must own 
the project while it is rehabilitated. Z issues its notes to provide 
funds for construction. A portion of the notes will be retired using the 
H contribution, and the balance of the notes will be retired through the 
issuance by Z of long-term bonds. Z lends the proceeds of its notes to 
Developer B as construction financing and transfers title to B for a 
nominal

[[Page 35]]

amount. The conveyance is made on condition that B rehabilitate the 
property and reconvey it upon completion, with Z retaining the right to 
force reconveyance if these conditions are not satisfied. B must name Z 
as an additional insured on all insurance. Upon completion, B must 
transfer title to the project back to Z at a set price, which price 
reflects B's costs and profit, not fair market value. Further, this 
price is adjusted downward to reflect any cost-underruns. For purposes 
of section 141(c), this transaction does not involve a private loan.
    Example 2. Essential government function requirement not met. City D 
creates a special taxing district consisting of property owned by 
nongovernmental persons that requires environmental clean-up. D imposes 
a special tax on each parcel within the district in an amount that is 
related to the expected environmental clean-up costs of that parcel. The 
payment of the tax over a 20-year period is treated as a loan by the 
property owners for purposes of the private loan financing test. The 
special district issues bonds, acting on behalf of D, that are payable 
from the special tax levied within the district, and uses the proceeds 
to pay for the costs of environmental clean-up on the property within 
the district. The bonds meet the private loan financing test because 
more than 5 percent of the proceeds of the issue are loaned to 
nongovernmental persons. The issue does not meet the tax assessment loan 
exception because the improvements to property owned by a 
nongovernmental person are not an essential governmental function under 
section 141(c)(2). The issue also meets the private business tests of 
section 141(b).

[T.D. 8712, 62 FR 2296, Jan. 16, 1997, as amended by T.D. 9085, 68 FR 
45775, Aug. 4, 2003]



Sec.  1.141-6  Allocation and accounting rules.

    (a) Allocations of proceeds to expenditures, projects, and uses in 
general--(1) Allocations to expenditures. The allocations of proceeds 
and other sources of funds to expenditures under Sec.  1.148-6(d) apply 
for purposes of Sec. Sec.  1.141-1 through 1.141-15.
    (2) Allocations of sources to a project and its uses. Except as 
provided in paragraph (b) of this section (regarding an eligible mixed-
use project), if two or more sources of funding (including two or more 
tax-exempt issues) are allocated to capital expenditures (as defined in 
Sec.  1.150-1(b)) for a project (as defined in paragraph (a)(3) of this 
section), those sources are allocated throughout that project to the 
governmental use and private business use of the project in proportion 
to the relative amounts of those sources of funding spent on the 
project.
    (3) Definition of project--(i) In general. For purposes of this 
section, project means one or more facilities or capital projects, 
including land, buildings, equipment, or other property, financed in 
whole or in part with proceeds of the issue.
    (ii) Output facilities. If an output facility has multiple undivided 
ownership interests (respectively owned by governmental persons or by 
both governmental and nongovernmental persons), each owner's interest in 
the facility is treated as a separate facility for purposes of this 
section, provided that all owners of the undivided ownership interests 
share the ownership and output in proportion to their contributions to 
the capital costs of the output facility.
    (b) Special allocation rules for eligible mixed-use projects--(1) In 
general. The sources of funding allocated to capital expenditures for an 
eligible mixed-use project (as defined in paragraph (b)(2) of this 
section) are allocated to undivided portions of the eligible mixed-use 
project and the governmental use and private business use of the 
eligible mixed-use project in accordance with this paragraph (b). 
Qualified equity (as defined in paragraph (b)(3) of this section) is 
allocated first to the private business use of the eligible mixed-use 
project and then to governmental use, and proceeds are allocated first 
to the governmental use and then to private business use, using the 
percentages of the eligible mixed-use project financed with the 
respective sources and the percentages of the respective uses. Thus, if 
the percentage of the eligible mixed-use project financed with qualified 
equity is less than the percentage of private business use of the 
project, all of the qualified equity is allocated to the private 
business use. Proceeds are allocated to the balance of the private 
business use of the project. Similarly, if the percentage of the 
eligible mixed-use project financed with proceeds is less than the 
percentage of governmental use of the project, all of the proceeds are 
allocated to the governmental use, and qualified equity is

[[Page 36]]

allocated to the balance of the governmental use of the project. 
Further, if proceeds of more than one issue finance the eligible mixed-
use project, proceeds of each issue are allocated ratably to the uses to 
which proceeds are allocated in proportion to the relative amounts of 
the proceeds of such issues allocated to the eligible mixed-use project. 
For private business use measured under Sec.  1.141-3(g), qualified 
equity and proceeds are allocated to the uses of the eligible mixed-use 
project in each one-year period under Sec.  1.141-3(g)(4). See Example 1 
of paragraph (f) of this section.
    (2) Definition of eligible mixed-use project. Eligible mixed-use 
project means a project (as defined in paragraph (a)(3) of this section) 
that is financed with proceeds of bonds that, when issued, purported to 
be governmental bonds (as defined in Sec.  1.150-1(b)) (the applicable 
bonds) and with qualified equity pursuant to the same plan of financing 
(within the meaning of Sec.  1.150-1(c)(1)(ii)). An eligible mixed-use 
project must be wholly owned by one or more governmental persons or by a 
partnership in which at least one governmental person is a partner.
    (3) Definition of qualified equity. For purposes of this section, 
qualified equity means proceeds of bonds that are not tax-advantaged 
bonds and funds that are not derived from proceeds of a borrowing that 
are spent on the same eligible mixed-use project as the proceeds of the 
applicable bonds. Qualified equity does not include equity interests in 
real property or tangible personal property. Further, qualified equity 
does not include funds used to redeem or repay governmental bonds. See 
Sec. Sec.  1.141-2(d)(2)(ii) and 1.141-12(i) (regarding the effects of 
certain redemptions as remedial actions).
    (4) Same plan of financing. Qualified equity finances a project 
under the same plan of financing that includes the applicable bonds if 
the qualified equity pays for capital expenditures of the project on a 
date that is no earlier than a date on which such expenditures would be 
eligible for reimbursement by proceeds of the applicable bonds under 
Sec.  1.150-2(d)(2) (regardless of whether the applicable bonds are 
reimbursement bonds) and, except for a reasonable retainage (within the 
meaning of Sec.  1.148-7(h)), no later than the date on which the 
measurement period begins.
    (c) Allocations of private payments. Except as provided in this 
paragraph (c), private payments for a project are allocated in 
accordance with Sec.  1.141-4. Payments under an output contract that 
result in private business use of an eligible mixed-use project are 
allocated to the same source of funding (notwithstanding Sec.  1.141-
4(c)(3)(v) (regarding certain allocations of private payments to 
equity)) allocated to the private business use from such contract under 
paragraph (b) of this section.
    (d) Allocations of proceeds to common costs of an issue. Proceeds 
used for expenditures for common costs (for example, issuance costs, 
qualified guarantee fees, or reasonably required reserve or replacement 
funds) are allocated in accordance with Sec.  1.141-3(g)(6). Proceeds, 
as allocated under Sec.  1.141-3(g)(6) to an eligible mixed-use project, 
are allocated to the uses of the project in the same proportions as the 
proceeds allocated to the uses under paragraph (b) of this section.
    (e) Allocations of proceeds to bonds. In general, proceeds are 
allocated to bonds in accordance with the rules for allocations of 
proceeds to bonds for separate purposes of multipurpose issues in Sec.  
1.141-13(d). For an issue that is not a multipurpose issue (or is a 
multipurpose issue for which the issuer has not made a multipurpose 
allocation), proceeds are allocated to bonds ratably in a manner similar 
to the allocation of proceeds to projects under paragraph (a)(2) of this 
section.
    (f) Examples. The following examples illustrate the application of 
this section:

    Example 1. Mixed-use project. City A issues $70x of bonds (the 
Bonds) and finances the construction of a 10-story office building 
costing $100x (the Project) with proceeds of the Bonds and $30x of 
qualified equity (the Qualified Equity). To the extent that the private 
business use of the Project does not exceed 30 percent in any particular 
year, the Qualified Equity is allocated to the private business use. If 
private business use of the Project were, for example, 44 percent in a 
year, the Qualified Equity would be allocated to 30 percent ($30x) 
private business use and proceeds of the Bonds would be allocated to the 
excess (that is, 14 percent or

[[Page 37]]

$14x), resulting in private business use of the Bonds in that year of 20 
percent ($14x/$70x). Conversely, if private business use of the Project 
were 20 percent, Qualified Equity would be allocated to that 20 percent. 
The remaining Qualified Equity (that is, 10 percent or $10x) would be 
allocated to the governmental use in excess of the 70 percent to which 
the proceeds of the Bonds would be allocated.
    Example 2. Mixed-use output facility. Authority A is a governmental 
person that owns and operates an electric transmission facility. Several 
years ago, Authority A used its equity to pay capital expenditures of 
$1000x for the facility. Authority A wants to make capital improvements 
to the facility in the amount of $100x (the Project). Authority A 
reasonably expects that, after completion of the Project, it will sell 
46 percent of the available output of the facility, as determined under 
Sec.  1.141-7, under output contracts that result in private business 
use and it will sell 54 percent of the available output of the facility 
for governmental use. On January 1, 2017, Authority A issues $60x of 
bonds (the Bonds) and uses the proceeds of the Bonds and $40x of 
qualified equity (the Qualified Equity) to finance the Project. The 
Qualified Equity is allocated to 40 of the 46 percent private business 
use resulting from the output contracts. Proceeds of the Bonds are 
allocated to the 54 percent governmental use and thereafter to the 
remaining 6 percent private business use.
    Example 3. Subsequent improvements and replacements. County A owns a 
hospital, which opened in 2001, that it financed entirely with proceeds 
of bonds it issued in 1998 (the 1998 Bonds). In 2017, County A finances 
the cost of an addition to the hospital with proceeds of bonds (the 2017 
Bonds) and qualified equity (the 2017 Qualified Equity). The original 
hospital is a project (the 1998 Project) and the addition is a project 
(the 2017 Project). Proceeds of the 2017 Bonds and the 2017 Qualified 
Equity are allocated to the 2017 Project. The 2017 Qualified Equity is 
allocated first to the private business use of the 2017 Project and then 
to the governmental use of the 2017 Project. Proceeds of the 2017 Bonds 
are allocated first to the governmental use of the 2017 Project and then 
to the private business use of that project. Neither proceeds of the 
2017 Bonds nor 2017 Qualified Equity is allocated to the uses of the 
1998 Project. Proceeds of the 1998 Bonds are not allocated to uses of 
the 2017 Project.

[T.D. 9741, 80 FR 65643, Oct. 27, 2015]



Sec.  1.141-7  Special rules for output facilities.

    (a) Overview. This section provides special rules to determine 
whether arrangements for the purchase of output from an output facility 
cause an issue of bonds to meet the private business tests. For this 
purpose, unless otherwise stated, water facilities are treated as output 
facilities. Sections 1.141-3 and 1.141-4 generally apply to determine 
whether other types of arrangements for use of an output facility cause 
an issue to meet the private business tests.
    (b) Definitions. For purposes of this section and Sec.  1.141-8, the 
following definitions and rules apply:
    (1) Available output. The available output of a facility financed by 
an issue is determined by multiplying the number of units produced or to 
be produced by the facility in one year by the number of years in the 
measurement period of that facility for that issue.
    (i) Generating facilities. The number of units produced or to be 
produced by a generating facility in one year is determined by reference 
to its nameplate capacity or the equivalent (or where there is no 
nameplate capacity or the equivalent, its maximum capacity), which is 
not reduced for reserves, maintenance or other unutilized capacity.
    (ii) Transmission and other output facilities--(A) In general. For 
transmission, distribution, cogeneration, and other output facilities, 
available output must be measured in a reasonable manner to reflect 
capacity.
    (B) Electric transmission facilities. Measurement of the available 
output of all or a portion of electric transmission facilities may be 
determined in a manner consistent with the reporting rules and 
requirements for transmission networks promulgated by the Federal Energy 
Regulatory Commission (FERC). For example, for a transmission network, 
the use of aggregate load and load share ratios in a manner consistent 
with the requirements of the FERC may be reasonable. In addition, 
depending on the facts and circumstances, measurement of the available 
output of transmission facilities using thermal capacity or transfer 
capacity may be reasonable.
    (iii) Special rule for facilities with significant unutilized 
capacity. If an issuer reasonably expects on the issue date that persons 
that are treated as private business users will purchase more than

[[Page 38]]

30 percent of the actual output of the facility financed with the issue, 
the Commissioner may determine the number of units produced or to be 
produced by the facility in one year on a reasonable basis other than by 
reference to nameplate or other capacity, such as the average expected 
annual output of the facility. For example, the Commissioner may 
determine the available output of a financed peaking electric generating 
unit by reference to the reasonably expected annual output of that unit 
if the issuer reasonably expects, on the issue date of bonds that 
finance the unit, that an investor-owned utility will purchase more than 
30 percent of the actual output of the facility during the measurement 
period under a take or pay contract, even if the amount of output 
purchased is less than 10 percent of the available output determined by 
reference to nameplate capacity. The reasonably expected annual output 
of the generating facility must be consistent with the capacity reported 
for prudent reliability purposes.
    (iv) Special rule for facilities with a limited source of supply. If 
a limited source of supply constrains the output of an output facility, 
the number of units produced or to be produced by the facility must be 
determined by reasonably taking into account those constraints. For this 
purpose, a limited source of supply shall include a physical limitation 
(for example, flow of water), but not an economic limitation (for 
example, cost of coal or gas). For example, the available output of a 
hydroelectric unit must be determined by reference to the reasonably 
expected annual flow of water through the unit.
    (2) Measurement period. The measurement period of an output facility 
financed by an issue is determined under Sec.  1.141-3(g).
    (3) Sale at wholesale. A sale at wholesale means a sale of output to 
any person for resale.
    (4) Take contract and take or pay contract. A take contract is an 
output contract under which a purchaser agrees to pay for the output 
under the contract if the output facility is capable of providing the 
output. A take or pay contract is an output contract under which a 
purchaser agrees to pay for the output under the contract, whether or 
not the output facility is capable of providing the output.
    (5) Requirements contract. A requirements contract is an output 
contract, other than a take contract or a take or pay contract, under 
which a nongovernmental person agrees to purchase all or part of its 
output requirements.
    (6) Nonqualified amount. The nonqualified amount with respect to an 
issue is determined under section 141(b)(8).
    (c) Output contracts--(1) General rule. The purchase pursuant to a 
contract by a nongovernmental person of available output of an output 
facility (output contract) financed with proceeds of an issue is taken 
into account under the private business tests if the purchase has the 
effect of transferring the benefits of owning the facility and the 
burdens of paying the debt service on bonds used (directly or 
indirectly) to finance the facility (the benefits and burdens test). See 
paragraph (c)(4) of this section for the treatment of an output contract 
that is properly characterized as a lease for Federal income tax 
purposes. See paragraphs (d) and (e) of this section for rules regarding 
measuring the use of, and payments of debt service for, an output 
facility for determining whether the private business tests are met. See 
also Sec.  1.141-8 for rules for when an issue that finances an output 
facility (other than a water facility) meets the private business tests 
because the nonqualified amount of the issue exceeds $15 million.
    (2) Take contract or take or pay contract. The benefits and burdens 
test is met if a nongovernmental person agrees pursuant to a take 
contract or a take or pay contract to purchase available output of a 
facility.
    (3) Requirements contract--(i) In general. A requirements contract 
may satisfy the benefits and burdens test under paragraph (c)(3)(ii) or 
(iii) of this section. See Sec.  1.141-15(f)(2) for special effective 
dates for the application of this paragraph (c)(3) to issues financing 
facilities subject to requirements contracts.
    (ii) Requirements contract similar to take contract or take or pay 
contract. A requirements contract generally meets

[[Page 39]]

the benefits and burdens test to the extent that it contains contractual 
terms that obligate the purchaser to make payments that are not 
contingent on the output requirements of the purchaser or that obligate 
the purchaser to have output requirements. For example, a requirements 
contract with an industrial purchaser meets the benefits and burdens 
test if the purchaser enters into additional contractual obligations 
with the issuer or another governmental unit not to cease operations. A 
requirements contract does not meet the benefits and burdens test, 
however, by reason of a provision that requires the purchaser to pay 
reasonable and customary damages (including liquidated damages) in the 
event of a default, or a provision that permits the purchaser to pay a 
specified amount to terminate the contract while the purchaser has 
requirements, in each case if the amount of the payment is reasonably 
related to the purchaser's obligation to buy requirements that is 
discharged by the payment.
    (iii) Wholesale requirements contract--(A) In general. A 
requirements contract that is a sale at wholesale (a wholesale 
requirements contract) may satisfy the benefits and burdens test, 
depending on all the facts and circumstances.
    (B) Significant factors. Significant factors that tend to establish 
that a wholesale requirements contract meets the benefits and burdens 
test include, but are not limited to--
    (1) The term of the contract is substantial relative to the term of 
the issue or issues that finance the facility; and
    (2) The amount of output to be purchased under the contract 
represents a substantial portion of the available output of the 
facility.
    (C) Safe harbors. A wholesale requirements contract does not meet 
the benefits and burdens test if--
    (1) The term of the contract, including all renewal options, does 
not exceed the lesser of 5 years or 30 percent of the term of the issue; 
or
    (2) The amount of output to be purchased under the contract (and any 
other requirements contract with the same purchaser or a related party 
with respect to the facility) does not exceed 5 percent of the available 
output of the facility.
    (iv) Retail requirements contract. Except as otherwise provided in 
this paragraph (c)(3), a requirements contract that is not a sale at 
wholesale does not meet the benefits and burdens test.
    (4) Output contract properly characterized as a lease. 
Notwithstanding any other provision of this section, an output contract 
that is properly characterized as a lease for Federal income tax 
purposes shall be tested under the rules contained in Sec. Sec.  1.141-3 
and 1.141-4 to determine whether it is taken into account under the 
private business tests.
    (d) Measurement of private business use. If an output contract 
results in private business use under this section, the amount of 
private business use generally is the amount of output purchased under 
the contract.
    (e) Measurement of private security or payment. The measurement of 
payments made or to be made by nongovernmental persons under output 
contracts as a percent of the debt service of an issue is determined 
under the rules provided in Sec.  1.141-4.
    (f) Exceptions for certain contracts--(1) Small purchases of output. 
An output contract for the use of a facility is not taken into account 
under the private business tests if the average annual payments to be 
made under the contract do not exceed 1 percent of the average annual 
debt service on all outstanding tax-exempt bonds issued to finance the 
facility, determined as of the effective date of the contract.
    (2) Swapping and pooling arrangements. An agreement that provides 
for swapping or pooling of output by one or more governmental persons 
and one or more nongovernmental persons does not result in private 
business use of the output facility owned by the governmental person to 
the extent that--
    (i) The swapped output is reasonably expected to be approximately 
equal in value (determined over periods of three years or less); and
    (ii) The purpose of the agreement is to enable each of the parties 
to satisfy different peak load demands, to accommodate temporary 
outages, to diversify

[[Page 40]]

supply, or to enhance reliability in accordance with prudent reliability 
standards.
    (3) Short-term output contracts. An output contract with a 
nongovernmental person is not taken into account under the private 
business tests if--
    (i) The term of the contract, including all renewal options, is not 
longer than 3 years;
    (ii) The contract either is a negotiated, arm's-length arrangement 
that provides for compensation at fair market value, or is based on 
generally applicable and uniformly applied rates; and
    (iii) The output facility is not financed for a principal purpose of 
providing that facility for use by that nongovernmental person.
    (4) Certain conduit parties disregarded. A nongovernmental person 
acting solely as a conduit for the exchange of output among 
governmentally owned and operated utilities is disregarded in 
determining whether the private business tests are met with respect to 
financed facilities owned by a governmental person.
    (g) Special rules for electric output facilities used to provide 
open access--(1) Operation of transmission facilities by nongovernmental 
persons--(i) In general. The operation of an electric transmission 
facility by a nongovernmental person may result in private business use 
of the facility under Sec.  1.141-3 and this section based on all the 
facts and circumstances. For example, a transmission facility is 
generally used for a private business use if a nongovernmental person 
enters into a contract to operate the facility and receives compensation 
based, in whole or in part, on a share of net profits from the operation 
of the facility.
    (ii) Certain use by independent transmission operators. A contract 
for the operation of an electric transmission facility by an independent 
entity, such as a regional transmission organization or an independent 
system operator (independent transmission operator), does not constitute 
private business use of the facility if--
    (A) The facility is owned by a governmental person;
    (B) The operation of the facility by the independent transmission 
operator is approved by the FERC under one or more provisions of the 
Federal Power Act (16 U.S.C. 791a through 825r) (or by a state authority 
under comparable provisions of state law);
    (C) No portion of the compensation of the independent transmission 
operator is based on a share of net profits from the operation of the 
facility; and
    (D) The independent transmission operator does not bear risk of loss 
of the facility.
    (2) Certain use by nongovernmental persons under output contracts--
(i) Transmission facilities. The use of an electric transmission 
facility by a nongovernmental person pursuant to an output contract does 
not constitute private business use of the facility if--
    (A) The facility is owned by a governmental person;
    (B) The facility is operated by an independent transmission operator 
in a manner that satisfies paragraph (g)(1)(ii) of this section; and
    (C) The facility is not financed for a principal purpose of 
providing that facility for use by that nongovernmental person.
    (ii) Distribution facilities. The use of an electric distribution 
facility by a nongovernmental person pursuant to an output contract does 
not constitute private business use of the facility if--
    (A) The facility is owned by a governmental person;
    (B) The facility is available for use on a nondiscriminatory, open 
access basis by buyers and sellers of electricity in accordance with 
rates that are generally applicable and uniformly applied within the 
meaning of Sec.  1.141-3(c)(2); and
    (C) The facility is not financed for a principal purpose of 
providing that facility for use by that nongovernmental person (other 
than a retail end-user).
    (3) Ancillary services. The use of an electric output facility to 
provide ancillary services required to be offered as part of an open 
access transmission tariff under rules promulgated by the FERC under the 
Federal Power Act (16 U.S.C. 791a through 825r) (or by a state 
regulatory authority under comparable provisions of state law) does not 
result in private business use.

[[Page 41]]

    (4) Exceptions to deliberate action rules--(i) Mandated wheeling. 
Entering into a contract for the use of electric transmission or 
distribution facilities is not treated as a deliberate action under 
Sec.  1.141-2(d) if--
    (A) The contract is entered into in response to (or in anticipation 
of) an order by the United States under sections 211 and 212 of the 
Federal Power Act (16 U.S.C. 824j and 824k) (or a state regulatory 
authority under comparable provisions of state law); and
    (B) The terms of the contract are bona fide and arm's-length, and 
the consideration paid is consistent with the provisions of section 
212(a) of the Federal Power Act.
    (ii) Actions taken to implement non-discriminatory, open access. An 
action is not treated as a deliberate action under Sec.  1.141-2(d) if 
it is taken to implement the offering of non-discriminatory, open access 
tariffs for the use of electric transmission or distribution facilities 
in a manner consistent with rules promulgated by the FERC under sections 
205 and 206 of the Federal Power Act (16 U.S.C. 824d and 824e) (or 
comparable provisions of state law). This paragraph (g)(4)(ii) does not 
apply, however, to the sale, exchange, or other disposition (within the 
meaning of section 1001(a)) of transmission or distribution facilities 
to a nongovernmental person.
    (iii) Application of reasonable expectations test to certain current 
refunding bonds. An action taken or to be taken with respect to electric 
transmission or distribution facilities refinanced by an issue is not 
taken into account under the reasonable expectations test of Sec.  
1.141-2(d) if--
    (A) The action is described in paragraph (g)(4)(i) or (ii) of this 
section;
    (B) The bonds of the issue are current refunding bonds that refund 
bonds originally issued before February 23, 1998; and
    (C) The weighted average maturity of the refunding bonds is not 
greater than the remaining weighted average maturity of the prior bonds.
    (5) Additional transactions as permitted by the Commissioner. The 
Commissioner may, by published guidance, set forth additional 
circumstances in which the use of electric output facilities in a 
restructured electric industry does not constitute private business use.
    (h) Allocations of output facilities and systems--(1) Facts and 
circumstances analysis. Whether output sold under an output contract is 
allocated to a particular facility (for example, a generating unit), to 
the entire system of the seller of that output (net of any uses of that 
system output allocated to a particular facility), or to a portion of a 
facility is based on all the facts and circumstances. Significant 
factors to be considered in determining the allocation of an output 
contract to financed property are the following:
    (i) The extent to which it is physically possible to deliver output 
to or from a particular facility or system.
    (ii) The terms of a contract relating to the delivery of output 
(such as delivery limitations and options or obligations to deliver 
power from additional sources).
    (iii) Whether a contract is entered into as part of a common plan of 
financing for a facility.
    (iv) The method of pricing output under the contract, such as the 
use of market rates rather than rates designed to pay debt service of 
tax-exempt bonds used to finance a particular facility.
    (2) Illustrations. The following illustrate the factors set forth in 
paragraph (h)(1) of this section:
    (i) Physical possibility. Output from a generating unit that is fed 
directly into a low voltage distribution system of the owner of that 
unit and that cannot physically leave that distribution system generally 
must be allocated to those receiving electricity through that 
distribution system. Output may be allocated without regard to physical 
limitations, however, if exchange or similar agreements provide output 
to a purchaser where, but for the exchange agreements, it would not be 
possible for the seller to provide output to that purchaser.
    (ii) Contract terms relating to performance. A contract to provide a 
specified amount of electricity from a system, but only when at least 
that amount of electricity is being generated by a particular unit, is 
allocated to that unit. For example, a contract to buy 20 MW of system 
power with a right to take

[[Page 42]]

up to 40 percent of the actual output of a specific 50 MW facility 
whenever total system output is insufficient to meet all of the seller's 
obligations generally is allocated to the specific facility rather than 
to the system.
    (iii) Common plan of financing. A contract entered into as part of a 
common plan of financing for a facility generally is allocated to the 
facility if debt service for the issue of bonds is reasonably expected 
to be paid, directly or indirectly, from payments under the contract.
    (iv) Pricing method. Pricing based on the capital and generating 
costs of a particular turbine tends to indicate that output under the 
contract is properly allocated to that turbine.
    (3) Transmission and distribution contracts. Whether use under an 
output contract for transmission or distribution is allocated to a 
particular facility or to a transmission or distribution network is 
based on all the facts and circumstances, in a manner similar to 
paragraphs (h)(1) and (2) of this section. In general, the method used 
to determine payments under a contract is a more significant contract 
term for this purpose than nominal contract path. In general, if 
reasonable and consistently applied, the determination of use of 
transmission or distribution facilities under an output contract may be 
based on a method used by third parties, such as reliability councils.
    (4) Allocation of payments. Payments for output provided by an 
output facility financed with two or more sources of funding are 
generally allocated under the rules in Sec.  1.141-4(c).
    (i) Examples. The following examples illustrate the application of 
this section:

    Example 1 Joint ownership. Z, an investor-owned electric utility, 
and City H agree to construct an electric generating facility of a size 
sufficient to take advantage of the economies of scale. H will issue $50 
million of its 24-year bonds, and Z will use $100 million of its funds 
for construction of a facility they will jointly own as tenants in 
common. Each of the participants will share in the ownership, output, 
and operating expenses of the facility in proportion to its contribution 
to the cost of the facility, that is, one-third by H and two-thirds by 
Z. H's bonds will be secured by H's ownership interest in the facility 
and by revenues to be derived from its share of the annual output of the 
facility. H will need only 50 percent of its share of the annual output 
of the facility during the first 20 years of operations. It agrees to 
sell 10 percent of its share of the annual output to Z for a period of 
20 years pursuant to a contract under which Z agrees to take that power 
if available. The facility will begin operation, and Z will begin to 
receive power, 4 years after the H bonds are issued. The measurement 
period for the property financed by the issue is 20 years. H also will 
sell the remaining 40 percent of its share of the annual output to 
numerous other private utilities under contracts of three years or less 
that satisfy the exception under paragraph (f)(3) of this section. No 
other contracts will be executed obligating any person to purchase any 
specified amount of the power for any specified period of time. No 
person (other than Z) will make payments that will result in a transfer 
of the burdens of paying debt service on bonds used directly or 
indirectly to provide H's share of the facilities. The bonds are not 
private activity bonds, because H's one-third interest in the facility 
is not treated as used by the other owners of the facility. Although 10 
percent of H's share of the annual output of the facility will be used 
in the trade or business of Z, a nongovernmental person, under this 
section, that portion constitutes not more than 10 percent of the 
available output of H's ownership interest in the facility.
    Example 2 Wholesale requirements contract. (i) City J issues 20-year 
bonds to acquire an electric generating facility having a reasonably 
expected economic life substantially greater than 20 years and a 
nameplate capacity of 100 MW. The available output of the facility under 
paragraph (b)(1) of this section is approximately 17,520,000 MWh (100 MW 
x 24 hours x 365 days x 20 years). On the issue date, J enters into a 
contract with T, an investor-owned utility, to provide T with all of its 
power requirements for a period of 10 years, commencing on the issue 
date. J reasonably expects that T will actually purchase an average of 
30 MW over the 10-year period. The contract is taken into account under 
the private business tests pursuant to paragraph (c)(3) of this section 
because the term of the contract is substantial relative to the term of 
the issue and the amount of output to be purchased is a substantial 
portion of the available output.
    (ii) Under paragraph (d) of this section, the amount of reasonably 
expected private business use under this contract is approximately 15 
percent (30 MW x 24 hours x 365 days x 10 years, or 2,628,000 MWh) of 
the available output. Accordingly, the issue meets the private business 
use test. J reasonably expects that the amount to be paid for an average 
of 30 MW of power (less the operation and maintenance costs directly 
attributable to generating that 30 MW of

[[Page 43]]

power), will be more than 10 percent of debt service on the issue on a 
present-value basis. Accordingly, the issue meets the private security 
or payment test because J reasonably expects that payment of more than 
10 percent of the debt service will be indirectly derived from payments 
by T. The bonds are private activity bonds under paragraph (c) of this 
section. Further, if 15 percent of the sale proceeds of the issue is 
greater than $15 million and the issue meets the private security or 
payment test with respect to the $15 million output limitation, the 
bonds are also private activity bonds under section 141(b)(4). See Sec.  
1.141-8.
    Example 3 Retail contracts. (i) State Agency M, a political 
subdivision, issues bonds in 2003 to finance the construction of a 
generating facility that will be used to furnish electricity to M's 
retail customers. In 2007, M enters into a 10-year contract with 
industrial corporation I. Under the contract, M agrees to supply I with 
all of its power requirements during the contract term, and I agrees to 
pay for that power at a negotiated price as it is delivered. The 
contract does not require I to pay for any power except to the extent I 
has requirements. In addition, the contract requires I to pay reasonable 
and customary liquidated damages in the event of a default by I, and 
permits I to terminate the contract while it has requirements by paying 
M a specified amount that is a reasonable and customary amount for 
terminating the contract. Any damages or termination payment by I will 
be reasonably related to I's obligation to buy requirements that is 
discharged by the payment. Under paragraph (c)(3) of this section, the 
contract does not meet the benefits and burdens test. Thus, it is not 
taken into account under the private business tests.
    (ii) The facts are the same as in paragraph (i) of this Example 3, 
except that the contract requires I to make guaranteed minimum payments, 
regardless of I's requirements, in an amount such that the contract does 
not meet the exception for small purchases in paragraph (f)(1) of this 
section. Under paragraph (c)(3)(ii) of this section, the contract meets 
the benefits and burdens test because it obligates I to make payments 
that are not contingent on its output requirements. Thus, it is taken 
into account under the private business tests.
    Example 4 Allocation of existing contracts to new facilities. Power 
Authority K, a political subdivision created by the legislature in State 
X to own and operate certain power generating facilities, sells all of 
the power from its existing facilities to four private utility systems 
under contracts executed in 1999, under which the four systems are 
required to take or pay for specified portions of the total power output 
until the year 2029. Existing facilities supply all of the present needs 
of the four utility systems, but their future power requirements are 
expected to increase substantially beyond the capacity of K's current 
generating system. K issues 20-year bonds in 2004 to construct a large 
generating facility. As part of the financing plan for the bonds, a 
fifth private utility system contracts with K to take or pay for 15 
percent of the available output of the new facility. The balance of the 
output of the new facility will be available for sale as required, but 
initially it is not anticipated that there will be any need for that 
power. The revenues from the contract with the fifth private utility 
system will be sufficient to pay less than 10 percent of the debt 
service on the bonds (determined on a present value basis). The balance, 
which will exceed 10 percent of the debt service on the bonds, will be 
paid from revenues derived from the contracts with the four systems 
initially from sale of power produced by the old facilities. The output 
contracts with all the private utilities are allocated to K's entire 
generating system. See paragraphs (h)(1) and (2) of this section. Thus, 
the bonds meet the private business use test because more than 10 
percent of the proceeds will be used in the trade or business of a 
nongovernmental person. In addition, the bonds meet the private security 
or payment test because payment of more than 10 percent of the debt 
service, pursuant to underlying arrangements, will be derived from 
payments in respect of property used for a private business use.
    Example 5 Allocation to displaced resource. Municipal utility MU, a 
political subdivision, purchases all of the electricity required to meet 
the needs of its customers (1,000 MW) from B, an investor-owned utility 
that operates its own electric generating facilities, under a 50-year 
take or pay contract. MU does not anticipate that it will require 
additional electric resources, and any new resources would produce 
electricity at a higher cost to MU than its cost under its contract with 
B. Nevertheless, B encourages MU to construct a new generating plant 
sufficient to meet MU's requirements. MU issues obligations to construct 
facilities that will produce 1,000 MW of electricity. MU, B, and I, 
another investor-owned utility, enter into an agreement under which MU 
assigns to I its rights under MU's take or pay contract with B. Under 
this arrangement, I will pay MU, and MU will continue to pay B, for the 
1,000 MW. I's payments to MU will at least equal the amounts required to 
pay debt service on MU's bonds. In addition, under paragraph (h)(1)(iii) 
of this section, the contract among MU, B, and I is entered into as part 
of a common plan of financing of the MU facilities. Under all the facts 
and circumstances, MU's assignment to I of its rights under the original 
take or pay contract is allocable to MU's new facilities under paragraph 
(h) of this section. Because I is a nongovernmental

[[Page 44]]

person, MU's bonds are private activity bonds.
    Example 6 Operation of transmission facilities by regional 
transmission organization. (i) Public Power Agency D is a political 
subdivision that owns and operates electric generation, transmission and 
distribution facilities. In 2003, D transfers operating control of its 
transmission system to a regional transmission organization (RTO), a 
nongovernmental person, pursuant to an operating agreement that is 
approved by the FERC under sections 205 and 206 of the Federal Power 
Act. D retains ownership of its facilities. No portion of the RTO's 
compensation is based on a share of net profits from the operation of 
D's facilities, and the RTO does not bear any risk of loss of those 
facilities. Under paragraph (g)(1)(ii) of this section, the RTO's use of 
D's facilities does not constitute a private business use.
    (ii) Company A is located in D's service territory. In 2004, Power 
Supplier E, a nongovernmental person, enters into a 10-year contract 
with A to supply A's electricity requirements. The electricity supplied 
by E to A will be transmitted over D's transmission and distribution 
facilities. D's distribution facilities are available for use on a 
nondiscriminatory, open access basis by buyers and sellers of 
electricity in accordance with rates that are generally applicable and 
uniformly applied within the meaning of Sec.  1.141-3(c)(2). D's 
facilities are not financed for a principal purpose of providing the 
facilities for use by E. Under paragraph (g)(2) of this section, the 
contract between A and E does not result in private business use of D's 
facilities.
    Example 7 Certain actions not treated as deliberate actions. The 
facts are the same as in Example 6 of this paragraph (i), except that 
the RTO's compensation is based on a share of net profits from operating 
D's facilities. In addition, D had issued bonds in 1994 to finance 
improvements to its transmission system. At the time D transfers 
operating control of its transmission system to the RTO, D chooses to 
apply the private activity bond regulations of Sec. Sec.  1.141-1 
through 1.141-15 to the 1994 bonds. The operation of D's facilities by 
the RTO results in private business use under Sec.  1.141-3 and 
paragraph (g)(1)(i) of this section. Under the special exception in 
paragraph (g)(4)(ii) of this section, however, the transfer of control 
is not treated as a deliberate action. Accordingly, the transfer of 
control does not cause the 1994 bonds to meet the private activity bond 
tests.
    Example 8 Current refunding. The facts are the same as in Example 7 
of this paragraph (i), and in addition D issues bonds in 2004 to 
currently refund the 1994 bonds. The weighted average maturity of the 
2004 bonds is not greater than the remaining weighted average maturity 
of the 1994 bonds. D chooses to apply the private activity bond 
regulations of Sec. Sec.  1.141-1 through 1.141-15 to the refunding 
bonds. In general, reasonable expectations must be separately tested on 
the date that refunding bonds are issued under Sec.  1.141-2(d). Under 
the special exception in paragraph (g)(4)(iii) of this section, however, 
the transfer of the financed facilities to the RTO need not be taken 
into account in applying the reasonable expectations test to the 
refunding bonds.

[T.D. 9016, 67 FR 59759, Sept. 23, 2002; 67 FR 70845, Nov. 27, 2002]



Sec.  1.141-8  $15 million limitation for output facilities.

    (a) In general--(1) General rule. Section 141(b)(4) provides a 
special private activity bond limitation (the $15 million output 
limitation) for issues 5 percent or more of the proceeds of which are to 
be used to finance output facilities (other than a facility for the 
furnishing of water). Under this rule, an issue consists of private 
activity bonds under the private business tests of section 141(b)(1) and 
(2) if the nonqualified amount with respect to output facilities 
financed by the proceeds of the issue exceeds $15 million. The $15 
million output limitation applies in addition to the private business 
tests of section 141(b)(1) and (2). Under section 141(b)(4) and 
paragraph (a)(2) of this section, the $15 million output limitation is 
reduced in certain cases. Specifically, an issue meets the test in 
section 141(b)(4) if both of the following tests are met:
    (i) More than $15 million of the proceeds of the issue to be used 
with respect to an output facility are to be used for a private business 
use. Investment proceeds are disregarded for this purpose if they are 
not allocated disproportionately to the private business use portion of 
the issue.
    (ii) The payment of the principal of, or the interest on, more than 
$15 million of the sale proceeds of the portion of the issue used with 
respect to an output facility is (under the terms of the issue or any 
underlying arrangement) directly or indirectly--
    (A) Secured by any interest in an output facility used or to be used 
for a private business use (or payments in respect of such an output 
facility); or

[[Page 45]]

    (B) To be derived from payments (whether or not to the issuer) in 
respect of an output facility used or to be used for a private business 
use.
    (2) Reduction in $15 million output limitation for outstanding 
issues--(i) General rule. In determining whether an issue 5 percent or 
more of the proceeds of which are to be used with respect to an output 
facility consists of private activity bonds under the $15 million output 
limitation, the $15 million limitation on private business use and 
private security or payments is applied by taking into account the 
aggregate nonqualified amounts of any outstanding bonds of other issues 
5 percent or more of the proceeds of which are or will be used with 
respect to that output facility or any other output facility that is 
part of the same project.
    (ii) Bonds taken into account. For purposes of this paragraph 
(a)(2), in applying the $15 million output limitation to an issue (the 
later issue), a tax-exempt bond of another issue (the earlier issue) is 
taken into account if--
    (A) That bond is outstanding on the issue date of the later issue;
    (B) That bond will not be redeemed within 90 days of the issue date 
of the later issue in connection with the refunding of that bond by the 
later issue; and
    (C) 5 percent or more of the sale proceeds of the earlier issue 
financed an output facility that is part of the same project as the 
output facility that is financed by 5 percent or more of the sale 
proceeds of the later issue.
    (3) Benefits and burdens test applicable--(i) In general. In 
applying the $15 million output limitation, the benefits and burdens 
test of Sec.  1.141-7 applies, except that ``$15 million'' is applied in 
place of ``10 percent'', or ``5 percent'' as appropriate.
    (ii) Earlier issues for the project. If bonds of an earlier issue 
are outstanding and must be taken into account under paragraph (a)(2) of 
this section, the nonqualified amount for that earlier issue is 
multiplied by a fraction, the numerator of which is the adjusted issue 
price of the earlier issue as of the issue date of the later issue, and 
the denominator of which is the issue price of the earlier issue. Pre-
issuance accrued interest as defined in Sec.  1.148-1(b) is disregarded 
for this purpose.
    (b) Definition of project--(1) General rule. For purposes of 
paragraph (a)(2) of this section, project has the meaning provided in 
this paragraph. Facilities that are functionally related and subordinate 
to a project are treated as part of that same project. Facilities having 
different purposes or serving different customer bases are not 
ordinarily part of the same project. For example, the following are 
generally not part of the same project--
    (i) Generation, transmission and distribution facilities;
    (ii) Separate facilities designed to serve wholesale customers and 
retail customers; and
    (iii) A peaking unit and a baseload unit (regardless of the location 
of the units).
    (2) Separate ownership. Except as otherwise provided in this 
paragraph (b)(2), facilities that are not owned by the same person are 
not part of the same project. If different governmental persons act in 
concert to finance a project, however (for example as participants in a 
joint powers authority), their interests are aggregated with respect to 
that project to determine whether the $15 million output limitation is 
met. In the case of undivided ownership interests in a single output 
facility, property that is not owned by different persons is treated as 
separate projects only if the separate interests are financed--
    (i) With bonds of different issuers; and
    (ii) Without a principal purpose of avoiding the limitation in this 
section.
    (3) Generating property--(i) Property on same site. In the case of 
generation and related facilities, project means property located at the 
same site.
    (ii) Special rule for generating units. Separate generating units 
are not part of the same project if one unit is reasonably expected, on 
the issue date of each issue that finances the units, to be placed in 
service more than 3 years before the other. Common facilities or 
property that will be functionally related to more than one generating 
unit must be allocated on a reasonable basis. If a generating unit 
already is constructed or is under construction

[[Page 46]]

(the first unit) and bonds are to be issued to finance an additional 
generating unit (the second unit), all costs for any common facilities 
paid or incurred before the earlier of the issue date of bonds to 
finance the second unit or the commencement of construction of the 
second unit are allocated to the first unit. At the time that bonds are 
issued to finance the second unit (or, if earlier, upon commencement of 
construction of that unit), any remaining costs of the common facilities 
may be allocated between the first and second units so that in the 
aggregate the allocation is reasonable.
    (4) Transmission and distribution. In the case of transmission or 
distribution facilities, project means functionally related or 
contiguous property. Separate transmission or distribution facilities 
are not part of the same project if one facility is reasonably expected, 
on the issue date of each issue that finances the facilities, to be 
placed in service more than 2 years before the other.
    (5) Subsequent improvements--(i) In general. An improvement to 
generation, transmission or distribution facilities that is not part of 
the original design of those facilities (the original project) is not 
part of the same project as the original project if the construction, 
reconstruction, or acquisition of that improvement commences more than 3 
years after the original project was placed in service and the bonds 
issued to finance that improvement are issued more than 3 years after 
the original project was placed in service.
    (ii) Special rule for transmission and distribution facilities. An 
improvement to transmission or distribution facilities that is not part 
of the original design of that property is not part of the same project 
as the original project if the issuer did not reasonably expect the need 
to make that improvement when it commenced construction of the original 
project and the construction, reconstruction, or acquisition of that 
improvement is mandated by the federal government or a state regulatory 
authority to accommodate requests for wheeling.
    (6) Replacement property. For purposes of this section, property 
that replaces existing property of an output facility is treated as part 
of the same project as the replaced property unless--
    (i) The need to replace the property was not reasonably expected on 
the issue date or the need to replace the property occurred more than 3 
years before the issuer reasonably expected (determined on the issue 
date of the bonds financing the property) that it would need to replace 
the property; and
    (ii) The bonds that finance (and refinance) the output facility have 
a weighted average maturity that is not greater than 120 percent of the 
reasonably expected economic life of the facility.
    (c) Example. The application of the provisions of this section is 
illustrated by the following example:

    Example. (i) Power Authority K, a political subdivision, intends to 
issue a single issue of tax-exempt bonds at par with a stated principal 
amount and sale proceeds of $500 million to finance the acquisition of 
an electric generating facility. No portion of the facility will be used 
for a private business use, except that L, an investor-owned utility, 
will purchase 10 percent of the output of the facility under a take 
contract and will pay 10 percent of the debt service on the bonds. The 
nonqualified amount with respect to the bonds is $50 million.
    (ii) The maximum amount of tax-exempt bonds that may be issued for 
the acquisition of an interest in the facility in paragraph (i) of this 
Example is $465 million (that is, $450 million for the 90 percent of the 
facility that is governmentally owned and used plus a nonqualified 
amount of $15 million).

[T.D. 9016, 67 FR 59763, Sept. 23, 2002]



Sec.  1.141-9  Unrelated or disproportionate use test.

    (a) General rules--(1) Description of test. Under section 141(b)(3) 
(the unrelated or disproportionate use test), an issue meets the private 
business tests if the amount of private business use and private 
security or payments attributable to unrelated or disproportionate 
private business use exceeds 5 percent of the proceeds of the issue. For 
this purpose, the private business use test is applied by taking into 
account only use that is not related to any government use of proceeds 
of the issue (unrelated use) and use that is related but 
disproportionate to any government use of those proceeds 
(disproportionate use).

[[Page 47]]

    (2) Application of unrelated or disproportionate use test--(i) Order 
of application. The unrelated or disproportionate use test is applied by 
first determining whether a private business use is related to a 
government use. Next, private business use that relates to a government 
use is examined to determine whether it is disproportionate to that 
government use.
    (ii) Aggregation of unrelated and disproportionate use. All the 
unrelated use and disproportionate use financed with the proceeds of an 
issue are aggregated to determine compliance with the unrelated or 
disproportionate use test. The amount of permissible unrelated and 
disproportionate private business use is not reduced by the amount of 
private business use financed with the proceeds of an issue that is 
neither unrelated use nor disproportionate use.
    (iii) Deliberate actions. A deliberate action that occurs after the 
issue date does not result in unrelated or disproportionate use if the 
issue meets the conditions of Sec.  1.141-12(a).
    (b) Unrelated use--(1) In general. Whether a private business use is 
related to a government use financed with the proceeds of an issue is 
determined on a case-by-case basis, emphasizing the operational 
relationship between the government use and the private business use. In 
general, a facility that is used for a related private business use must 
be located within, or adjacent to, the governmentally used facility.
    (2) Use for the same purpose as government use. Use of a facility by 
a nongovernmental person for the same purpose as use by a governmental 
person is not treated as unrelated use if the government use is not 
insignificant. Similarly, a use of a facility in the same manner both 
for private business use that is related use and private business use 
that is unrelated use does not result in unrelated use if the related 
use is not insignificant. For example, a privately owned pharmacy in a 
governmentally owned hospital does not ordinarily result in unrelated 
use solely because the pharmacy also serves individuals not using the 
hospital. In addition, use of parking spaces in a garage by a 
nongovernmental person is not treated as unrelated use if more than an 
insignificant portion of the parking spaces are used for a government 
use (or a private business use that is related to a government use), 
even though the use by the nongovernmental person is not directly 
related to that other use.
    (c) Disproportionate use--(1) Definition of disproportionate use. A 
private business use is disproportionate to a related government use 
only to the extent that the amount of proceeds used for that private 
business use exceeds the amount of proceeds used for the related 
government use. For example, a private use of $100 of proceeds that is 
related to a government use of $70 of proceeds results in $30 of 
disproportionate use.
    (2) Aggregation of related uses. If two or more private business 
uses of the proceeds of an issue relate to a single government use of 
those proceeds, those private business uses are aggregated to apply the 
disproportionate use test.
    (3) Allocation rule. If a private business use relates to more than 
a single use of the proceeds of the issue (for example, two or more 
government uses of the proceeds of the issue or a government use and a 
private use), the amount of any disproportionate use may be determined 
by--
    (i) Reasonably allocating the proceeds used for the private business 
use among the related uses;
    (ii) Aggregating government uses that are directly related to each 
other; or
    (iii) Allocating the private business use to the government use to 
which it is primarily related.
    (d) Maximum use taken into account. The determination of the amount 
of unrelated use or disproportionate use of a facility is based on the 
maximum amount of reasonably expected government use of a facility 
during the measurement period. Thus, no unrelated use or 
disproportionate use arises solely because a facility initially has 
excess capacity that is to be used by a nongovernmental person if the 
facility will be completely used by the issuer during the term of the 
issue for more than an insignificant period.

[[Page 48]]

    (e) Examples. The following examples illustrate the application of 
this section:

    Example 1. School and remote cafeteria. County X issues bonds with 
proceeds of $20 million and uses $18.1 million of the proceeds for 
construction of a new school building and $1.9 million of the proceeds 
for construction of a privately operated cafeteria in its administrative 
office building, which is located at a remote site. The bonds are 
secured, in part, by the cafeteria. The $1.9 million of proceeds is 
unrelated to the government use (that is, school construction) financed 
with the bonds and exceeds 5 percent of $20 million. Thus, the issue 
meets the private business tests.
    Example 2. Public safety building and courthouse. City Y issues 
bonds with proceeds of $50 million for construction of a new public 
safety building ($32 million) and for improvements to an existing 
courthouse ($15 million). Y uses $3 million of the bond proceeds for 
renovations to an existing privately operated cafeteria located in the 
courthouse. The bonds are secured, in part, by the cafeteria. Y's use of 
the $3 million for the privately operated cafeteria does not meet the 
unrelated or disproportionate use test because these expenditures are 
neither unrelated use nor disproportionate use.
    Example 3. Unrelated garage. City Y issues bonds with proceeds of 
$50 million for construction of a new public safety building ($30.5 
million) and for improvements to an existing courthouse ($15 million). Y 
uses $3 million of the bond proceeds for renovations to an existing 
privately operated cafeteria located in the courthouse. The bonds are 
secured, in part, by the cafeteria. Y also uses $1.5 million of the 
proceeds to construct a privately operated parking garage adjacent to a 
private office building. The private business use of the parking garage 
is unrelated to any government use of proceeds of the issue. Since the 
proceeds used for unrelated uses and disproportionate uses do not exceed 
5 percent of the proceeds, the unrelated or disproportionate use test is 
not met.
    Example 4. Disproportionate use of garage. County Z issues bonds 
with proceeds of $20 million for construction of a hospital with no 
private business use ($17 million); renovation of an office building 
with no private business use ($1 million); and construction of a garage 
that is entirely used for a private business use ($2 million). The use 
of the garage is related to the use of the office building but not to 
the use of the hospital. The private business use of the garage results 
in $1 million of disproportionate use because the proceeds used for the 
garage ($2 million) exceed the proceeds used for the related government 
use ($1 million). The bonds are not private activity bonds, however, 
because the disproportionate use does not exceed 5 percent of the 
proceeds of the issue.
    Example 5. Bonds for multiple projects. (i) County W issues bonds 
with proceeds of $80 million for the following purposes: (1) $72 million 
to construct a County-owned and operated waste incinerator; (2) $1 
million for a County-owned and operated facility for the temporary 
storage of hazardous waste prior to final disposal; (3) $1 million to 
construct a privately owned recycling facility located at a remote site; 
and (4) $6 million to build a garage adjacent to the County-owned 
incinerator that will be leased to Company T to store and repair trucks 
that it owns and uses to haul County W refuse. Company T uses 75 percent 
of its trucks to haul materials to the incinerator and the remaining 25 
percent of its trucks to haul materials to the temporary storage 
facility.
    (ii) The $1 million of proceeds used for the recycling facility is 
used for an unrelated use. The garage is related use. In addition, 75 
percent of the use of the $6 million of proceeds used for the garage is 
allocable to the government use of proceeds at the incinerator. The 
remaining 25 percent of the proceeds used for the garage ($1.5 million) 
relates to the government use of proceeds at the temporary storage 
facility. Thus, this portion of the proceeds used for the garage exceeds 
the proceeds used for the temporary storage facility by $0.5 million and 
this excess is disproportionate use (but not unrelated use). Thus, the 
aggregate amount of unrelated use and disproportionate use financed with 
the proceeds of the issue is $1.5 million. Alternatively, under 
paragraph (c)(3)(iii) of this section, the entire garage may be treated 
as related to the government use of the incinerator and, under that 
allocation, the garage is not disproportionate use. In either event, 
section 141(b)(3) limits the aggregate unrelated use and 
disproportionate use to $4 million. Therefore, the bonds are not private 
activity bonds under this section.

[T.D. 8712, 62 FR 2297, Jan. 16, 1997]



Sec.  1.141-10  Coordination with volume cap. [Reserved]



Sec.  1.141-11  Acquisition of nongovernmental output property. [Reserved]



Sec.  1.141-12  Remedial actions.

    (a) Conditions to taking remedial action. An action that causes an 
issue to meet the private business tests or the private loan financing 
test is not treated as a deliberate action if the issuer takes a 
remedial action described in paragraph (d), (e), or (f) of this section 
with respect to the nonqualified bonds

[[Page 49]]

and if all of the requirements in paragraphs (a) (1) through (5) of this 
section are met.
    (1) Reasonable expectations test met. The issuer reasonably expected 
on the issue date that the issue would meet neither the private business 
tests nor the private loan financing test for the entire term of the 
bonds. For this purpose, if the issuer reasonably expected on the issue 
date to take a deliberate action prior to the final maturity date of the 
issue that would cause either the private business tests or the private 
loan financing test to be met, the term of the bonds for this purpose 
may be determined by taking into account a redemption provision if the 
provisions of Sec.  1.141-2(d)(2)(ii) (A) through (C) are met.
    (2) Maturity not unreasonably long. The term of the issue must not 
be longer than is reasonably necessary for the governmental purposes of 
the issue (within the meaning of Sec.  1.148-1(c)(4)). Thus, this 
requirement is met if the weighted average maturity of the bonds of the 
issue is not greater than 120 percent of the average reasonably expected 
economic life of the property financed with the proceeds of the issue as 
of the issue date.
    (3) Fair market value consideration. Except as provided in paragraph 
(f) of this section, the terms of any arrangement that results in 
satisfaction of either the private business tests or the private loan 
financing test are bona fide and arm's-length, and the new user pays 
fair market value for the use of the financed property. Thus, for 
example, fair market value may be determined in a manner that takes into 
account restrictions on the use of the financed property that serve a 
bona fide governmental purpose.
    (4) Disposition proceeds treated as gross proceeds for arbitrage 
purposes. The issuer must treat any disposition proceeds as gross 
proceeds for purposes of section 148. For purposes of eligibility for 
temporary periods under section 148(c) and exemptions from the 
requirement of section 148(f) the issuer may treat the date of receipt 
of the disposition proceeds as the issue date of the bonds and disregard 
the receipt of disposition proceeds for exemptions based on expenditure 
of proceeds under Sec.  1.148-7 that were met before the receipt of the 
disposition proceeds.
    (5) Proceeds expended on a governmental purpose. Except for a 
remedial action under paragraph (d) of this section, the proceeds of the 
issue that are affected by the deliberate action must have been expended 
on a governmental purpose before the date of the deliberate action.
    (b) Effect of a remedial action--(1) In general. The effect of a 
remedial action is to cure use of proceeds that causes the private 
business use test or the private loan financing test to be met. A 
remedial action does not affect application of the private security or 
payment test.
    (2) Effect on bonds that have been advance refunded. If proceeds of 
an issue were used to advance refund another bond, a remedial action 
taken with respect to the refunding bond proportionately reduces the 
amount of proceeds of the advance refunded bond that is taken into 
account under the private business use test or the private loan 
financing test.
    (c) Disposition proceeds--(1) Definition. Disposition proceeds are 
any amounts (including property, such as an agreement to provide 
services) derived from the sale, exchange, or other disposition 
(disposition) of property (other than investments) financed with the 
proceeds of an issue.
    (2) Allocating disposition proceeds to an issue. In general, if the 
requirements of paragraph (a) of this section are met, after the date of 
the disposition, the proceeds of the issue allocable to the transferred 
property are treated as financing the disposition proceeds rather than 
the transferred property. If a disposition is made pursuant to an 
installment sale, the proceeds of the issue continue to be allocated to 
the transferred property. If an issue does not meet the requirements for 
remedial action in paragraph (a) of this section or the issuer does not 
take an appropriate remedial action, the proceeds of the issue are 
allocable to either the transferred property or the disposition 
proceeds, whichever allocation produces the greater amount of private 
business use and private security or payments.
    (3) Allocating disposition proceeds to different sources of funding. 
If property

[[Page 50]]

has been financed by different sources of funding, for purposes of this 
section, the disposition proceeds from that property are first allocated 
to the outstanding bonds that financed that property in proportion to 
the principal amounts of those outstanding bonds. In no event may 
disposition proceeds be allocated to bonds that are no longer 
outstanding or to a source of funding not derived from a borrowing (such 
as revenues of the issuer) if the disposition proceeds are not greater 
than the total principal amounts of the outstanding bonds that are 
allocable to that property. For purposes of this paragraph (c)(3), 
principal amount has the same meaning as in Sec.  1.148-9(b)(2) and 
outstanding bonds do not include advance refunded bonds.
    (d) Redemption or defeasance of nonqualified bonds--(1) In general. 
The requirements of this paragraph (d) are met if all of the 
nonqualified bonds of the issue are redeemed. Proceeds of tax-exempt 
bonds must not be used for this purpose, unless the tax-exempt bonds are 
qualified bonds, taking into account the purchaser's use of the 
facility. Except as provided in paragraph (d)(3) of this section, if the 
bonds are not redeemed within 90 days of the date of the deliberate 
action, a defeasance escrow must be established for those bonds within 
90 days of the deliberate action.
    (2) Special rule for dispositions for cash. If the consideration for 
the disposition of financed property is exclusively cash, the 
requirements of this paragraph (d) are met if the disposition proceeds 
are used to redeem a pro rata portion of the nonqualified bonds at the 
earliest call date after the deliberate action. If the bonds are not 
redeemed within 90 days of the date of the deliberate action, the 
disposition proceeds must be used to establish a defeasance escrow for 
those bonds within 90 days of the deliberate action.
    (3) Anticipatory remedial action. The requirements of paragraphs 
(d)(1) and (2) of this section for redemption or defeasance of the 
nonqualified bonds within 90 days of the deliberate action are met if 
the issuer declares its official intent to redeem or defease all of the 
bonds that would become nonqualified bonds in the event of a subsequent 
deliberate action that would cause the private business tests or the 
private loan financing test to be met and redeems or defeases such bonds 
prior to that deliberate action. The issuer must declare its official 
intent on or before the date on which it redeems or defeases such bonds, 
and the declaration of intent must identify the financed property or 
loan with respect to which the anticipatory remedial action is being 
taken and describe the deliberate action that potentially may result in 
the private business tests being met (for example, sale of financed 
property that the buyer may then lease to a nongovernmental person). 
Rules similar to those in Sec.  1.150-2(e) (regarding official intent 
for reimbursement bonds) apply to declarations of intent under this 
paragraph (d)(3), including deviations in the descriptions of the 
project or loan and deliberate action and the reasonableness of the 
official intent.
    (4) Notice of defeasance. The issuer must provide written notice to 
the Commissioner of the establishment of the defeasance escrow within 90 
days of the date the defeasance escrow is established.
    (5) Special limitation. The establishment of a defeasance escrow 
does not satisfy the requirements of this paragraph (d) if the period 
between the issue date and the first call date of the bonds is more than 
10\1/2\ years.
    (6) Defeasance escrow defined. A defeasance escrow is an irrevocable 
escrow established to redeem bonds on their earliest call date in an 
amount that, together with investment earnings, is sufficient to pay all 
the principal of, and interest and call premium on, bonds from the date 
the escrow is established to the earliest call date. The escrow may not 
be invested in higher yielding investments or in any investment under 
which the obligor is a user of the proceeds of the bonds.
    (e) Alternative use of disposition proceeds--(1) In general. The 
requirements of this paragraph (e) are met if--
    (i) The deliberate action is a disposition for which the 
consideration is exclusively cash;
    (ii) The issuer reasonably expects to expend the disposition 
proceeds within

[[Page 51]]

two years of the date of the deliberate action;
    (iii) The disposition proceeds are treated as proceeds for purposes 
of section 141 and are used in a manner that does not cause the issue to 
meet either the private business tests or the private loan financing 
test, and the issuer does not take any action subsequent to the date of 
the deliberate action to cause either of these tests to be met; and
    (iv) If the issuer does not use all of the disposition proceeds for 
an alternative use described in paragraph (e)(1)(iii) of this section, 
the issuer uses those remaining disposition proceeds for a remedial 
action that meets paragraph (d) of this section.
    (2) Special rule for use by 501(c)(3) organizations. If the 
disposition proceeds are to be used by a 501(c)(3) organization, the 
nonqualified bonds must in addition be treated as reissued for purposes 
of sections 141, 145, 147, 149, and 150 and, under this treatment, 
satisfy all of the applicable requirements for qualified 501(c)(3) 
bonds. Thus, beginning on the date of the deliberate action, 
nonqualified bonds that satisfy these requirements must be treated as 
qualified 501(c)(3) bonds for all purposes, including sections 145(b) 
and 150(b).
    (f) Alternative use of facility. The requirements of this paragraph 
(f) are met if--
    (1) The facility with respect to which the deliberate action occurs 
is used in an alternative manner (for example, used for a qualifying 
purpose by a nongovernmental person or used by a 501(c)(3) organization 
rather than a governmental person);
    (2) The nonqualified bonds are treated as reissued, as of the date 
of the deliberate action, for purposes of sections 55 through 59 and 
141, 142, 144, 145, 146, 147, 149 and 150, and under this treatment, the 
nonqualified bonds satisfy all the applicable requirements for qualified 
bonds throughout the remaining term of the nonqualified bonds;
    (3) The deliberate action does not involve a disposition to a 
purchaser that finances the acquisition with proceeds of another issue 
of tax-exempt bonds; and
    (4) Any disposition proceeds other than those arising from an 
agreement to provide services (including disposition proceeds from an 
installment sale) resulting from the deliberate action are used to pay 
the debt service on the bonds on the next available payment date or, 
within 90 days of receipt, are deposited into an escrow that is 
restricted to the yield on the bonds to pay the debt service on the 
bonds on the next available payment date.
    (g) Rules for deemed reissuance. For purposes of determining whether 
bonds that are treated as reissued under paragraphs (e) and (f) of this 
section are qualified bonds--
    (1) The provisions of the Code and regulations thereunder in effect 
as of the date of the deliberate action apply; and
    (2) For purposes of paragraph (f) of this section, section 147(d) 
(relating to the acquisition of existing property) does not apply.
    (h) Authority of Commissioner to provide for additional remedial 
actions. The Commissioner may, by publication in the Federal Register or 
the Internal Revenue Bulletin, provide additional remedial actions, 
including making a remedial payment to the United States, under which a 
subsequent action will not be treated as a deliberate action for 
purposes of Sec.  1.141-2.
    (i) Effect of remedial action on continuing compliance. Solely for 
purposes of determining whether deliberate actions that are taken after 
a remedial action cause an issue to meet the private business tests or 
the private loan financing test--
    (1) If a remedial action is taken under paragraph (d) of this 
section, the amount of private business use or private loans resulting 
from the deliberate action that is taken into account for purposes of 
determining whether the bonds are private activity bonds is that portion 
of the remaining bonds that is used for private business use or private 
loans (as calculated under paragraph (j) of this section);
    (2) If a remedial action is taken under paragraph (e) or (f) of this 
section, the amount of private business use or private loans resulting 
from the deliberate action is not taken into account for purposes of 
determining

[[Page 52]]

whether the bonds are private activity bonds; and
    (3) After a remedial action is taken, the amount of disposition 
proceeds is treated as equal to the proceeds of the issue that had been 
allocable to the transferred property immediately prior to the 
disposition. See paragraph (k) of this section, Example 5.
    (j) Nonqualified bonds--(1) Amount of nonqualified bonds. The 
nonqualified bonds are a portion of the outstanding bonds in an amount 
that, if the remaining bonds were issued on the date on which the 
deliberate action occurs, the remaining bonds would not meet the private 
business use test or private loan financing test, as applicable. For 
this purpose, the amount of private business use is the greatest 
percentage of private business use in any one-year period commencing 
with the one-year period in which the deliberate action occurs.
    (2) Allocation of nonqualified bonds. Allocations of nonqualified 
bonds must be made on a pro rata basis, except that, for purposes of 
paragraph (d) of this section (relating to redemption or defeasance), an 
issuer may treat any bonds of an issue as the nonqualified bonds so long 
as--
    (i) The remaining weighted average maturity of the issue, determined 
as of the date on which the nonqualified bonds are redeemed or defeased 
(determination date), and excluding from the determination the 
nonqualified bonds redeemed or defeased by the issuer in accordance with 
this section, is not greater than
    (ii) The remaining weighted average maturity of the issue, 
determined as of the determination date, but without regard to the 
redemption or defeasance of any bonds (including the nonqualified bonds) 
occurring on the determination date.
    (k) Examples. The following examples illustrate the application of 
this section:

    Example 1 Disposition proceeds less than outstanding bonds used to 
retire bonds. On June 1, 1997, City C issues 30-year bonds with an issue 
price of $10 million to finance the construction of a hospital building. 
The bonds have a weighted average maturity that does not exceed 120 
percent of the reasonably expected economic life of the building. On the 
issue date, C reasonably expects that it will be the only user of the 
building for the entire term of the bonds. Six years after the issue 
date, C sells the building to Corporation P for $5 million. The sale 
price is the fair market value of the building, as verified by an 
independent appraiser. C uses all of the $5 million disposition proceeds 
to immediately retire a pro rata portion of the bonds. The sale does not 
cause the bonds to be private activity bonds because C has taken a 
remedial action described in paragraph (d) of this section so that P is 
not treated as a private business user of bond proceeds.
    Example 2. Lease to nongovernmental person. The facts are the same 
as in Example 1, except that instead of selling the building, C, 6 years 
after the issue date, leases the building to P for 7 years and uses 
other funds to redeem all of the $10 million outstanding bonds within 90 
days of the deliberate act. The bonds are not treated as private 
activity bonds because C has taken the remedial action described in 
paragraph (d) of this section.
    Example 3. Sale for less than fair market value. The facts are the 
same as in Example 1, except that the fair market value of the building 
at the time of the sale to P is $6 million. Because the transfer was for 
less than fair market value, the bonds are ineligible for the remedial 
actions under this section. The bonds are private activity bonds because 
P is treated as a user of all of the proceeds and P makes a payment ($6 
million) for this use that is greater than 10 percent of the debt 
service on the bonds, on a present value basis.
    Example 4. Fair market value determined taking into account 
governmental restrictions. The facts are the same as in Example 1, 
except that the building was used by C only for hospital purposes and C 
determines to sell the building subject to a restriction that it be used 
only for hospital purposes. After conducting a public bidding procedure 
as required by state law, the best price that C is able to obtain for 
the building subject to this restriction is $4.5 million from P. C uses 
all of the $4.5 million disposition proceeds to immediately retire a pro 
rata portion of the bonds. The sale does not cause the bonds to be 
private activity bonds because C has taken a remedial action described 
in paragraph (d) of this section so that P is not treated as a private 
business user of bond proceeds.
    Example 5. Alternative use of disposition proceeds. The facts are 
the same as in Example 1, except that C reasonably expects on the date 
of the deliberate action to use the $5 million disposition proceeds for 
another governmental purpose (construction of governmentally owned 
roads) within two years of receipt, rather than using the $5 million to 
redeem outstanding bonds. C treats these disposition proceeds as gross 
proceeds for purposes of section 148. The bonds are not

[[Page 53]]

private activity bonds because C has taken a remedial action described 
in paragraph (e) of this section. After the date of the deliberate 
action, the proceeds of all of the outstanding bonds are treated as used 
for the construction of the roads, even though only $5 million of 
disposition proceeds was actually used for the roads.
    Example 6. Alternative use of financed property. The facts are the 
same as in Example 1, except that C determines to lease the hospital 
building to Q, an organization described in section 501(c)(3), for a 
term of 10 years rather than to sell the building to P. In order to 
induce Q to provide hospital services, C agrees to lease payments that 
are less than fair market value. Before entering into the lease, an 
applicable elected representative of C approves the lease after a 
noticed public hearing. As of the date of the deliberate action, the 
issue meets all the requirements for qualified 501(c)(3) bonds, treating 
the bonds as reissued on that date. For example, the issue meets the two 
percent restriction on use of proceeds of finance issuance costs of 
section 147(g) because the issue pays no costs of issuance from 
disposition proceeds in connection with the deemed reissuance. C and Q 
treat the bonds as qualified 501(c)(3) bonds for all purposes commencing 
with the date of the deliberate action. The bonds are treated as 
qualified 501(c)(3) bonds commencing with the date of the deliberate 
action.
    Example 7. Deliberate action before proceeds are expended on a 
governmental purpose. County J issues bonds with proceeds of $10 million 
that can be used only to finance a correctional facility. On the issue 
date of the bonds, J reasonably expects that it will be the sole user of 
the bonds for the useful life of the facility. The bonds have a weighted 
average maturity that does not exceed 120 percent of the reasonably 
expected economic life of the facility. After the issue date of the 
bonds, but before the facility is placed in service, J enters into a 
contract with the federal government pursuant to which the federal 
government will make a fair market value, lump sum payment equal to 25 
percent of the cost of the facility. In exchange for this payment, J 
provides the federal government with priority rights to use of 25 
percent of the facility. J uses the payment received from the federal 
government to defease the nonqualified bonds. The agreement does not 
cause the bonds to be private activity bonds because J has taken a 
remedial action described in paragraph (d) of this section. See 
paragraph (a)(5) of this section.
    Example 8. Compliance after remedial action. In 2007, City G issues 
bonds with proceeds of $10 million to finance a courthouse. The bonds 
have a weighted average maturity that does not exceed 120 percent of the 
reasonably expected economic life of the courthouse. City G enters into 
contracts with nongovernmental persons that result in private business 
use of 10 percent of the courthouse per year. More than 10 percent of 
the debt service on the issue is secured by private security or 
payments. In 2019, in a bona fide and arm's length arrangement, City G 
enters into a management contract with a nongovernmental person that 
results in private business use of an additional 40 percent of the 
courthouse per year during the remaining term of the bonds. City G 
immediately redeems the nonqualified bonds, or 44.44 percent of the 
outstanding bonds. This is the portion of the outstanding bonds that, if 
the remaining bonds were issued on the date on which the deliberate 
action occurs, the remaining bonds would not meet the private business 
use test, treating the amount of private business use as the greatest 
percentage of private business use in any one-year period commencing 
with the one-year period in which the deliberate action occurs (50 
percent). This percentage is computed by dividing the percentage of the 
facility used for a government use (50 percent) by the minimum amount of 
government use required (90 percent), and subtracting the resulting 
percentage (55.56 percent) from 100 percent (44.44 percent). For 
purposes of subsequently applying section 141 to the issue, City G may 
continue to use all of the proceeds of the outstanding bonds in the same 
manner (that is, for the courthouse and the private business use) 
without causing the issue to meet the private business use test. The 
issue continues to meet the private security or payment test. The result 
would be the same if City G, instead of redeeming the bonds, established 
a defeasance escrow for those bonds, provided that the requirement of 
paragraph (d)(5) of this section is met. If City G takes a subsequent 
deliberate action that results in further private business use, it must 
take into account 10 percent of private business use in addition to that 
caused by the second deliberate act.

[T.D. 8712, 62 FR 2298, Jan. 16, 1997, as amended by T.D. 9741, 80 FR 
65644, Oct. 27, 2015]



Sec.  1.141-13  Refunding issues.

    (a) In general. Except as provided in this section, a refunding 
issue and a prior issue are tested separately under section 141. Thus, 
the determination of whether a refunding issue consists of private 
activity bonds generally does not depend on whether the prior issue 
consists of private activity bonds.
    (b) Application of private business use test and private loan 
financing test--(1) Allocation of proceeds. In applying the private 
business use test and the private loan financing test to a refunding 
issue, the proceeds of the refunding

[[Page 54]]

issue are allocated to the same expenditures and purpose investments as 
the proceeds of the prior issue.
    (2) Determination of amount of private business use--(i) In general. 
Except as provided in paragraph (b)(2)(ii) of this section, the amount 
of private business use of a refunding issue is determined under Sec.  
1.141-3(g), based on the measurement period for that issue (for example, 
without regard to any private business use that occurred prior to the 
issue date of the refunding issue).
    (ii) Refundings of governmental bonds. In applying the private 
business use test to a refunding issue that refunds a prior issue of 
governmental bonds, the amount of private business use of the refunding 
issue is the amount of private business use--
    (A) During the combined measurement period; or
    (B) At the option of the issuer, during the period described in 
paragraph (b)(2)(i) of this section, but only if, without regard to the 
reasonable expectations test of Sec.  1.141-2(d), the prior issue does 
not satisfy the private business use test, based on a measurement period 
that begins on the first day of the combined measurement period and ends 
on the issue date of the refunding issue.
    (iii) Combined measurement period--(A) In general. Except as 
provided in paragraph (b)(2)(iii)(B) of this section, the combined 
measurement period is the period that begins on the first day of the 
measurement period (as defined in Sec.  1.141-3(g)) for the prior issue 
(or, in the case of a series of refundings of governmental bonds, the 
first issue of governmental bonds in the series) and ends on the last 
day of the measurement period for the refunding issue.
    (B) Transition rule for refundings of bonds originally issued before 
May 16, 1997. If the prior issue (or, in the case of a series of 
refundings of governmental bonds, the first issue of governmental bonds 
in the series) was issued before May 16, 1997, then the issuer, at its 
option, may treat the combined measurement period as beginning on the 
date (the transition date) that is the earlier of December 19, 2005 or 
the first date on which the prior issue (or an earlier issue in the case 
of a series of refundings of governmental bonds) became subject to the 
1997 regulations (as defined in Sec.  1.141-15(b)). If the issuer treats 
the combined measurement period as beginning on the transition date in 
accordance with this paragraph (b)(2)(iii)(B), then paragraph (c)(2) of 
this section shall be applied by treating the transition date as the 
issue date of the earliest issue, by treating the bonds as reissued on 
the transition date at an issue price equal to the value of the bonds 
(as determined under Sec.  1.148-4(e)) on that date, and by disregarding 
any private security or private payments before the transition date.
    (iv) Governmental bond. For purposes of this section, the term 
governmental bond means any bond that, when issued, purported to be a 
governmental bond, as defined in Sec.  1.150-1(b), or a qualified 
501(c)(3) bond, as defined in section 145(a).
    (v) Special rule for refundings of qualified 501(c)(3) bonds with 
governmental bonds. For purposes of applying this paragraph (b)(2) to a 
refunding issue that refunds a qualified 501(c)(3) bond, any use of the 
property refinanced by the refunding issue before the issue date of the 
refunding issue by a 501(c)(3) organization with respect to its 
activities that do not constitute an unrelated trade or business under 
section 513(a) is treated as government use.
    (c) Application of private security or payment test--(1) Separate 
issue treatment. If the amount of private business use of a refunding 
issue is determined based on the measurement period for that issue in 
accordance with paragraph (b)(2)(i) or (b)(2)(ii)(B) of this section, 
then the amount of private security and private payments allocable to 
the refunding issue is determined under Sec.  1.141-4 by treating the 
refunding issue as a separate issue.
    (2) Combined issue treatment. If the amount of private business use 
of a refunding issue is determined based on the combined measurement 
period for that issue in accordance with paragraph (b)(2)(ii)(A) of this 
section, then the amount of private security and private payments 
allocable to the refunding issue is determined under Sec.  1.141-4 by 
treating the refunding issue and all

[[Page 55]]

earlier issues taken into account in determining the combined 
measurement period as a combined issue. For this purpose, the present 
value of the private security and private payments is compared to the 
present value of the debt service on the combined issue (other than debt 
service paid with proceeds of any refunding bond). Present values are 
computed as of the issue date of the earliest issue taken into account 
in determining the combined measurement period (the earliest issue). 
Except as provided in paragraph (c)(3) of this section, present values 
are determined by using the yield on the combined issue as the discount 
rate. The yield on the combined issue is determined by taking into 
account payments on the refunding issue and all earlier issues taken 
into account in determining the combined measurement period (other than 
payments made with proceeds of any refunding bond), and based on the 
issue price of the earliest issue. In the case of a refunding of only a 
portion of the original principal amount of a prior issue, the refunded 
portion of the prior issue is treated as a separate issue and any 
private security or private payments with respect to the prior issue are 
allocated ratably between the combined issue and the unrefunded portion 
of the prior issue in a consistent manner based on relative debt 
service. See paragraph (b)(2)(iii)(B) of this section for special rules 
relating to certain refundings of governmental bonds originally issued 
before May 16, 1997.
    (3) Special rule for arrangements not entered into in contemplation 
of the refunding issue. In applying the private security or payment test 
to a refunding issue that refunds a prior issue of governmental bonds, 
the issuer may use the yield on the prior issue to determine the present 
value of private security and private payments under arrangements that 
were not entered into in contemplation of the refunding issue. For this 
purpose, any arrangement that was entered into more than 1 year before 
the issue date of the refunding issue is treated as not entered into in 
contemplation of the refunding issue.
    (d) Multipurpose issue allocations--(1) In general. For purposes of 
section 141, unless the context clearly requires otherwise, Sec.  1.148-
9(h) applies to allocations of multipurpose issues (as defined in Sec.  
1.148-1(b)), including allocations involving the refunding purposes of 
the issue. An allocation under this paragraph (d) may be made at any 
time, but once made, may not be changed. An allocation is not reasonable 
under this paragraph (d) if it achieves more favorable results under 
section 141 than could be achieved with actual separate issues. Each of 
the separate issues under the allocation must consist of one or more 
tax-exempt bonds. Allocations made under this paragraph (d) and Sec.  
1.148-9(h) must be consistent for purposes of sections 141 and 148.
    (2) Exceptions. This paragraph (d) does not apply for purposes of 
sections 141(c)(1) and 141(d)(1).
    (e) Application of reasonable expectations test to certain refunding 
bonds. An action that would otherwise cause a refunding issue to satisfy 
the private business tests or the private loan financing test is not 
taken into account under the reasonable expectations test of Sec.  
1.141-2(d) if--
    (1) The action is not a deliberate action within the meaning of 
Sec.  1.141-2(d)(3); and
    (2) The weighted average maturity of the refunding bonds is not 
greater than the weighted average reasonably expected economic life of 
the property financed by the prior bonds.
    (f) Special rule for refundings of certain general obligation bonds. 
Notwithstanding any other provision of this section, a refunding issue 
does not consist of private activity bonds if--
    (1) The prior issue meets the requirements of Sec.  1.141-2(d)(5) 
(relating to certain general obligation bond programs that finance a 
large number of separate purposes); or
    (2) The refunded portion of the prior issue is part of a series of 
refundings of all or a portion of an issue that meets the requirements 
of Sec.  1.141-2(d)(5).
    (g) Examples. The following examples illustrate the application of 
this section:

    Example 1. Measuring private business use. In 2002, Authority A 
issues tax-exempt bonds that mature in 2032 to acquire an office 
building. The measurement period for the 2002 bonds under Sec.  1.141-
3(g) is 30 years. At

[[Page 56]]

the time A acquires the building, it enters into a 10-year lease with a 
nongovernmental person under which the nongovernmental person will use 5 
percent of the building in its trade or business during each year of the 
lease term. In 2007, A issues bonds to refund the 2002 bonds. The 2007 
bonds mature on the same date as the 2002 bonds and have a measurement 
period of 25 years under Sec.  1.141-3(g). Under paragraph (b)(2)(ii)(A) 
of this section, the amount of private business use of the proceeds of 
the 2007 bonds is 1.67 percent, which equals the amount of private 
business use during the combined measurement period (5 percent of \1/3\ 
of the 30-year combined measurement period). In addition, the 2002 bonds 
do not satisfy the private business use test, based on a measurement 
period beginning on the first day of the measurement period for the 2002 
bonds and ending on the issue date of the 2007 bonds, because only 5 
percent of the proceeds of the 2002 bonds are used for a private 
business use during that period. Thus, under paragraph (b)(2)(ii)(B) of 
this section, A may treat the amount of private business use of the 2007 
bonds as 1 percent (5 percent of \1/5\ of the 25-year measurement period 
for the 2007 bonds). The 2007 bonds do not satisfy the private business 
use test.
    Example 2. Combined issue yield computation. (i) On January 1, 2000, 
County B issues 20-year bonds to finance the acquisition of a municipal 
auditorium. The 2000 bonds have a yield of 7.7500 percent, compounded 
annually, and an issue price and par amount of $100 million. The debt 
service payments on the 2000 bonds are as follows:

------------------------------------------------------------------------
                         Date                             Debt service
------------------------------------------------------------------------
1/1/01...............................................         $9,996,470
1/1/02...............................................          9,996,470
1/1/03...............................................          9,996,470
1/1/04...............................................          9,996,470
1/1/05...............................................          9,996,470
1/1/06...............................................          9,996,470
1/1/07...............................................          9,996,470
1/1/08...............................................          9,996,470
1/1/09...............................................          9,996,470
1/1/10...............................................          9,996,470
1/1/11...............................................          9,996,470
1/1/12...............................................          9,996,470
1/1/13...............................................          9,996,470
1/1/14...............................................          9,996,470
1/1/15...............................................          9,996,470
1/1/16...............................................          9,996,470
1/1/17...............................................          9,996,470
1/1/18...............................................          9,996,470
1/1/19...............................................          9,996,470
1/1/20...............................................          9,996,470
                                                      ------------------
                                                             199,929,400
------------------------------------------------------------------------

    (ii) On January 1, 2005, B issues 15-year bonds to refund all of the 
outstanding 2000 bonds maturing after January 1, 2005 (in the aggregate 
principal amount of $86,500,000). The 2005 bonds have a yield of 6.0000 
percent, compounded annually, and an issue price and par amount of 
$89,500,000. The debt service payments on the 2005 bonds are as follows:

------------------------------------------------------------------------
                         Date                             Debt service
------------------------------------------------------------------------
1/1/06...............................................         $9,215,167
1/1/07...............................................          9,215,167
1/1/08...............................................          9,215,167
1/1/09...............................................          9,215,167
1/1/10...............................................          9,215,167
1/1/11...............................................          9,215,167
1/1/12...............................................          9,215,167
1/1/13...............................................          9,215,167
1/1/14...............................................          9,215,167
1/1/15...............................................          9,215,167
1/1/16...............................................          9,215,167
1/1/17...............................................          9,215,167
1/1/18...............................................          9,215,167
1/1/19...............................................          9,215,167
1/1/20...............................................          9,215,167
                                                      ------------------
                                                             138,227,511
------------------------------------------------------------------------

    (iii) In accordance with Sec.  1.141-15(h), B chooses to apply Sec.  
1.141-13 (together with the other provisions set forth in Sec.  1.141-
15(h)), to the 2005 bonds. For purposes of determining the amount of 
private security and private payments with respect to the 2005 bonds, 
the 2005 bonds and the refunded portion of the 2000 bonds are treated as 
a combined issue under paragraph (c)(2) of this section. The yield on 
the combined issue is determined in accordance with Sec. Sec.  1.148-4, 
1.141-4(b)(2)(iii) and 1.141-13(c)(2). Under this methodology, the yield 
on the combined issue is 7.1062 percent per year compounded annually, 
illustrated as follows:

----------------------------------------------------------------------------------------------------------------
                                             Previous debt
                                              service on
                   Date                        refunded     Refunding debt      Total debt      Present value on
                                              portion of        service          service             1/1/00
                                              prior issue
----------------------------------------------------------------------------------------------------------------
1/1/00....................................  ..............  ..............  .................   ($86,500,000.00)
1/1/01....................................       6,689,793  ..............          6,689,793       6,245,945.33
1/1/02....................................       6,689,793  ..............          6,689,793       5,831,545.62
1/1/03....................................       6,689,793  ..............          6,689,793       5,444,640.09
1/1/04....................................       6,689,793  ..............          6,689,793       5,083,404.58
1/1/05....................................       6,689,793  ..............          6,689,793       4,746,135.95
1/1/06....................................  ..............       9,215,167          9,215,167       6,104,023.84
1/1/07....................................  ..............       9,215,167          9,215,167       5,699,040.20
1/1/08....................................  ..............       9,215,167          9,215,167       5,320,926.00
1/1/09....................................  ..............       9,215,167          9,215,167       4,967,898.55
1/1/10....................................  ..............       9,215,167          9,215,167       4,638,293.40

[[Page 57]]

 
1/1/11....................................  ..............       9,215,167          9,215,167       4,330,556.57
1/1/12....................................  ..............       9,215,167          9,215,167       4,043,237.15
1/1/13....................................  ..............       9,215,167          9,215,167       3,774,980.51
1/1/14....................................  ..............       9,215,167          9,215,167       3,524,521.90
1/1/15....................................  ..............       9,215,167          9,215,167       3,290,680.46
1/1/16....................................  ..............       9,215,167          9,215,167       3,072,353.70
1/1/17....................................  ..............       9,215,167          9,215,167       2,868,512.26
1/1/18....................................  ..............       9,215,167          9,215,167       2,678,195.09
1/1/19....................................  ..............       9,215,167          9,215,167       2,500,504.89
1/1/20....................................  ..............       9,215,167          9,215,167       2,334,603.90
                                           ---------------------------------------------------------------------
                                                33,448,965     138,227,511    171,676,4760.00               0.00
----------------------------------------------------------------------------------------------------------------

    Example 3. Determination of private payments allocable to combined 
issue. The facts are the same as in Example 2. In addition, on January 
1, 2001, B enters into a contract with a nongovernmental person for the 
use of the auditorium. The contract results in a private payment in the 
amount of $500,000 on each January 1 beginning on January 1, 2001, and 
ending on January 1, 2020. Under paragraph (c)(2) of this section, the 
amount of the private payments allocable to the combined issue is 
determined by treating the refunded portion of the 2000 bonds 
($86,500,000 principal amount) as a separate issue, and by allocating 
the total private payments ratably between the combined issue and the 
unrefunded portion of the 2000 bonds ($13,500,000 principal amount) 
based on relative debt service, as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                         Percentage   Amount of
                                                            Debt                         of private    private
                                             Private     service on   Debt service on     payments     payments
                   Date                      payments    unrefunded    combined issue    allocable    allocable
                                                         portion of                     to combined  to combined
                                                        prior issue                        issue        issue
----------------------------------------------------------------------------------------------------------------
1/1/01...................................     $500,000   $3,306,677         $6,689,793        66.92     $334,608
1/1/02...................................      500,000    3,306,677          6,689,793        66.92      334,608
1/1/03...................................      500,000    3,306,677          6,689,793        66.92      334,608
1/1/04...................................      500,000    3,306,677          6,689,793        66.92      334,608
1/1/05...................................      500,000    3,306,677          6,689,793        66.92      334,608
1/1/06...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/07...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/08...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/09...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/10...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/11...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/12...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/13...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/14...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/15...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/16...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/17...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/18...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/19...................................      500,000  ...........          9,215,167       100.00      500,000
1/1/20...................................      500,000  ...........          9,215,167       100.00      500,000
                                          ----------------------------------------------------------------------
                                           $10,000,000  $16,533,385       $171,676,476  ...........   $9,173,039
----------------------------------------------------------------------------------------------------------------

    Example 4. Refunding taxable bonds and qualified bonds. (i) In 1999, 
City C issues taxable bonds to finance the construction of a facility 
for the furnishing of water. The bonds are secured by revenues from the 
facility. The facility is managed pursuant to a management contract with 
a nongovernmental person that gives rise to private business use. In 
2007, C terminates the management contract and takes over the operation 
of the facility. In 2009, C issues bonds to refund the 1999 bonds. On 
the issue date of the 2009 bonds, C reasonably expects that the facility 
will not be used for a private business use during the term of the 2009 
bonds. In addition, during the term of the 2009 bonds, the facility is 
not used for a private business use. Under paragraph (b)(2)(i) of this 
section, the 2009 bonds do not satisfy the private business use test 
because the amount of private business use is based on the measurement 
period for those bonds and therefore does not take

[[Page 58]]

into account any private business use that occurred pursuant to the 
management contract.
    (ii) The facts are the same as in paragraph (i) of this Example 4, 
except that the 1999 bonds are issued as exempt facility bonds under 
section 142(a)(4). The 2009 bonds do not satisfy the private business 
use test.
    Example 5. Multipurpose issue. (i) In 2017, State D issues bonds to 
finance the construction of two office buildings, Building 1 and 
Building 2. D expends an equal amount of the proceeds on each building. 
D enters into arrangements that result in private business use of 8 
percent of Building 1 and 12 percent of Building 2 during the 
measurement period under Sec.  1.141-3(g) and private payments of 4 
percent of the 2017 bonds in respect of Building 1 and 6 percent of the 
2017 bonds in respect of Building 2. These arrangements result in a 
total of 10 percent of the proceeds of the 2017 bonds being used for a 
private business use and total private payments of 10 percent. In 2022, 
D purports to make a multipurpose issue allocation under paragraph (d) 
of this section of the outstanding 2017 bonds, allocating the issue into 
two separate issues of equal amounts with one issue allocable to 
Building 1 and the second allocable to Building 2. An allocation is 
unreasonable under paragraph (d) of this section if it achieves more 
favorable results under section 141 than could be achieved with actual 
separate issues. D's allocation is unreasonable because, if permitted, 
it would allow more favorable results under section 141 for the 2017 
bonds (that is, private business use and private payments that exceed 10 
percent for the 2017 bonds allocable to Building 2) than could be 
achieved with actual separate issues. In addition, if D's purported 
allocation was intended to result in two separate issues of tax-exempt 
governmental bonds (versus tax-exempt private activity bonds), the 
allocation would violate paragraph (d) of this section in the first 
instance because the allocation to the separate issue for Building 2 
would fail to qualify separately as an issue of tax-exempt governmental 
bonds as a result of its 12 percent of private business use and private 
payments.
    (ii) The facts are the same as in paragraph (i) of this Example 5, 
except that D enters into arrangements only for Building 1, and it 
expects no private business use of Building 2. In 2022, D allocates an 
equal amount of the outstanding 2017 bonds to Building 1 and Building 2. 
D selects particular bonds for each separate issue such that the 
allocation does not achieve a more favorable result than could have been 
achieved by issuing actual separate issues. D uses the same allocation 
for purposes of both sections 141 and 148. D's allocation is reasonable.
    (iii) The facts are the same as in paragraph (ii) of this Example 5, 
except that as part of the same issue, D issues bonds for a privately 
used airport. The airport bonds, if issued as a separate issue, would be 
qualified private activity bonds. The remaining bonds, if issued 
separately from the airport bonds, would be governmental bonds. Treated 
as one issue, however, the bonds are taxable private activity bonds. 
Therefore, D makes its allocation of the bonds under paragraph (d) of 
this section and Sec.  1.150-1(c)(3) into 3 separate issues on or before 
the issue date. Assuming all other applicable requirements are met, the 
bonds of the respective issues will be tax-exempt qualified private 
activity bonds or governmental bonds.
    Example 6. Non-deliberate action. In 1998, City E issues bonds to 
finance the purchase of land and construction of a building (the prior 
bonds). On the issue date of the prior bonds, E reasonably expects that 
it will be the sole user of the financed property for the entire term of 
the bonds. In 2003, the federal government acquires the financed 
property in a condemnation action. In 2006, E issues bonds to refund the 
prior bonds (the refunding bonds). The weighted average maturity of the 
refunding bonds is not greater than the reasonably expected economic 
life of the financed property. In general, under Sec.  1.141-2(d) and 
this section, reasonable expectations must be separately tested on the 
issue date of a refunding issue. Under paragraph (e) of this section, 
however, the condemnation action is not taken into account in applying 
the reasonable expectations test to the refunding bonds because the 
condemnation action is not a deliberate action within the meaning of 
Sec.  1.141-2(d)(3) and the weighted average maturity of the refunding 
bonds is not greater than the weighted average reasonably expected 
economic life of the property financed by the prior bonds. Thus, the 
condemnation action does not cause the refunding bonds to be private 
activity bonds.
    Example 7. Non-transitioned refunding of bonds subject to 1954 Code. 
In 1985, County F issues bonds to finance a court house. The 1985 bonds 
are subject to the provisions of the Internal Revenue Code of 1954. In 
2006, F issues bonds to refund all of the outstanding 1985 bonds. The 
weighted average maturity of the 2006 bonds is longer than the remaining 
weighted average maturity of the 1985 bonds. In addition, the 2006 bonds 
do not satisfy any transitional rule for refundings in the Tax Reform 
Act of 1986, 100 Stat. 2085 (1986). Section 141 and this section apply 
to determine whether the 2006 bonds are private activity bonds including 
whether, for purposes of Sec.  1.141-13(b)(2)(ii)(B), the 1985 bonds 
satisfy the private business use test based on a measurement period that 
begins on the

[[Page 59]]

first day of the combined measurement period for the 2006 bonds and ends 
on the issue date of the 2006 bonds.

[T.D. 9234, 70 FR 75032, Dec. 19, 2006, as amended by T.D. 9741, 80 FR 
65645, Oct. 27, 2015]



Sec.  1.141-14  Anti-abuse rules.

    (a) Authority of Commissioner to reflect substance of transactions. 
If an issuer enters into a transaction or series of transactions with 
respect to one or more issues with a principal purpose of transferring 
to nongovernmental persons (other than as members of the general public) 
significant benefits of tax-exempt financing in a manner that is 
inconsistent with the purposes of section 141, the Commissioner may take 
any action to reflect the substance of the transaction or series of 
transactions, including--
    (1) Treating separate issues as a single issue for purposes of the 
private activity bond tests;
    (2) Reallocating proceeds to expenditures, property, use, or bonds;
    (3) Reallocating payments to use or proceeds;
    (4) Measuring private business use on a basis that reasonably 
reflects the economic benefit in a manner different than as provided in 
Sec.  1.141-3(g); and
    (5) Measuring private payments or security on a basis that 
reasonably reflects the economic substance in a manner different than as 
provided in Sec.  1.141-4.
    (b) Examples. The following examples illustrate the application of 
this section:
    Example 1. Reallocating proceeds to indirect use. City C issues 
bonds with proceeds of $20 million for the stated purpose of financing 
improvements to roads that it owns. As a part of the same plan of 
financing, however, C also agrees to make a loan of $7 million to 
Corporation M from its general revenues that it otherwise would have 
used for the road improvements. The interest rate of the loan 
corresponds to the interest rate on a portion of the issue. A principal 
purpose of the financing arrangement is to transfer to M significant 
benefits of the tax-exempt financing. Although C actually allocates all 
of the proceeds of the bonds to the road improvements, the Commissioner 
may reallocate a portion of the proceeds of the bonds to the loan to M 
because a principal purpose of the financing arrangement is to transfer 
to M significant benefits of tax-exempt financing in a manner that is 
inconsistent with the purposes of section 141. The bonds are private 
activity bonds because the issue meets the private loan financing test. 
The bonds also meet the private business tests. See also Sec. Sec.  
1.141-3(a)(2), 1.141-4(a)(1), and 1.141-5(a), under which indirect use 
of proceeds and payments are taken into account.
    Example 2. Taking into account use of amounts derived from proceeds 
that would be otherwise disregarded. County B issues bonds with proceeds 
of $10 million to finance the purchase of land. On the issue date, B 
reasonably expects that it will be the sole user of the land. 
Subsequently, the federal government acquires the land for $3 million in 
a condemnation action. B uses this amount to make a loan to Corporation 
M. In addition, the interest rate on the loan reflects the tax-exempt 
interest rate on the bonds and thus is substantially less than a current 
market rate. A principal purpose of the arrangement is to transfer to M 
significant benefits of the tax-exempt financing. Although the 
condemnation action is not a deliberate action, the Commissioner may 
treat the condemnation proceeds as proceeds of the issue because a 
principal purpose of the arrangement is to transfer to M significant 
benefits of tax-exempt financing in a manner inconsistent with the 
purposes of section 141. The bonds are private activity bonds.
    Example 3. Measuring private business use on an alternative basis. 
City F issues bonds with a 30-year term to finance the acquisition of an 
industrial building having a remaining reasonably expected useful 
economic life of more than 30 years. On the issue date, F leases the 
building to Corporation G for 3 years. F reasonably expects that it will 
be the sole user of the building for the remaining term of the bonds. 
Because of the local market conditions, it is reasonably expected that 
the fair rental value of the industrial building will be significantly 
greater during the early years of the term of the bonds than in the 
later years. The annual rental payments are significantly less than fair 
market value, reflecting the interest rate on the bonds. The present 
value of these rental payments (net of operation and maintenance 
expenses) as of the issue date, however, is approximately 25 percent of 
the present value of debt service on the issue. Under Sec.  1.141-3, the 
issue does not meet the private business tests, because only 10 percent 
of the proceeds are used in a trade or business by a nongovernmental 
person. A principal purpose of the issue is to transfer to G significant 
benefits of tax-exempt financing in a manner inconsistent with the 
purposes of section 141. The method of measuring private business use 
over the reasonably expected useful economic life of financed property 
is for the administrative convenience of issuers of state and local 
bonds. In cases where this method is used in a manner inconsistent with 
the purposes of section 141, the Commissioner

[[Page 60]]

may measure private business use on another basis that reasonably 
reflects economic benefit, such as in this case on an annual basis. If 
the Commissioner measures private business use on an annual basis, the 
bonds are private activity bonds because the private payment test is met 
and more than 10 percent of the proceeds are used in a trade or business 
by a nongovernmental person.
    Example 4. Treating separate issues as a single issue. City D enters 
into a development agreement with Corporation T to induce T to locate 
its headquarters within D's city limits. Pursuant to the development 
agreement, in 1997 D will issue $20 million of its general obligation 
bonds (the 1997 bonds) to purchase land that it will grant to T. The 
development agreement also provides that, in 1998, D will issue $20 
million of its tax increment bonds (the 1998 bonds), secured solely by 
the increase in property taxes in a special taxing district. 
Substantially all of the property within the special taxing district is 
owned by T or D. T will separately enter into an agreement to guarantee 
the payment of tax increment to D in an amount sufficient to retire the 
1998 bonds. The proceeds of the 1998 bonds will be used to finance 
improvements owned and operated by D that will not give rise to private 
business use. Treated separately, the 1997 issue meets the private 
business use test, but not the private security or payment test; the 
1998 issue meets the private security or payment test, but not the 
private business use test. A principal purpose of the financing plan, 
including the two issues, is to transfer significant benefits of tax-
exempt financing to T for its headquarters. Thus, the 1997 issue and the 
1998 issue may be treated by the Commissioner as a single issue for 
purposes of applying the private activity bond tests. Accordingly, the 
bonds of both the 1997 issue and the 1998 issue may be treated as 
private activity bonds.
    Example 5. Reallocating proceeds. City E acquires an electric 
generating facility with a useful economic life of more than 40 years 
and enters into a 30-year take or pay contract to sell 30 percent of the 
available output to investor-owned utility M. E plans to use the 
remaining 70 percent of available output for its own governmental 
purposes. To finance the entire cost of the facility, E issues $30 
million of its series A taxable bonds at taxable interest rates and $70 
million series B bonds, which purport to be tax-exempt bonds, at tax-
exempt interest rates. E allocates all of M's private business use to 
the proceeds of the series A bonds and all of its own government use to 
the proceeds of the series B bonds. The series A bonds have a weighted 
average maturity of 15 years, while the series B bonds have a weighted 
average maturity of 26 years. M's payments under the take or pay 
contract are expressly determined by reference to 30 percent of M's 
total costs (that is, the sum of the debt service required to be paid on 
both the series A and the series B bonds and all other operating costs). 
The allocation of all of M's private business use to the series A bonds 
does not reflect economic substance because the series of transactions 
transfers to M significant benefits of the tax-exempt interest rates 
paid on the series B bonds. A principal purpose of the financing 
arrangement is to transfer to M significant benefits of the tax-exempt 
financing. Accordingly, the Commissioner may allocate M's private 
business use on a pro rata basis to both the series B bonds as well as 
the series A bonds, in which case the series B bonds are private 
activity bonds.
    Example 6. Allocations respected. The facts are the same as in 
Example 5, except that the debt service component of M's payments under 
the take or pay contract is based exclusively on the amounts necessary 
to pay the debt service on the taxable series A bonds. E's allocation of 
all of M's private business use to the series A bonds is respected 
because the series of transactions does not actually transfer benefits 
of tax-exempt interest rates to M. Accordingly, the series B bonds are 
not private activity bonds. The result would be the same if M's payments 
under the take or pay contract were based exclusively on fair market 
value pricing, rather than the tax-exempt interest rates on E's bonds. 
The result also would be the same if the series A bonds and the series B 
bonds had substantially equivalent weighted average maturities and E and 
M had entered into a customary contract providing for payments based on 
a ratable share of total debt service. E would not be treated by the 
Commissioner in any of these cases as entering into the contract with a 
principal purpose of transferring the benefits of tax-exempt financing 
to M in a manner inconsistent with the purposes of section 141.

[T.D. 8712, 62 FR 2301, Jan. 16, 1997]



Sec.  1.141-15  Effective/applicability dates.

    (a) Scope. The effective dates of this section apply for purposes of 
Sec. Sec.  1.141-1 through 1.141-14, 1.145-1 through 1.145-2, and 1.150-
1(a)(3) and the definition of bond documents contained in Sec.  1.150-
1(b).
    (b) Effective dates--(1) In general. Except as otherwise provided in 
this section, Sec. Sec.  1.141-0 through 1.141-6(a), 1.141-9 through 
1.141-12, 1.141-14, 1.145-1 through 1.145-2(c), and the definition of 
bond documents contained in Sec.  1.150-1(b) (the 1997 regulations) 
apply to bonds issued on or after May 16, 1997, that are subject to 
section 1301 of the Tax Reform Act of 1986 (100 Stat. 2602).
    (2) Certain short-term arrangements. The provisions of Sec.  1.141-3 
that refer to

[[Page 61]]

arrangements for 200 days, 100 days, or 50 days apply to any bond sold 
on or after November 20, 2001 and may be applied to any bond outstanding 
on November 20, 2001 to which Sec.  1.141-3 applies.
    (3) Certain prepayments. Except as provided in paragraph (c) of this 
section, paragraphs (c)(2)(ii), (c)(2)(iii) and (c)(2)(iv) of Sec.  
1.141-5 apply to bonds sold on or after October 3, 2003. Issuers may 
apply paragraphs (c)(2)(ii), (c)(2)(iii) and (c)(2)(iv) of Sec.  1.141-
5, in whole but not in part, to bonds sold before October 3, 2003 that 
are subject to Sec.  1.141-5.
    (4) Certain remedial actions--(i) General rule. For bonds subject to 
Sec.  1.141-12, the provisions of Sec.  1.141-12(d)(3), (i), (j), and 
(k), Example 8, apply to deliberate actions that occur on or after 
January 25, 2016.
    (ii) Special rule for allocations of nonqualified bonds. For 
purposes of Sec.  1.141-12(j)(2), in addition to the allocation methods 
permitted in Sec.  1.141-12(j)(2), an issuer may treat bonds with the 
longest maturities (determined on a bond-by-bond basis) as the 
nonqualified bonds, but only for bonds sold before January 25, 2016.
    (c) Refunding bonds. Except as otherwise provided in this section, 
the 1997 regulations (defined in paragraph (b)(1) of this section) do 
not apply to any bonds issued on or after May 16, 1997, to refund a bond 
to which those regulations do not apply unless--
    (1) The refunding bonds are subject to section 1301 of the Tax 
Reform Act of 1986 (100 Stat. 2602); and
    (2)(i) The weighted average maturity of the refunding bonds is 
longer than--
    (A) The weighted average maturity of the refunded bonds; or
    (B) In the case of a short-term obligation that the issuer 
reasonably expects to refund with a long-term financing (such as a bond 
anticipation note), 120 percent of the weighted average reasonably 
expected economic life of the facilities financed; or
    (ii) A principal purpose for the issuance of the refunding bonds is 
to make one or more new conduit loans.
    (d) Permissive application of regulations. Except as provided in 
paragraph (e) of this section, the 1997 regulations (defined in 
paragraph (b)(1) of this section) may be applied in whole, but not in 
part, to actions taken before February 23, 1998, with respect to--
    (1) Bonds that are outstanding on May 16, 1997, and subject to 
section 141; or
    (2) Refunding bonds issued on or after May 16, 1997, that are 
subject to 141.
    (e) Permissive application of certain sections--(1) In general. The 
following sections may each be applied by issuers to any bonds:
    (i) Section 1.141-3(b)(4);
    (ii) Section 1.141-3(b)(6); and
    (iii) Section 1.141-12.
    (2) Transition rule for pre-effective date bonds. For purposes of 
paragraphs (e)(1) and (h) of this section, issuers may apply Sec.  
1.141-12 to bonds issued before May 16, 1997, without regard to 
paragraph (d)(5) thereof with respect to deliberate actions that occur 
on or after April 21, 2003.
    (f) Effective dates for certain regulations relating to output 
facilities--(1) General rule. Except as otherwise provided in this 
section, Sec. Sec.  1.141-7 and 1.141-8 apply to bonds sold on or after 
November 22, 2002, that are subject to section 1301 of the Tax Reform 
Act of 1986 (100 Stat. 2602).
    (2) Transition rule for requirements contracts. For bonds otherwise 
subject to Sec. Sec.  1.141-7 and 1.141-8, Sec.  1.141-7(c)(3) applies 
to output contracts entered into on or after September 19, 2002. An 
output contract is treated as entered into on or after that date if it 
is amended on or after that date, but only if the amendment results in a 
change in the parties to the contract or increases the amount of 
requirements covered by the contract by reason of an extension of the 
contract term or a change in the method for determining such 
requirements. For purposes of this paragraph (f)(2)--
    (i) The extension of the term of a contract causes the contract to 
be treated as entered into on the first day of the additional term;
    (ii) The exercise by a party of a legally enforceable right that was 
provided under a contract before September 19, 2002, on terms that were 
fixed and determinable before such date, is not treated as an amendment 
of the contract. For example, the exercise by a purchaser after 
September 19,

[[Page 62]]

2002 of a renewal option that was provided under a contract before that 
date, on terms identical to the original contract, is not treated as an 
amendment of the contract; and
    (iii) An amendment that increases the amount of requirements covered 
by the contract by reason of a change in the method for determining such 
requirements is treated as a separate contract that is entered into as 
of the effective date of the amendment, but only with respect to the 
increased output to be provided under the contract.
    (g) Refunding bonds for output facilities. Except as otherwise 
provided in paragraph (h) or (i) of this section, Sec. Sec.  1.141-7 and 
1.141-8 do not apply to any bonds sold on or after November 22, 2002, to 
refund a bond to which Sec. Sec.  1.141-7 and 1.141-8 do not apply 
unless--
    (1) The refunding bonds are subject to section 1301 of the Tax 
Reform Act of 1986 (100 Stat. 2602); and
    (2)(i) The weighted average maturity of the refunding bonds is 
longer than--
    (A) The weighted average maturity of the refunded bonds; or
    (B) In the case of a short-term obligation that the issuer 
reasonably expects to refund with a long-term financing (such as a bond 
anticipation note), 120 percent of the weighted average reasonably 
expected economic life of the facilities financed; or
    (ii) A principal purpose for the issuance of the refunding bonds is 
to make one or more new conduit loans.
    (h) Permissive retroactive application. Except as provided in 
paragraphs (d), (e) or (i) of this section, Sec. Sec.  1.141-1 through 
1.141-6(a), 1.141-7 through 1.141-14, 1.145-1 through 1.145-2, 1.149(d)-
1(g), 1.150-1(a)(3), the definition of bond documents contained in Sec.  
1.150-1(b) and Sec.  1.150-1(c)(3)(ii) may be applied by issuers in 
whole, but not in part, to--
    (1) Outstanding bonds that are sold before February 17, 2006, and 
subject to section 141; or
    (2) Refunding bonds that are sold on or after February 17, 2006, and 
subject to section 141.
    (i) Permissive application of certain regulations relating to output 
facilities. Issuers may apply each of the following sections to any 
bonds used to finance output facilities:
    (1) Section 1.141-6;
    (2) Section 1.141-7(f)(3); and
    (3) Section 1.141-7(g).
    (j) Effective dates for certain regulations relating to refundings. 
Except as otherwise provided in this section, Sec. Sec.  1.141-13, 
1.145-2(d), 1.149(d)-1(g), 1.150-1(a)(3) and 1.150-1(c)(3)(ii) apply to 
bonds that are sold on or after February 17, 2006, and that are subject 
to the 1997 regulations (defined in paragraph (b)(1) of this section).
    (k) Effective/applicability dates for certain regulations relating 
to generally applicable taxes and payments in lieu of tax--(1) In 
general. Except as otherwise provided in paragraphs (k)(2) and (k)(3) of 
this section, revised Sec. Sec.  1.141-4(e)(2), 1.141-4(e)(3) and 1.141-
4(e)(5) apply to bonds sold on or after October 24, 2008 that are 
otherwise subject to the 1997 Regulations (defined in paragraph (b)(1) 
of this section).
    (2) Transitional rule for certain refundings. Paragraph (k)(1) does 
not apply to bonds that are issued to refund bonds if--
    (i) Either--
    (A) The refunded bonds (or the original bonds in a series of 
refundings) were sold before October 24, 2008, or
    (B) The refunded bonds (or the original bonds in a series of 
refundings) satisfied the transitional rule for projects substantially 
in progress under paragraph (k)(3) of this section; and
    (ii) The weighted average maturity of the refunding bonds does not 
exceed the remaining weighted average maturity of the refunded bonds.
    (3) Transitional rule for certain projects substantially in 
progress. Paragraph (k)(1) of this section does not apply to bonds 
issued for projects for which all of the following requirements are met:
    (i) A governmental person (as defined in Sec.  1.141-1) took 
official action evidencing its preliminary approval of the project 
before October 19, 2006, and the plan of finance for the project in 
place at that time contemplated financing the project with tax-exempt 
bonds to be paid or secured by PILOTs.
    (ii) Before October 19, 2006, significant expenditures were paid or 
incurred with respect to the project or a contract was entered into to 
pay or incur significant expenditures with respect to the project.

[[Page 63]]

    (iii) The bonds for the project (excluding refunding bonds) are 
issued on or before December 31, 2009.
    (l) Applicability date for certain regulations relating to 
allocation and accounting--(1) In general. Except as otherwise provided 
in this section, Sec. Sec.  1.141-1(e), 1.141-3(g)(2)(v), 1.141-6, 
1.141-13(d), and 1.145-2(b)(4), (b)(5), and (c)(2) apply to bonds that 
are sold on or after January 25, 2016, and to which the 1997 regulations 
(as defined in paragraph (b)(1) of this section) apply.
    (2) Refunding bonds. Except as otherwise provided in this section, 
Sec. Sec.  1.141-1(e), 1.141-3(g)(2)(v), 1.141-6, and 1.145-2(b)(4), 
(5), and (c)(2) do not apply to any bonds sold on or after January 25, 
2016, to refund a bond to which these sections do not apply, provided 
that the weighted average maturity of the refunding bonds is no longer 
than--
    (i) The remaining weighted average maturity of the refunded bonds; 
or
    (ii) In the case of a short-term obligation that the issuer 
reasonably expects to refund with a long-term financing (such as a bond 
anticipation note), 120 percent of the weighted average reasonably 
expected economic life of the facilities financed.
    (3) Permissive application. Except as otherwise provided in this 
section, issuers may apply Sec. Sec.  1.141-1(e), 1.141-3(g)(2)(v), 
1.141-6, and 1.145-2(b)(4), (b)(5), and (c)(2), in whole but not in 
part, to bonds to which the 1997 regulations apply.
    (m) Permissive retroactive application of certain regulations. 
Issuers may apply Sec.  1.141-13(d) to bonds to which Sec.  1.141-13 
applies.
    (n) Effective/applicability dates for certain regulations relating 
to certain definitions. Sec.  1.141-1(a) applies to bonds that are sold 
on or after October 17, 2016.

[T.D. 8757, 63 FR 3265, Jan. 22, 1998, as amended by T.D. 8941, 66 FR 
4670, Jan. 18, 2001; T.D. 8967, 66 FR 58062, Nov. 20, 2001; T.D. 9016, 
67 FR 59765, Sept. 23, 2002; T.D. 9085, 68 FR 45775, Aug. 4, 2003; T.D. 
9234, 70 FR 75035, Dec. 19, 2005; 71 FR 1971, Jan. 12, 2006; T.D. 9429, 
73 FR 63375, Oct. 24, 2008; T.D. 9741, 80 FR 65645, Oct. 27, 2015; 80 FR 
74678, Nov. 30, 2015; T.D. 9777, 81 FR 46592, July 18, 2016]



Sec.  1.141-16  Effective dates for qualified private activity bond provisions.

    (a) Scope. The effective dates of this section apply for purposes of 
Sec. Sec.  1.142-0 through 1.142-2, 1.144-0 through 1.144-2, 1.147-0 
through 1.147-2, and 1.150-4.
    (b) Effective dates. Except as otherwise provided in this section, 
the regulations designated in paragraph (a) of this section apply to 
bonds issued on or after May 16, 1997 (the effective date).
    (c) Permissive application. The regulations designated in paragraph 
(a) of this section may be applied by issuers in whole, but not in part, 
to bonds outstanding on the effective date. For this purpose, issuers 
may apply Sec.  1.142-2 without regard to paragraph (c)(3) thereof to 
failures to properly use proceeds that occur on or after April 21, 2003.
    (d) Certain remedial actions--(1) General rule. The provisions of 
Sec.  1.142-2(e) apply to failures to properly use proceeds that occur 
on or after August 13, 2004 and may be applied by issuers to failures to 
properly use proceeds that occur on or after May 14, 2004, provided that 
the bonds are subject to Sec.  1.142-2.
    (2) Special rule for allocations of nonqualified bonds. For purposes 
of Sec.  1.142-2(e)(2), in addition to the allocation methods permitted 
in Sec.  1.142-2(e)(2), an issuer may treat bonds with the longest 
maturities (determined on a bond-by-bond basis) as the nonqualified 
bonds, but only with respect to failures to properly use proceeds that 
occur on or after May 14, 2004, with respect to bonds sold before August 
13, 2004.

[T.D. 8712, 62 FR 2302, Jan. 16, 1997, as amended by T.D. 9150, 69 FR 
50066, Aug. 13, 2004]



Sec.  1.142-0  Table of contents.

    This section lists the captioned paragraphs contained in Sec. Sec.  
1.142-1 through 1.142-3.

                  Sec.  1.142-1 Exempt facility bonds.

    (a) Overview.
    (b) Scope.
    (c) Effective dates.

                     Sec.  1.142-2 Remedial actions.

    (a) General rule.
    (b) Reasonable expectations requirement.
    (c) Redemption or defeasance.
    (1) In general.
    (2) Notice of defeasance.
    (3) Special limitation.
    (4) Special rule for dispositions of personal property.
    (5) Definitions.

[[Page 64]]

    (d) When a failure to properly use proceeds occurs.
    (1) Proceeds not spent.
    (2) Proceeds spent.
    (e) Nonqualified bonds.
    (1) Amount of nonqualified bonds.
    (2) Allocation of nonqualified bonds.

               Sec.  1.142-3 Refunding issues. [Reserved]

[T.D. 8712, 62 FR 2302, Jan. 16, 1997, as amended by T.D. 9150, 69 FR 
50066, Aug. 13, 2004]



Sec.  1.142-1  Exempt facility bonds.

    (a) Overview. Interest on a private activity bond is not excludable 
from gross income under section 103(a) unless the bond is a qualified 
bond. Under section 141(e)(1)(A), an exempt facility bond issued under 
section 142 may be a qualified bond.
    Under section 142(a), an exempt facility bond is any bond issued as 
a part of an issue using 95 percent or more of the proceeds for certain 
exempt facilities.
    (b) Scope. Sections 1.142-0 through 1.142-3 apply for purposes of 
the rules for exempt facility bonds under section 142, except that, with 
respect to net proceeds that have been spent, Sec.  1.142-2 does not 
apply to bonds issued under section 142(d) (relating to bonds issued to 
provide qualified residential rental projects) and section 142(f) (2) 
and (4) (relating to bonds issued to provide local furnishing of 
electric energy or gas).
    (c) Effective dates. For effective dates of Sec. Sec.  1.142-0 
through 1.142-2, see Sec.  1.141-16.

[T.D. 8712, 62 FR 2302, Jan. 16, 1997]



Sec.  1.142-2  Remedial actions.

    (a) General rule. If less than 95 percent of the net proceeds of an 
exempt facility bond are actually used to provide an exempt facility, 
and for no other purpose, the issue will be treated as meeting the use 
of proceeds requirement of section 142(a) if the issue meets the 
condition of paragraph (b) of this section and the issuer takes the 
remedial action described in paragraph (c) of this section.
    (b) Reasonable expectations requirement. The issuer must have 
reasonably expected on the issue date that 95 percent of the net 
proceeds of the issue would be used to provide an exempt facility and 
for no other purpose for the entire term of the bonds (disregarding any 
redemption provisions). To meet this condition the amount of the issue 
must have been based on reasonable estimates about the cost of the 
facility.
    (c) Redemption or defeasance--(1) In general. The requirements of 
this paragraph (c) are met if all of the nonqualified bonds of the issue 
are redeemed on the earliest call date after the date on which the 
failure to properly use the proceeds occurs under paragraph (d) of this 
section. Proceeds of tax-exempt bonds (other than those described in 
paragraph (d)(1) of this section) must not be used for this purpose. If 
the bonds are not redeemed within 90 days of the date on which the 
failure to properly use proceeds occurs, a defeasance escrow must be 
established for those bonds within 90 days of that date.
    (2) Notice of defeasance. The issuer must provide written notice to 
the Commissioner of the establishment of the defeasance escrow within 90 
days of the date the escrow is established.
    (3) Special limitation. The establishment of a defeasance escrow 
does not satisfy the requirements of this paragraph (c) if the period 
between the issue date and the first call date is more than 10\1/2\ 
years.
    (4) Special rule for dispositions of personal property. For 
dispositions of personal property exclusively for cash, the requirements 
of this paragraph (c) are met if the issuer expends the disposition 
proceeds within 6 months of the date of the disposition to acquire 
replacement property for the same qualifying purpose of the issue under 
section 142.
    (5) Definitions. For purposes of paragraph (c)(4) of this section, 
disposition proceeds means disposition proceeds as defined in Sec.  
1.141-12(c).
    (d) When a failure to properly use proceeds occurs--(1) Proceeds not 
spent. For net proceeds that are not spent, a failure to properly use 
proceeds occurs on the earlier of the date on which the issuer 
reasonably determines that the financed facility will not be completed 
or the date on which the financed facility is placed in service.
    (2) Proceeds spent. For net proceeds that are spent, a failure to 
properly use proceeds occurs on the date on which

[[Page 65]]

an action is taken that causes the bonds not to be used for the 
qualifying purpose for which the bonds were issued.
    (e) Nonqualified bonds--(1) Amount of nonqualified bonds. For 
purposes of this section, the nonqualified bonds are a portion of the 
outstanding bonds in an amount that, if the remaining bonds were issued 
on the date on which the failure to properly use the proceeds occurs, at 
least 95 percent of the net proceeds of the remaining bonds would be 
used to provide an exempt facility. If no proceeds have been spent to 
provide an exempt facility, all of the outstanding bonds are 
nonqualified bonds.
    (2) Allocation of nonqualified bonds. Allocations of nonqualified 
bonds must be made on a pro rata basis, except that an issuer may treat 
any bonds of an issue as the nonqualified bonds so long as--
    (i) The remaining weighted average maturity of the issue, determined 
as of the date on which the nonqualified bonds are redeemed or defeased 
(determination date), and excluding from the determination the 
nonqualified bonds redeemed or defeased by the issuer to meet the 
requirements of paragraph (c) of this section, is not greater than
    (ii) The remaining weighted average maturity of the issue, 
determined as of the determination date, but without regard to the 
redemption or defeasance of any bonds (including the nonqualified bonds) 
occurring on the determination date.

[T.D. 8712, 62 FR 2302, Jan. 16, 1997, as amended by T.D. 9150, 69 FR 
50067, Aug. 13, 2004]



Sec.  1.142-3  Refunding Issues. [Reserved]



Sec.  1.142-4  Use of proceeds to provide a facility.

    (a) In general. [Reserved]
    (b) Reimbursement allocations. If an expenditure for a facility is 
paid before the issue date of the bonds to provide that facility, the 
facility is described in section 142(a) only if the expenditure meets 
the requirements of Sec.  1.150-2 (relating to reimbursement 
allocations). For purposes of this paragraph (b), if the proceeds of an 
issue are used to pay principal of or interest on an obligation other 
than a State or local bond (for example, temporary construction 
financing of the conduit borrower), that issue is not a refunding issue, 
and, thus, Sec.  1.150-2(g) does not apply.
    (c) Limitation on use of facilities by substantial users--(1) In 
general. If the original use of a facility begins before the issue date 
of the bonds to provide the facility, the facility is not described in 
section 142(a) if any person that was a substantial user of the facility 
at any time during the 5-year period before the issue date or any 
related person to that user receives (directly or indirectly) 5 percent 
or more of the proceeds of the issue for the user's interest in the 
facility and is a substantial user of the facility at any time during 
the 5-year period after the issue date, unless--
    (i) An official intent for the facility is adopted under Sec.  
1.150-2 within 60 days after the date on which acquisition, 
construction, or reconstruction of that facility commenced; and
    (ii) For an acquisition, no person that is a substantial user or 
related person after the acquisition date was also a substantial user 
more than 60 days before the date on which the official intent was 
adopted.
    (2) Definitions. For purposes of paragraph (c)(1) of this section, 
substantial user has the meaning used in section 147(a)(1), related 
person has the meaning used in section 144(a)(3), and a user that is a 
governmental unit within the meaning of Sec.  1.103-1 is disregarded.
    (d) Effective date--(1) In general. This section applies to bonds 
sold on or after July 8, 1997. See Sec.  1.103-8(a)(5) for rules 
applicable to bonds sold before that date.
    (2) Elective retroactive application. An issuer may apply this 
section to any bond sold before July 8, 1997.

[T.D. 8718, 62 FR 25506, May 9, 1997]



Sec.  1.142(a)(5)-1  Exempt facility bonds: Sewage facilities.

    (a) In general. Under section 103(a), a private activity bond is a 
tax-exempt bond only if it is a qualified bond. A qualified bond 
includes an exempt facility bond, defined as any bond issued as part of 
an issue 95 percent or more of the net proceeds of which are used to 
provide a facility specified in section 142. One type of facility 
specified in section 142(a) is a sewage facility. This

[[Page 66]]

section defines the term sewage facility for purposes of section 142(a).
    (b) Definitions--(1) Sewage facility defined. A sewage facility is 
property--
    (i) Except as provided in paragraphs (b)(2) and (d) of this section, 
used for the secondary treatment of wastewater; however, for property 
treating wastewater reasonably expected to have an average daily raw 
wasteload concentration of biochemical oxygen demand (BOD) that exceeds 
350 milligrams per liter as oxygen (measured at the time the influent 
enters the facility) (the BOD limit), this paragraph (b)(1)(i) applies 
only to the extent the treatment is for wastewater having an average 
daily raw wasteload concentration of BOD that does not exceed the BOD 
limit;
    (ii) Used for the preliminary and/or primary treatment of wastewater 
but only to the extent used in connection with secondary treatment 
(without regard to the BOD limit described in paragraph (b)(1)(i) of 
this section);
    (iii) Used for the advanced or tertiary treatment of wastewater but 
only to the extent used in connection with and after secondary 
treatment;
    (iv) Used for the collection, storage, use, processing, or final 
disposal of--
    (A) Wastewater, which property is necessary for such preliminary, 
primary, secondary, advanced, or tertiary treatment; or
    (B) Sewage sludge removed during such preliminary, primary, 
secondary, advanced, or tertiary treatment (without regard to the BOD 
limit described in paragraph (b)(1)(i) of this section);
    (v) Used for the treatment, collection, storage, use, processing, or 
final disposal of septage (without regard to the BOD limit described in 
paragraph (b)(1)(i) of this section); and
    (vi) Functionally related and subordinate to property described in 
this paragraph (b)(1), such as sewage disinfection property.
    (2) Special rules and exceptions--(i) Exception to BOD limit. A 
facility treating wastewater with an average daily raw wasteload 
concentration of BOD exceeding the BOD limit will not fail to qualify as 
a sewage facility described in paragraph (b)(1) of this section to the 
extent that the failure to satisfy the BOD limit results from the 
implementation of a federal, state, or local water conservation program 
(for example, a program designed to promote water use efficiency that 
results in BOD concentrations beyond the BOD limit).
    (ii) Anti-abuse rule for BOD limit. A facility does not satisfy the 
BOD limit if there is any intentional manipulation of the BOD level to 
circumvent the BOD limit (for example, increasing the volume of water in 
the wastewater before the influent enters the facility with the 
intention of reducing the BOD level).
    (iii) Authority of Commissioner. In appropriate cases upon 
application to the Commissioner, the Commissioner may determine that 
facilities employing technologically advanced or innovative treatment 
processes qualify as sewage facilities if it is demonstrated that these 
facilities perform functions that are consistent with the definition of 
sewage facilities described in paragraph (b)(1) of this section.
    (3) Other applicable definitions--(i) Advanced or tertiary treatment 
means the treatment of wastewater after secondary treatment. Advanced or 
tertiary treatment ranges from biological treatment extensions to 
physical-chemical separation techniques such as denitrification, ammonia 
stripping, carbon adsorption, and chemical precipitation.
    (ii) Nonconventional pollutants are any pollutants that are not 
listed in 40 CFR 401.15, 401.16, or appendix A to part 423.
    (iii) Preliminary treatment means treatment that removes large 
extraneous matter from incoming wastewater and renders the incoming 
wastewater more amenable to subsequent treatment and handling.
    (iv) Pretreatment means a process that preconditions wastewater to 
neutralize or remove toxic, priority, or nonconventional pollutants that 
could adversely affect sewers or inhibit a preliminary, primary, 
secondary, advanced, or tertiary treatment operation.
    (v) Primary treatment means treatment that removes material that 
floats or will settle, usually by screens or settling tanks.

[[Page 67]]

    (vi) Priority pollutants are those pollutants listed in appendix A 
to 40 CFR part 423.
    (vii) Secondary treatment means the stage in sewage treatment in 
which a bacterial process (or an equivalent process) consumes the 
organic parts of wastes, usually by trickling filters or an activated 
sludge process.
    (viii) Sewage sludge is defined in 40 CFR 122.2 and includes 
septage.
    (ix) Toxic pollutants are those pollutants listed in 40 CFR 401.15.
    (c) Other property not included in the definition of a sewage 
facility. Property other than property described in paragraph (b)(1) of 
this section is not a sewage facility. Thus, for example, property is 
not a sewage facility, or functionally related and subordinate property, 
if the property is used for pretreatment of wastewater (whether or not 
this treatment is necessary to perform preliminary, primary, secondary, 
advanced, or tertiary treatment), or the related collection, storage, 
use, processing, or final disposal of the wastewater. In addition, 
property used to treat, process, or use wastewater subsequent to the 
time the wastewater can be discharged into navigable waters, as defined 
in 33 U.S.C. 1362, is not a sewage facility.
    (d) Allocation of costs. In the case of property that has both a use 
described in paragraph (b)(1) of this section (a sewage treatment 
function) and a use other than sewage treatment, only the portion of the 
cost of the property allocable to the sewage treatment function is taken 
into account as an expenditure to provide sewage facilities. The portion 
of the cost of property allocable to the sewage treatment function is 
determined by allocating the cost of that property between the 
property's sewage treatment function and any other uses by any method 
which, based on all the facts and circumstances, reasonably reflects a 
separation of costs for each use of the property.
    (e) Effective date--(1) In general. This section applies to issues 
of bonds issued after February 21, 1995.
    (2) Refundings. In the case of a refunding bond issued to refund a 
bond to which this section does not apply, the issuer need not apply 
this section to that refunding bond. This paragraph (e)(2) applies only 
if the weighted average maturity of the refunding bonds, as described in 
section 147(b), is not greater than the remaining weighted average 
maturity of the refunded bonds.

[T.D. 8576, 59 FR 66163, Dec. 23, 1994, as amended by T.D. 9546, Aug. 
19, 2011]



Sec.  1.142(a)(6)-1  Exempt facility bonds: solid waste disposal facilities.

    (a) In general. This section defines the term solid waste disposal 
facility for purposes of section 142(a)(6).
    (b) Solid waste disposal facility. The term solid waste disposal 
facility means a facility to the extent that the facility--
    (1) Processes solid waste (as defined in paragraph (c) of this 
section) in a qualified solid waste disposal process (as defined in 
paragraph (d) of this section);
    (2) Performs a preliminary function (as defined in paragraph (f) of 
this section); or
    (3) Is functionally related and subordinate (within the meaning of 
Sec.  1.103-8(a)(3)) to a facility described in paragraph (b)(1) or 
(b)(2) of this section.
    (c) Solid waste--(1) In general. Except to the extent excluded under 
paragraph (c)(2) of this section, for purposes of section 142(a)(6), the 
term solid waste means garbage, refuse, and other solid material derived 
from any agricultural, commercial, consumer, governmental, or industrial 
operation or activity if the material meets the requirements of both 
paragraph (c)(1)(i) and paragraph (c)(1)(ii) of this section. For 
purposes of this section, material is solid if it is solid at ambient 
temperature and pressure.
    (i) Used material or residual material. Material meets the 
requirements of this paragraph (c)(1)(i) if it is either used material 
(as defined in paragraph (c)(1)(i)(A)) of this section or residual 
material (as defined in paragraph (c)(1)(i)(B) of this section).
    (A) Used material. The term used material means any material that is 
a product of any agricultural, commercial, consumer, governmental, or 
industrial operation or activity, or a component of any such product or 
activity, and that has been used previously. Used material also includes 
animal waste

[[Page 68]]

produced by animals from a biological process.
    (B) Residual material. The term residual material means material 
that meets the requirements of this paragraph (c)(1)(i)(B). The material 
must be a residual byproduct or excess raw material that results from or 
remains after the completion of any agricultural, commercial, consumer, 
governmental, or industrial production process or activity or from the 
provision of any service. In the case of multiple processes constituting 
an integrated manufacturing or industrial process, the material must 
result from or remain after the completion of such integrated process. 
As of the issue date of the bonds used to finance the solid waste 
disposal facility, the material must be reasonably expected to have a 
fair market value that is lower than the value of all of the products 
made in that production process or lower than the value of the service 
that produces such residual material.
    (ii) Reasonably expected introduction into a qualified solid waste 
disposal process. Material meets the requirements of this paragraph 
(c)(1)(ii) if it is reasonably expected by the person who generates, 
purchases, or otherwise acquires it to be introduced within a reasonable 
time after such generation, purchase or acquisition into a qualified 
solid waste disposal process described in paragraph (d) of this section.
    (2) Exclusions from solid waste. The following materials do not 
constitute solid waste:
    (i) Virgin material. Except to the extent that virgin material 
constitutes an input to a final disposal process or residual material, 
solid waste excludes any virgin material. The term virgin material means 
material that has not been processed into an agricultural, commercial, 
consumer, governmental, or industrial product, or a component of any 
such product. Further, for this purpose, material continues to be virgin 
material after it has been grown, harvested, mined, or otherwise 
extracted from its naturally occurring location and cleaned, divided 
into component elements, modified, or enhanced, as long as further 
processing is required before it becomes an agricultural, commercial, 
consumer, or industrial product, or a component of any such product.
    (ii) Solids within liquids and liquid waste. Solid waste excludes 
any solid or dissolved material in domestic sewage or other significant 
pollutant in water resources, such as silt, dissolved or suspended 
solids in industrial waste water effluents, dissolved materials in 
irrigation return flows or other common water pollutants, and liquid or 
gaseous waste.
    (iii) Precious metals. Except to the extent that a precious metal 
constitutes an input to a final disposal process and/or an unrecoverable 
trace of the particular precious metal, solid waste excludes gold, 
silver, ruthenium, rhodium, palladium, osmium, iridium, platinum, 
gallium, rhenium, and any other precious metal material as may be 
identified by the Internal Revenue Service in future public 
administrative guidance.
    (iv) Hazardous material. Solid waste excludes any hazardous material 
that must be disposed of at a facility that is subject to final permit 
requirements under subtitle C of title II of the Solid Waste Disposal 
Act as in effect on the date of the enactment of the Tax Reform Act of 
1986 (which is October 22, 1986). See section 142(h)(1) of the Internal 
Revenue Code for the definition of qualified hazardous waste facilities.
    (v) Radioactive material. Solid waste excludes any radioactive 
material subject to regulation under the Nuclear Regulatory Act (10 CFR 
1.1 et seq.), as in effect on the issue date of the bonds.
    (d) Qualified solid waste disposal process. The term qualified solid 
waste disposal process means the processing of solid waste in a final 
disposal process (as defined in paragraph (d)(1) of this section), an 
energy conversion process (as defined in paragraph (d)(2) of this 
section), or a recycling process (as defined in paragraph (d)(3) of this 
section). Absent an express restriction to the contrary in this section, 
a qualified solid waste disposal process may employ any biological, 
engineering, industrial, or technological method.
    (1) Final disposal process. The term final disposal process means 
the placement of solid waste in a landfill (including, for this purpose, 
the spreading

[[Page 69]]

of solid waste over land in an environmentally compliant and safe manner 
with no intent to remove such solid waste), the incineration of solid 
waste without capturing any useful energy, or the containment of solid 
waste with a reasonable expectation as of the date of issue of the bonds 
that the containment will continue indefinitely and that the solid waste 
has no current or future beneficial use.
    (2) Energy conversion process. The term energy conversion process 
means a thermal, chemical, or other process that is applied to solid 
waste to create and capture synthesis gas, heat, hot water, steam, or 
other useful energy. The energy conversion process begins at the point 
of the first application of such process. The energy conversion process 
ends at the point at which the useful energy is first created, captured, 
or incorporated into the form of synthesis gas, heat, hot water, or 
other useful energy and before any transfer or distribution of such 
synthesis gas, heat, hot water or other useful energy, regardless of 
whether such synthesis gas, heat, hot water, or other useful energy 
constitutes a first useful product within the meaning of paragraph (e) 
of this section.
    (3) Recycling process--(i) In general. The term recycling process 
means reconstituting, transforming, or otherwise processing solid waste 
into a useful product. The recycling process begins at the point of the 
first application of a process to reconstitute or transform the solid 
waste into a useful product, such as decontamination, melting, re-
pulping, shredding, or other processing of the solid waste to accomplish 
this purpose. The recycling process ends at the point of completion of 
production of the first useful product from the solid waste.
    (ii) Refurbishment, repair, or similar activities. The term 
recycling process does not include refurbishment, repair, or similar 
activities. The term refurbishment means the breakdown and reassembly of 
a product if such activity is done on a product-by-product basis and if 
the finished product contains more than 30 percent of its original 
materials or components.
    (e) First useful product. The term first useful product means the 
first product produced from the processing of solid waste in a solid 
waste disposal process that is useful for consumption in agricultural, 
consumer, commercial, governmental, or industrial operation or activity 
and that could be sold for such use, whether or not actually sold. A 
useful product includes both a product useful to an individual consumer 
as an ultimate end-use consumer product and a product useful to an 
industrial user as a material or input for processing in some stage of a 
manufacturing or production process to produce a different end-use 
consumer product. The determination of whether a useful product has been 
produced may take into account operational constraints that affect the 
point in production when a useful product reasonably can be extracted or 
isolated and sold independently. For this purpose, the costs of 
extracting, isolating, storing, and transporting the product to a market 
may only be taken into account as operational constraints if the product 
is not to be used as part of an integrated manufacturing or industrial 
process in the same location as that in which the product is produced.
    (f) Preliminary function. A preliminary function is a function to 
collect, separate, sort, store, treat, process, disassemble, or handle 
solid waste that is preliminary to and directly related to a qualified 
solid waste disposal process.
    (g) Mixed-use facilities--(1) In general. If a facility is used for 
both a qualified solid waste disposal function (including a qualified 
solid waste disposal process or a preliminary function) and a 
nonqualified function (a mixed-use facility), then the costs of the 
facility allocable to the qualified solid waste disposal function are 
determined using any reasonable method, based on all the facts and 
circumstances. See Sec.  1.103-8(a)(1) for allocation rules on amounts 
properly allocable to an exempt facility. Facilities qualify as 
functionally related and subordinate to a qualified solid waste disposal 
function only to the extent that they are functionally related and 
subordinate to the portion of the mixed-use facility that is used for 
one or more qualified solid waste disposal functions (including a 
qualified solid waste disposal process or a preliminary function).

[[Page 70]]

    (2) Mixed inputs--(i) In general. Except as otherwise provided in 
paragraph (g)(2)(ii) of this section, for each facility (or a portion of 
a mixed-use facility) performing a qualified solid waste disposal 
process or a preliminary function, the percentage of the costs of the 
property used for such process that are allocable to a qualified solid 
waste disposal process or a preliminary function cannot exceed the 
average annual percentage of solid waste processed in that qualified 
solid waste disposal process or that preliminary function while the 
issue is outstanding. The annual percentage of solid waste processed in 
that qualified solid waste disposal process or preliminary function for 
any year is the percentage, by weight or volume, of the total materials 
processed in that qualified solid waste disposal process or preliminary 
function that constitute solid waste for that year.
    (ii) Special rule for mixed-input processes if at least 65 percent 
of the materials processed are solid waste--(A) In general. Except as 
otherwise provided in paragraph (g)(2)(ii)(B) of this section, for each 
facility (or a portion of a mixed-use facility) performing a qualified 
solid waste disposal process or preliminary function, if the annual 
percentage of solid waste processed in that qualified solid waste 
disposal process or preliminary function for each year that the issue is 
outstanding (beginning with the date such facility is placed in service 
within the meaning of Sec.  1.150-2(c)) equals at least 65 percent of 
the materials processed in that qualified solid waste disposal process 
or preliminary function, then all of the costs of the property used for 
such process are treated as allocable to a qualified solid waste 
disposal process. The annual percentage of solid waste processed in such 
qualified solid waste disposal process or preliminary function for any 
year is the percentage, by weight or volume, of the total materials 
processed in that qualified solid waste disposal process or preliminary 
function that constitute solid waste for that year.
    (B) Special rule for extraordinary events. In the case of an 
extraordinary event that is beyond the control of the operator of a 
solid waste disposal facility (such as a natural disaster, strike, major 
utility disruption, or governmental intervention) and that causes a 
solid waste disposal facility to be unable to meet the 65 percent test 
under paragraph (g)(2)(ii)(A) of this section for a particular year, the 
percentage of solid waste processed for that year equals--
    (1) The sum of the amount of solid waste processed in the solid 
waste disposal facility for the year affected by the extraordinary event 
and the amount of solid waste processed in the solid waste disposal 
facility during the following two years in excess of the amount required 
to meet the general 65 percent threshold for the facility during each of 
such two years; divided by
    (2) The total materials processed in the solid waste disposal 
facility during the year affected by the extraordinary event. If the 
resulting measure of solid waste processed for the year affected by the 
extraordinary event equals at least 65 percent, then the facility is 
treated as meeting the requirements of the 65 percent test under 
paragraph (g)(2)(ii)(A) of this section for such year.
    (iii) Facilities functionally related and subordinate to mixed-input 
facilities. Except to the extent that facilities are functionally 
related and subordinate to a mixed-input facility that meets the 65 
percent test under paragraph (g)(2)(ii) of this section, facilities 
qualify as functionally related and subordinate to a mixed-input 
facility only to the extent that they are functionally related and 
subordinate to the qualified portion of the mixed-input facility that is 
used for one or more qualified solid waste disposal functions (including 
a qualified solid waste disposal process or a preliminary function).
    (h) Examples. The following examples illustrate the application of 
this section:

    Example 1. Nonqualified Unused Material--Cloth. Company A takes wool 
and weaves it into cloth and then sells the cloth to a manufacturer to 
manufacture clothing. The cloth is material that has not been used 
previously as a product of or otherwise used in an agricultural, 
commercial, consumer, governmental, or industrial operation or activity, 
or as a component of any such product or activity. Accordingly, the 
cloth is not solid waste.

[[Page 71]]

    Example 2. Residual Material--Waste Coal. Company B mines coal. Some 
of the ore mined is a low quality byproduct of coal mining commonly 
known as waste coal, which cannot be converted to energy under a normal 
energy-production process because the BTU content is too low. Waste coal 
has the lowest fair market value of any product produced in Company B's 
coal mining process. Waste coal is solid waste because it is residual 
material within the meaning of paragraph (c)(1)(i)(B) of this section 
and Company B reasonably expects to introduce the waste coal into a 
solid waste disposal process.
    Example 3. Virgin Material--Logs. Company C cuts down trees and 
sells the logs to another company, which further processes the logs into 
lumber. In order to facilitate shipping, Company C cuts the trees into 
uniform logs. The trees are not solid waste because they are virgin 
material within the meaning of paragraph (c)(2)(i) of this section that 
are not being introduced into a final disposal process within the 
meaning of paragraph (d)(1) of this section. The division of such trees 
into uniform logs does not change the status of the trees as virgin 
material.
    Example 4. Qualified Solid Waste Disposal Process--Landfill. Company 
D plans to construct a landfill. The landfill will not be subject to the 
final permit requirements under subtitle C of title II of the Solid 
Waste Disposal Act (as in effect on the date of enactment of the Tax 
Reform Act of 1986). As of the issue date, Company D expects that the 
landfill will be filled entirely with material that will qualify as 
solid waste within the meaning of paragraph (c) of this section. Placing 
solid waste into a landfill is a qualified solid waste disposal process. 
The landfill is a qualified solid waste disposal facility.
    Example 5. Qualified Solid Waste Disposal Process--Recycling Tires. 
Company E owns a facility that converts used tires into roadbed 
material. The used tires are used material within the meaning of 
paragraph (c)(1)(i)(A) of this section that qualifies as solid waste. 
Between the introduction of the old tires into the roadbed manufacturing 
process and the completion of the roadbed material, the facility does 
not create any interim useful products. The process for the 
manufacturing of the roadbed material from the old tires is a qualified 
solid waste disposal process as a recycling process and the facility 
that converts the tires into roadbed material is a qualified solid waste 
disposal facility. This conclusion would be the same if the recycling 
process took place at more than one plant.
    Example 6. Qualified Solid Waste Disposal Process--Energy Conversion 
Process. Company F receives solid waste from a municipal garbage 
collector. Company F burns that solid waste in an incinerator to remove 
exhaust gas and to produce heat. Company F further processes the heat in 
a heat exchanger to produce steam. Company F further processes the steam 
to generate electricity. The energy conversion process ends with the 
production of steam. The facilities used to burn the solid waste and to 
capture the steam as useful energy are qualified solid waste disposal 
facilities because they process solid waste in an energy conversion 
process. The generating facilities used to process the steam further to 
generate electricity are not engaged in the energy conversion process 
and are not qualified solid waste disposal facilities.
    Example 7. Nonqualified Refurbishment. Company G purchases used cars 
and restores them. This restoration process includes disassembly, 
cleaning, and repairing of the cars. Parts that cannot be repaired are 
replaced. The restored cars contain at least 30 percent of the original 
parts. While the cars are used material, the refurbishing process is not 
a qualified solid waste disposal process. Accordingly, Company G's 
facility is not a qualified solid waste disposal facility.
    Example 8. Qualified Solid Waste Disposal Facility--First Useful 
Product Rule--Paper Recycling. (i) Company H employs an integrated 
process to re-pulp discarded magazines, clean the pulp, and produce 
retail paper towel products. Operational constraints on Company H's 
process do not allow for reasonable extraction, isolation, and sale of 
the cleaned paper pulp independently without degradation of the pulp. 
Company H further processes the paper pulp into large industrial-sized 
rolls of paper which are approximately 12 feet in diameter. At this 
point in the process, Company H could either sell such industrial-sized 
rolls of paper to another company for further processing to produce 
retail paper products or it could produce those retail products itself. 
In general, paper pulp is a useful product that is bought and sold on 
the market as a material for input into manufacturing or production 
processes. The discarded magazines are used material within the meaning 
of paragraph (c)(1)(i)(A) of this section. Company H's facility is 
engaged in a recycling process within the meaning of paragraph (d)(3) of 
this section to the extent that it repulps and cleans the discarded 
magazines generally and further to the extent that it produces 
industrial-sized rolls of paper under the particular circumstances here. 
Specifically, taking into account the operational constraints on Company 
H's facility that limit its ability reasonably to extract, isolate, and 
sell the paper pulp independently, the first useful products within the 
meaning of paragraph (e) of this section from Company H's recycling 
process are the industrial-sized rolls of paper. The portion of Company 
H's facility that processes the discarded magazines and produces 
industrial-sized rolls of paper is a qualified solid waste disposal 
facility, and the portion of Company

[[Page 72]]

H's facility that further processes the industrial-sized rolls of paper 
into retail paper towels is not a qualified solid waste facility.
    (ii) The facts are the same as in paragraph (i) of this Example 8, 
except that Company H is able reasonably to extract the cleaned paper 
pulp from the process without degradation of the pulp and to sell the 
cleaned paper pulp at its dock for a price that exceeds its costs of 
extracting the pulp from the process. Therefore, the paper pulp is the 
first useful product within the meaning of paragraph (e) of this 
section. As a result, the portion of Company H's facility that processes 
the discarded magazines is a qualified solid waste disposal facility, 
and the portion of Company H's facility that produces industrial-sized 
rolls of paper is not a qualified solid waste disposal facility. If, 
however, the only reasonable way Company H could sell the pulp was to 
transport the pulp to a distant market, then the costs of storing and 
transporting the pulp to the market may be taken into account in 
determining whether the pulp is the first useful product.
    Example 9. Preliminary Function--Energy Conversion Process. (i) 
Company I owns a paper mill. At the mill, logs from nearby timber 
operations are processed through a machine that removes bark. The 
stripped logs are used to manufacture paper. The stripped bark has the 
lowest fair market value of any product produced from the paper mill. 
The stripped bark falls onto a conveyor belt that transports the bark to 
a storage bin that is used to store the bark briefly until Company I 
feeds the bark into a boiler. The conveyor belt and storage bin are used 
only for these purposes. The boiler is used only to create steam by 
burning the bark, and the steam is used to generate electricity. The 
stripped bark is solid waste because it is residual material within the 
meaning of paragraph (c)(1)(i)(B) of this section and Company I expects 
to introduce the bark into an energy conversion process within a 
reasonable period of time. The creation of steam from the stripped bark 
is an energy conversion process that starts with the incineration of the 
stripped bark. The energy conversion process is a qualified solid waste 
disposal process. The conveyor belt performs a collection activity that 
is preliminary and that is directly related to the solid waste disposal 
function. The storage bin performs a storage function that is 
preliminary and that is directly related to the solid waste disposal 
function. Thus, the conveyor belt and storage bin are solid waste 
disposal facilities. The bark removal process is not a preliminary 
function because it is not directly related to the energy conversion 
process and it does not become so related merely because it results in 
material that is solid waste.
    (ii) The facts are the same as in paragraph (i) of this Example 9, 
except that the stripped bark represents only 55 percent by weight and 
volume of the materials that are transported by the conveyor belt. The 
remaining 45 percent of the materials transported by the conveyor belt 
are not solid waste and these other materials are sorted from the 
conveyor belt by a sorting machine immediately before the stripped bark 
arrives at the storage bin. Fifty-five percent of the costs of the 
conveyor belt and the sorting machine are allocable to solid waste 
disposal functions.
    Example 10. Preliminary Function--Final Disposal Process. Company J 
owns a waste transfer station and uses it to collect, sort, and process 
solid waste. Company J uses its trucks to haul the solid waste to the 
nearest landfill. At least 65 percent by weight and volume of the 
material brought to the transfer station is solid waste. The waste 
transfer station and the trucks perform functions that are preliminary 
and directly related to the solid waste disposal function of the 
landfill. Thus, the waste transfer station and the trucks qualify as 
solid waste disposal facilities.
    Example 11. Mixed-Input Facility. Company K owns an incinerator 
financed by an issue and uses the incinerator exclusively to burn coal 
and other solid material to create steam. Each year while the issue is 
outstanding, 40 percent by volume and 45 percent by weight of the solid 
material that Company K processes in the conversion process is coal. The 
remainder of the solid material is either used material or residual 
material within the meaning of paragraph (c)(1)(i) of this section. 
Sixty percent of the costs of the property used to perform the energy 
conversion process are allocable to a solid waste disposal function.

    (i) Effective/Applicability Dates--(1) In general. Except as 
otherwise provided in this paragraph (i), this section applies to bonds 
to which section 142 applies that are sold on or after October 18, 2011.
    (2) Elective retroactive application. Issuers may apply this 
section, in whole, but not in part, to outstanding bonds to which 
section 142 applies and which were sold before October 18, 2011.
    (3) Certain refunding bonds. An issuer need not apply this section 
to bonds that are issued in a current refunding to refund bonds to which 
this section does not apply if the weighted average maturity of the 
refunding bonds is no longer than the remaining weighted average 
maturity of the refunded bonds.

[T.D. 9546, 76 FR 51881, Aug. 19, 2011; 76 FR 55255, Sept. 7, 2011]

[[Page 73]]



Sec.  1.142(f)(4)-1  Manner of making election to terminate 
tax-exempt bond financing.

    (a) Overview. Section 142(f)(4) permits a person engaged in the 
local furnishing of electric energy or gas (a local furnisher) that uses 
facilities financed with exempt facility bonds under section 142(a)(8) 
and that expands its service area in a manner inconsistent with the 
requirements of sections 142(a)(8) and (f) to make an election to ensure 
that those bonds will continue to be treated as exempt facility bonds. 
The election must meet the requirements of paragraphs (b) and (c) of 
this section.
    (b) Time for making election--(1) In general. An election under 
section 142(f)(4)(B) must be filed with the Internal Revenue Service on 
or before 90 days after the date of the service area expansion that 
causes bonds to cease to meet the requirements of sections 142(a)(8) and 
(f).
    (2) Date of service area expansion. For the purposes of this 
section, the date of the service area expansion is the first date on 
which the local furnisher is authorized to collect revenue for the 
provision of service in the expanded area.
    (c) Manner of making election. An election under section 
142(f)(4)(B) must be captioned ``ELECTION TO TERMINATE TAX-EXEMPT BOND 
FINANCING'', must be signed under penalties of perjury by a person who 
has authority to sign on behalf of the local furnisher, and must contain 
the following information--
    (1) The name of the local furnisher;
    (2) The tax identification number of the local furnisher;
    (3) The complete address of the local furnisher;
    (4) The date of the service area expansion;
    (5) Identification of each bond issue subject to the election, 
including the complete name of each issue, the tax identification number 
of each issuer, the report number of the information return filed under 
section 149(e) for each issue, the issue date of each issue, the CUSIP 
number (if any) of the bond with the latest maturity of each issue, the 
issue price of each issue, the adjusted issue price of each issue as of 
the date of the election, the earliest date on which the bonds of each 
issue may be redeemed, and the principal amount of bonds of each issue 
to be redeemed on the earliest redemption date;
    (6) A statement that the local furnisher making the election agrees 
to the conditions stated in section 142(f)(4)(B); and
    (7) A statement that each issuer of the bonds subject to the 
election has received written notice of the election.
    (d) Effect on section 150(b). Except as provided in paragraph (e) of 
this section, if a local furnisher files an election within the period 
specified in paragraph (b) of this section, section 150(b) does not 
apply to bonds identified in the election during and after that period.
    (e) Effect of failure to meet agreements. If a local furnisher fails 
to meet any of the conditions stated in an election pursuant to 
paragraph (c)(6) of this section, the election is invalid.
    (f) Corresponding provisions of the Internal Revenue Code of 1954. 
Section 103(b)(4)(E) of the Internal Revenue Code of 1954 set forth 
corresponding requirements for the exclusion from gross income of the 
interest on bonds issued for facilities for the local furnishing of 
electric energy or gas. For the purposes of this section any reference 
to sections 142(a)(8) and (f) of the Internal Revenue Code of 1986 
includes a reference to the corresponding portion of section 
103(b)(4)(E) of the Internal Revenue Code of 1954.
    (g) Effective dates. This section applies to elections made on or 
after January 19, 2001.

[T.D. 8941, 66 FR 4671, Jan. 18, 2001]



Sec.  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

[[Page 74]]

meets the requirements of paragraph (c) of this section. The 
requirements of section 143(g) and this section are applicable in 
addition to the requirements of section 148 and Sec. Sec.  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
    (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 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

[[Page 75]]

account in computing the effective rate of interest on the mortgages 
financed with X's bonds.

    (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, 
Sec.  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, Sec.  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, Sec.  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 Sec.  1.143(g)-1, 
in whole, but not in part, to bonds sold before May 23, 2005, that are 
subject to section 143.
    (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 Sec.  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.
    (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, Sec.  
6a.103A-2(i)(3) of this chapter also applies to the bonds.

[T.D. 9204, 70 FR 29449, May 23, 2005]



Sec.  1.144-0  Table of contents.

    This section lists the captioned paragraphs contained in Sec. Sec.  
1.144-1 and 1.144-2.

Sec.  1.144-1 Qualified small issue bonds, qualified student loan bonds, 
                   and qualified redevelopment bonds.

    (a) Overview.
    (b) Scope.
    (c) Effective dates.

                     Sec.  1.144-2 Remedial actions.

[T.D. 8712, 62 FR 2303, Jan. 16, 1997]



Sec.  1.144-1  Qualified small issue bonds, qualified student loan bonds, 
and qualified redevelopment bonds.

    (a) Overview. Interest on a private activity bond is not excludable 
from gross income under section 103(a) unless the bond is a qualified 
bond. Under section 141(e)(1)(D), a qualified small issue bond issued 
under section 144(a) may be a qualified bond. Under section 144(a), any 
qualified small issue bond is any bond issued as a part of an issue 95 
percent or more of the proceeds of which are to be used to provide 
certain manufacturing facilities or certain depreciable farm property 
and which meets other requirements. Under section 141(e)(1)(F) a 
qualified redevelopment bond issued under section 144(c) is a qualified 
bond. Under section 144(c), a qualified redevelopment bond is any bond 
issued as a part of an issue 95 percent or more of the net proceeds of 
which are to be used for one or more redevelopment purposes and which 
meets certain other requirements.
    (b) Scope. Sections 1.144-0 through 1.144-2 apply for purposes of 
the rules for small issue bonds under section 144(a) and qualified 
redevelopment bonds under section 144(c), except that Sec.  1.144-2 does 
not apply to the requirements for qualified small issue bonds under 
section 144(a)(4) (relating to the limitation on capital expenditures) 
or under section 144(a)(10) (relating to the aggregate limit of tax-
exempt bonds per taxpayer).
    (c) Effective dates. For effective dates of Sec. Sec.  1.144-0 
through 1.144-2, see Sec.  1.141-16.

[T.D. 8712, 62 FR 2303, Jan. 16, 1997]



Sec.  1.144-2  Remedial actions.

    The remedial action rules of Sec.  1.142-2 apply to qualified small 
issue bonds issued under section 144(a) and to qualified redevelopment 
bonds issued under section 144(c), for this purpose

[[Page 76]]

treating those bonds as exempt facility bonds and the qualifying 
purposes for those bonds as exempt facilities.

[T.D. 8712, 62 FR 2303, Jan. 16, 1997]



Sec.  1.145-0  Table of contents.

    This section lists the captioned paragraphs contained in Sec. Sec.  
1.145-1 and 1.145-2.

                Sec.  1.145-1 Qualified 501(c)(3) bonds.

    (a) Overview.
    (b) Scope.
    (c) Effective dates.

     Sec.  1.145-2 Application of private activity bond regulations.

    (a) In general.
    (b) Modification of private business tests.
    (c) Exceptions.
    (1) Certain provisions relating to governmental programs.
    (2) Costs of issuance.
    (d) Issuance costs financed by prior issue.

[T.D. 8712, 62 FR 2303, Jan. 16, 1997, as amended by T.D. 9234, 70 FR 
75035, Dec. 19, 2005]



Sec.  1.145-1  Qualified 501(c)(3) bonds.

    (a) Overview. Interest on a private activity bond is not excludable 
from gross income under section 103(a) unless the bond is a qualified 
bond. Under section 141(e)(1)(G), a qualified 501(c)(3) bond issued 
under section 145 is a qualified bond. Under section 145, a qualified 
501(c)(3) bond is any bond issued as a part of an issue that satisfies 
the requirements of sections 145(a) through (d).
    (b) Scope. Sections 1.145-0 through 1.145-2 apply for purposes of 
section 145(a).
    (c) Effective dates. For effective dates of Sec. Sec.  1.145-0 
through 1.145-2, see Sec.  1.141-15.

[T.D. 8712, 62 FR 2303, Jan. 16, 1997]



Sec.  1.145-2  Application of private activity bond regulations.

    (a) In general. Except as provided in this section, Sec. Sec.  
1.141-0 through 1.141-15 apply to section 145(a). For example, under 
this section, Sec.  1.141-1, and Sec.  1.141-2, an issue ceases to be an 
issue of qualified 501(c)(3) bonds if the issuer or a conduit borrower 
501(c)(3) organization takes a deliberate action, subsequent to the 
issue date, that causes the issue to fail to comply with the 
requirements of sections 141(e) and 145 (such as an action that results 
in revocation of exempt status of the 501(c)(3) organization).
    (b) Modification of private business tests. In applying Sec. Sec.  
1.141-0 through 1.141-15 to section 145(a)--
    (1) References to governmental persons include 501(c)(3) 
organizations with respect to their activities that do not constitute 
unrelated trades or businesses under section 513(a);
    (2) References to ``10 percent'' and ``proceeds'' in the context of 
the private business use test and the private security or payment test 
mean ``5 percent'' and ``net proceeds''; and
    (3) References to the private business use test in Sec. Sec.  1.141-
2 and 1.141-12 include the ownership test of section 145(a)(1).
    (4) References to governmental bonds in Sec.  1.141-6 mean qualified 
501(c)(3) bonds.
    (5) References to ownership by governmental persons in Sec.  1.141-6 
mean ownership by governmental persons or 501(c)(3) organizations.
    (c) Exceptions--(1) Certain provisions relating to governmental 
programs. The following provisions do not apply to section 145: Sec.  
1.141-2(d)(4) (relating to the special rule for dispositions of personal 
property in the ordinary course of an established governmental program) 
and Sec.  1.141-2(d)(5) (relating to the special rule for general 
obligation bond programs that finance a large number of separate 
purposes).
    (2) Costs of issuance. Sections 1.141-3(g)(6) and 1.141-6(d) do not 
apply to the extent costs of issuance are allocated among the other 
purposes for which the proceeds are used or to portions of a project. 
For purposes of section 145(a)(2), costs of issuance are treated as 
private business use.
    (d) Issuance costs financed by prior issue. Solely for purposes of 
applying the private business use test to a refunding issue under Sec.  
1.141-13, the use of proceeds of the prior issue (or any earlier issue 
in a series of refundings) to pay issuance costs of the prior issue (or 
the earlier issue) is treated as a government use.

[T.D. 8712, 62 FR 2303, Jan. 16, 1997, as amended by T.D. 9234, 70 FR 
75035, Dec. 19, 2005; T.D. 9741, 80 FR 65646, Oct. 27, 2015]

[[Page 77]]



Sec.  1.147-0  Table of contents.

    This section lists the captioned paragraphs contained in Sec. Sec.  
1.147-1 and 1.147-2.

Sec.  1.147-1 Other requirements applicable to certain private activity 
                                 bonds.

    (a) Overview.
    (b) Scope.
    (c) Effective dates.

                     Sec.  1.147-2 Remedial actions.

[T.D. 8712, 62 FR 2304, Jan. 16, 1997]



Sec.  1.147-1  Other requirements applicable to certain private activity bonds.

    (a) Overview. Interest on a private activity bond is not excludable 
from gross income under section 103(a) unless the bond is a qualified 
bond. Under section 147, certain requirements must be met for a private 
activity bond to qualify as a qualified bond.
    (b) Scope. Sections 1.147-0 through 1.147-2 apply for purposes of 
the rules in section 147 for qualified private activity bonds that 
permit use of proceeds to acquire land for environmental purposes 
(section 147(c)(3)), permit use of proceeds for certain rehabilitations 
(section 147(d) (2) and (3)), prohibit use of proceeds to finance 
skyboxes, airplanes, gambling establishments and similar facilities 
(section 147(e)), and require public approval (section 147(f)), but not 
for the rules limiting use of proceeds to acquire land or existing 
property under sections 147(c) (1) and (2), and (d)(1).
    (c) Effective dates. For effective dates of Sec. Sec.  1.147-0 
through 1.147-2, see Sec.  1.141-16.

[T.D. 8712, 62 FR 2304, Jan. 16, 1997]



Sec.  1.147-2  Remedial actions.

    The remedial action rules of Sec.  1.142-2 apply to the rules in 
section 147 for qualified private activity bonds that permit use of 
proceeds to acquire land for environmental purposes (section 147(c)(3)), 
permit use of proceeds for certain rehabilitations (section 147(d) (2) 
and (3)), prohibit use of proceeds to finance skyboxes, airplanes, 
gambling establishments and similar facilities (section 147(e)), and 
require public approval (section 147(f)), for this purpose treating 
those private activity bonds subject to the rules under section 147 as 
exempt facility bonds and the qualifying purposes for those bonds as 
exempt facilities.

[T.D. 8712, 62 FR 2304, Jan. 16, 1997]



Sec.  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.

[T.D. 8476, 58 FR 33515, June 18, 1993]



Sec.  1.147(f)-1  Public approval of private activity bonds.

    (a) In general. Interest on a private activity bond is excludable 
from gross income under section 103(a) only if the bond meets the 
requirements for a qualified bond as defined in section 141(e) and other 
applicable requirements provided in section 103. In order to be a 
qualified bond as defined in section 141(e), among other requirements, a 
private activity bond must meet the requirements of section 147(f). A 
private activity bond meets the requirements of section 147(f) only if 
the bond is publicly approved pursuant to paragraph (b) of this section 
or the bond qualifies for the exception for refunding bonds in section 
147(f)(2)(D).
    (b) Public approval requirement--(1) In general. Except as otherwise 
provided in this section, a bond meets the requirements of section 
147(f) if, before the issue date, the issue of which the bond is a part 
receives issuer approval and host approval (each a public approval) as 
defined in paragraphs (b)(2) and (3) of this section in accordance with 
the method and process set forth in paragraphs (c) through (f) of this 
section.
    (2) Issuer approval. Except as otherwise provided in this section, 
issuer approval means an approval that meets the requirements of this 
paragraph (b)(2). Either the governmental unit that issues the issue or 
the governmental unit on behalf of which the issue is issued must 
approve the issue. For this purpose, Sec.  1.103-1 applies to the 
determination of whether an issuer issues bonds on behalf of another 
governmental unit. If an issuer issues

[[Page 78]]

bonds on behalf of more than one governmental unit (for example, in the 
case of an authority that acts for two counties), any one of those 
governmental units may provide the issuer approval.
    (3) Host approval. Except as otherwise provided in this section, 
host approval means an approval that meets the requirements of this 
paragraph (b)(3). Each governmental unit the geographic jurisdiction of 
which contains the site of a project to be financed by the issue must 
approve the issue. If, however, the entire site of a project to be 
financed by the issue is within the geographic jurisdiction of more than 
one governmental unit within a State (counting the State as a 
governmental unit within such State), then any one of those governmental 
units may provide host approval for the issue for that project. For 
purposes of the host approval, if a project to be financed by the issue 
is located within the geographic jurisdiction of two or more 
governmental units but not entirely within any one of those governmental 
units, each portion of the project that is located entirely within the 
geographic jurisdiction of the respective governmental units may be 
treated as a separate project. The issuer approval provided pursuant to 
paragraph (b)(2) of this section may be treated as a host approval if 
the governmental unit providing the issuer approval is also a 
governmental unit eligible to provide the host approval pursuant to this 
section.
    (4) Special rule for host approval of airports or high-speed 
intercity rail facilities. Pursuant to a special rule in section 
147(f)(3), if the proceeds of an issue are to be used to finance a 
project that consists of either facilities located at an airport (within 
the meaning of section 142(a)(1)) or high-speed intercity rail 
facilities (within the meaning of section 142(a)(11)) and the issuer of 
that issue is the owner or operator of the airport or high-speed 
intercity rail facilities, the issuer is the only governmental unit that 
is required to provide the host approval for that project.
    (5) Special rule for issuer approval of scholarship funding bond 
issues and volunteer fire department bond issues. In the case of a 
qualified scholarship funding bond as defined in section 150(d)(2), the 
governmental unit that made a request described in section 150(d)(2)(B) 
with respect to the issuer of the bond is the governmental unit on 
behalf of which the bond was issued for purposes of the issuer approval. 
If more than one governmental unit within a State made a request 
described in section 150(d)(2)(B), the State or any such requesting 
governmental unit may be treated as the governmental unit on behalf of 
which the bond was issued for purposes of the issuer approval. In the 
case of a bond of a volunteer fire department treated as a bond of a 
political subdivision of a State under section 150(e), the political 
subdivision described in section 150(e)(2)(B) with respect to that 
volunteer fire department is the governmental unit on behalf of which 
the bond is issued for purposes of the issuer approval.
    (6) Special rules for host approval of mortgage revenue bonds, 
student loan bonds, and certain qualified 501(c)(3) bonds. In the case 
of a mortgage revenue bond (as defined in paragraph (g)(5) of this 
section), a qualified student loan bond as defined in section 144(b), 
and the portion of an issue of qualified 501(c)(3) bonds as defined in 
section 145 that finances working capital expenditures, the issue or 
portion of the issue must receive an issuer approval but no host 
approval is necessary. See also paragraph (f)(5) of this section, 
providing certain optional alternative special rules for certain 
qualified 501(c)(3) bonds for pooled loan financings described in 
section 147(b)(4)(B).
    (c) Method of public approval. The method of public approval of an 
issue must satisfy either paragraph (c)(1) or (2) of this section. An 
approval may satisfy the requirements of this paragraph (c) without 
regard to the authority under State or local law for the acts 
constituting that approval.
    (1) Applicable elected representative. An applicable elected 
representative of the approving governmental unit approves the issue 
following a public hearing for which there was reasonable public notice.
    (2) Voter referendum. A voter referendum of the approving 
governmental unit approves the issue.

[[Page 79]]

    (d) Public hearing and reasonable public notice--(1) Public hearing. 
Public hearing means a forum providing a reasonable opportunity for 
interested individuals to express their views, orally or in writing, on 
the proposed issue of bonds and the location and nature of the proposed 
project to be financed.
    (2) Location of the public hearing. The public hearing must be held 
in a location that, based on the facts and circumstances, is convenient 
for residents of the approving governmental unit. The location of the 
public hearing is presumed convenient for residents of the unit if the 
public hearing is located in the approving governmental unit's capital 
or seat of government. If more than one governmental unit is required to 
hold a public hearing, the hearings may be combined as long as the 
combined hearing affords the residents of all of the participating 
governmental units a reasonable opportunity to be heard. The location of 
any combined hearing is presumed convenient for residents of each 
participating governmental unit 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.
    (3) Procedures for conducting the public hearing. In general, a 
governmental unit may select its own procedure for a public hearing, 
provided that interested individuals have a reasonable opportunity to 
express their views. Thus, a governmental unit 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 make a 
written request to speak at least 24 hours before the hearing or that 
they limit their oral remarks to a prescribed time. For this purpose, it 
is unnecessary, for example, that the applicable elected representative 
of the approving governmental unit be present at the hearing, that a 
report on the hearing be submitted to that applicable elected 
representative, or that State administrative procedural requirements for 
public hearings be observed. Except to the extent State procedural 
requirements for public hearings are in conflict with a specific 
requirement of this section, a public hearing performed in compliance 
with State procedural requirements satisfies the requirements for a 
public hearing in this paragraph (d). A public hearing may be conducted 
by an individual appointed or employed to perform such function by the 
governmental unit or its agencies, or by the issuer. Thus, for example, 
for bonds to be issued by an authority that acts on behalf of a county, 
the hearing may be conducted by the authority, the county, or an 
appointee of either.
    (4) Reasonable public notice. Reasonable public notice means notice 
that is reasonably designed to inform residents of an approving 
governmental unit, including the issuing governmental unit and the 
governmental unit in whose geographic jurisdiction a project is to be 
located, of the proposed issue. The notice must state the time and place 
for the public hearing and contain the information required by paragraph 
(f)(2) of this section. Notice is presumed to be reasonably designed to 
inform residents of an approving governmental unit if it satisfies the 
requirements of this paragraph (d)(4) and is given no fewer than seven 
(7) calendar days before the public hearing in one or more of the ways 
set forth in paragraphs (d)(4)(i) through (iv) of this section.
    (i) Newspaper publication. Public notice may be given by publication 
in one or more newspapers of general circulation available to the 
residents of the governmental unit.
    (ii) Radio or television broadcast. Public notice may be given by 
radio or television broadcast to the residents of the governmental unit.
    (iii) Governmental unit website posting. Public notice may be given 
by electronic posting on the approving governmental unit's primary 
public website in an area of that website used to inform its residents 
about events affecting the residents (for example, notice of public 
meetings of the governmental unit). In the case of an issuer approval of 
an issue issued by an on-behalf-of issuer that acts on behalf of a 
governmental unit, such notice may be posted on the public website of 
the on-behalf-of issuer as an alternative to the public website of the 
approving governmental unit.

[[Page 80]]

    (iv) Alternative State law public notice procedures. Public notice 
may be given in a way that is permitted under a general State law for 
public notices for public hearings for the approving governmental unit, 
provided that the public notice is reasonably accessible.
    (e) Applicable elected representative--(1) In general--(i) 
Definition of applicable elected representative. The applicable elected 
representative of a governmental unit means--
    (A) The governmental unit's elected legislative body;
    (B) The governmental unit's chief elected executive officer;
    (C) In the case of a State, the chief elected legal officer of the 
State's executive branch of government; or
    (D) Any official elected by the voters of the governmental unit and 
designated for purposes of this section by the governmental unit's chief 
elected executive officer or by State or local law to approve issues for 
the governmental unit.
    (ii) Elected officials. For purposes of paragraphs (e)(1)(i)(B), 
(C), and (D) of this section, an official is considered elected only if 
that official is popularly elected at-large by the voters of the 
governmental unit. If an official popularly elected at-large by the 
voters of a governmental unit is appointed or selected pursuant to State 
or local law to be the chief executive officer of the unit, that 
official is deemed to be an elected chief executive officer for purposes 
of this section but for no longer than the official's tenure as an 
official popularly elected at-large.
    (iii) Legislative bodies. In the case of a bicameral legislature 
that is popularly elected, both chambers together constitute an 
applicable elected representative. Absent designation under paragraph 
(e)(1)(i)(D) of this section, however, neither such chamber 
independently constitutes an applicable elected representative. If 
multiple elected legislative bodies of a governmental unit have 
independent legislative authority, the body with the more specific 
authority relating to the issue is the only legislative body that is 
treated as an elected legislative body under paragraph (e)(1)(i)(A) of 
this section.
    (2) Governmental unit with no applicable elected representative--(i) 
In general. The applicable elected representatives of a governmental 
unit with no applicable elected representative (but for this paragraph 
(e)(2) and section 147(f)(2)(E)(ii)) are the applicable elected 
representatives of the next higher governmental unit (with an applicable 
elected representative) from which the governmental unit derives its 
authority. Except as otherwise provided in this section, any 
governmental unit from which the governmental unit with no applicable 
elected representative derives its authority may be treated as the next 
higher governmental unit without regard to the relative status of such 
higher governmental unit under State law. A governmental unit derives 
its authority from another governmental unit that--
    (A) Enacts a specific law (for example, a provision in a State 
constitution, charter, or statute) by or under which the governmental 
unit is created;
    (B) Otherwise empowers or approves the creation of the governmental 
unit; or
    (C) Appoints members to the governing body of the governmental unit.
    (ii) Host approval. For purposes of a host approval, a governmental 
unit may be treated as the next higher governmental unit only if the 
project is located within its geographic jurisdiction and eligible 
residents of the unit are entitled to vote for its applicable elected 
representatives.
    (3) On behalf of issuers. In the case of an issuer that issues bonds 
on behalf of a governmental unit, the applicable elected representative 
is any applicable elected representative of the governmental unit on 
behalf of which the bonds are issued.
    (f) Public approval process--(1) In general. The public approval 
process for an issue, including scope, content, and timing of the public 
approval, must meet the requirements of this paragraph (f). A 
governmental unit must timely approve either each project to be financed 
with proceeds of the issue or a plan of financing for each project to be 
financed with proceeds of the issue.
    (2) General rule on information required for a reasonable public 
notice and public approval. Except as otherwise provided in this 
section, a project to be financed

[[Page 81]]

with proceeds of an issue is within the scope of a public approval under 
section 147(f) if the reasonable public notice of the public hearing, if 
applicable, and the public approval (together the notice and approval) 
include the information set forth in paragraphs (f)(2)(i) through (iv) 
of this section.
    (i) The project. The notice and approval must include a general 
functional description of the type and use of the project to be financed 
with the issue. For this purpose, a project description is sufficient if 
it identifies the project by reference to a particular category of 
exempt facility bond to be issued (for example, an exempt facility bond 
for an airport pursuant to section 142(a)(1)) or by reference to another 
general category of private activity bond together with information on 
the type and use of the project to be financed with the issue (for 
example, a qualified small issue bond as defined in section 144(a) for a 
manufacturing facility or a qualified 501(c)(3) bond as defined in 
section 145 for a hospital facility and working capital expenditures).
    (ii) The maximum stated principal amount of the issue. The notice 
and approval must include the maximum stated principal amount of the 
issue of private activity bonds to be issued to finance the project or 
projects. If an issue finances multiple projects (for example, 
facilities at different locations on non-proximate sites that are not 
treated as part of the same project), the notice and approval must 
specify separately the maximum stated principal amount of bonds to be 
issued to finance each separate project to be financed as part of the 
issue. The maximum stated principal amount of bonds to be issued to 
finance a project may be determined on any reasonable basis and may take 
into account contingencies, without regard to whether the occurrence of 
any such contingency is reasonably expected at the time of the notice.
    (iii) The name of the initial legal owner or principal user of the 
project. The notice and approval must include the name of either the 
expected initial legal owner or principal user (within the meaning of 
section 144(a)) of the project or, alternatively, the name of a 
significant true beneficial party of interest for such legal owner or 
user (for example, the name of a section 501(c)(3) organization that is 
the sole member of a limited liability company that is the legal owner 
or the name of a general partner of a partnership that owns the 
project).
    (iv) The location of the project. The notice and approval must 
include a general description of the prospective location of the project 
by street address, reference to boundary streets or other geographic 
boundaries, or other description of the specific geographic location 
that is reasonably designed to inform readers of the location. For a 
project involving multiple capital projects or facilities located on the 
same site, or on adjacent or reasonably proximate sites with similar 
uses, a consolidated description of the location of those capital 
projects or facilities provides a sufficient description of the location 
of the project. For example, a project for a section 501(c)(3) 
educational entity involving multiple buildings on the entity's main 
urban college campus may describe the location of the project by 
reference to the outside street boundaries of that campus with a 
reference to any noncontiguous features of that campus.
    (3) Special rule for mortgage revenue bonds. Mortgage loans financed 
by mortgage revenue bonds are within the scope of a public approval if 
the notice and approval state that the bonds are to be issued to finance 
residential mortgages, provide the maximum stated principal amount of 
mortgage revenue bonds expected to be issued, and provide a general 
description of the geographic jurisdiction in which the residences to be 
financed with the proceeds of the mortgage revenue bonds are expected to 
be located (for example, residences located throughout a State for an 
issuer with a statewide jurisdiction or residences within a particular 
local geographic jurisdiction, such as within a city or county, for a 
local issuer). For this purpose, in the case of mortgage revenue bonds, 
no information is required on specific names of mortgage loan borrowers 
or specific locations of individual residences to be financed.
    (4) Special rule for qualified student loan bonds. Qualified student 
loans financed by qualified student loan bonds

[[Page 82]]

as defined in section 144(b) are within the scope of a public approval 
if the notice and approval state that the bonds will be issued to 
finance student loans and state the maximum stated principal amount of 
qualified student loan bonds expected to be issued for qualified student 
loans. For this purpose, in the case of qualified student loan bonds, no 
information is required with respect to names of specific student loan 
borrowers.
    (5) Special rule for certain qualified 501(c)(3) bonds. Qualified 
501(c)(3) bonds issued pursuant to section 145 for pooled loan 
financings that are described in section 147(b)(4)(B) (without regard to 
any election under section 147(b)(4)(A)) are within the scope of a 
public approval if the public approval either meets the general 
requirements of paragraph (b) of this section or, alternatively, at the 
issuer's option, meets the special requirements of paragraphs (f)(5)(i) 
and (ii) of this section.
    (i) Pre-issuance issuer approval. Within the time period required by 
paragraph (f)(7) of this section, an issuer approval is obtained after 
reasonable public notice of a public hearing is provided and a public 
hearing is held. For this purpose, a project is treated as described in 
the notice and approval if the notice and approval provide that the 
bonds will be qualified 501(c)(3) bonds to be used to finance loans 
described in section 147(b)(4)(B), state the maximum stated principal 
amount of bonds expected to be issued to finance loans to section 
501(c)(3) organizations or governmental units as described in section 
147(b)(4)(B), provide a general description of the type of project to be 
financed with such loans (for example, loans for hospital facilities or 
college facilities), and state that an additional public approval that 
includes specific project information will be obtained before any such 
loans are originated.
    (ii) Post-issuance public approval for specific loans. Before a loan 
described in section 147(b)(4)(B) is originated, a supplemental public 
approval, including issuer approval and host approval, for the bonds to 
be used to finance that loan is obtained that meets all the requirements 
of section 147(f) and the requirements for a public approval in 
paragraph (b) of this section. This post-issuance supplemental public 
approval requirement applies by treating the bonds to be used to finance 
such loan as if they were reissued for purposes of section 147(f) 
(without regard to paragraph (f)(5) of this section). For this purpose, 
proceeds to be used to finance such loan do not include the portion of 
the issue used to finance a common reserve fund or common costs of 
issuance.
    (6) Deviations in public approval information--(i) In general. 
Except as otherwise provided in this section, a substantial deviation 
between the stated use or amount of proceeds of an issue included in the 
information required to be provided in the notice and approval (public 
approval information) and the actual use or amount of proceeds of the 
issue causes that issue to fail to meet the public approval requirement. 
Conversely, insubstantial deviations between the stated use or amount of 
proceeds of an issue included in the public approval information and the 
actual use or amount of proceeds of the issue do not cause such a 
failure. In general, the determination of whether a deviation is 
substantial is based on all the facts and circumstances. In all events, 
however, a change in the fundamental nature or type of a project is a 
substantial deviation.
    (ii) Certain insubstantial deviations in public approval 
information. The following deviations from the public approval 
information in the notice and approval are treated as insubstantial 
deviations:
    (A) Size of bond issue and use of proceeds. A deviation between the 
maximum stated principal amount of a proposed issuance of bonds to 
finance a project that is specified in public approval information and 
the actual stated principal amount of bonds issued and used to finance 
that project is an insubstantial deviation if that actual stated 
principal amount is no more than ten percent (10%) greater than that 
maximum stated principal amount or is any amount less than that maximum 
stated principal amount. In addition, the use of proceeds to pay working 
capital expenditures directly associated with any project specified in 
the public approval

[[Page 83]]

information is an insubstantial deviation.
    (B) Initial legal owner or principal user. A deviation between the 
initial legal owner or principal user of the project named in the notice 
and approval and the actual initial legal owner or principal user of the 
project is an insubstantial deviation if such parties are related 
parties on the issue date of the issue.
    (iii) Supplemental public approval to cure certain substantial 
deviations in public approval information. A substantial deviation 
between the stated use or amount of proceeds of an issue included in the 
public approval information and the actual use or amount of the proceeds 
of the issue does not cause that issue to fail to meet the public 
approval requirement if all of the following requirements are met:
    (A) Original public approval and reasonable expectations. The issue 
met the requirements for a public approval in paragraph (b) of this 
section. In addition, on the issue date of the issue, the issuer 
reasonably expected there would be no substantial deviations between the 
stated use or amount of proceeds of an issue included in the public 
approval information and the actual use or amount of the proceeds of the 
issue.
    (B) Unexpected events or unforeseen changes in circumstances. As a 
result of unexpected events or unforeseen changes in circumstances that 
occur after the issue date of the issue, the issuer determines to use 
proceeds of the issue in a manner or amount not provided in a public 
approval.
    (C) Supplemental public approval. Before using proceeds of the bonds 
in a manner or amount not provided in a public approval, the issuer 
obtains a supplemental public approval for those bonds that meets the 
public approval requirement in paragraph (b) of this section. This 
supplemental public approval requirement applies by treating those bonds 
as if they were reissued for purposes of section 147(f).
    (7) Certain timing requirements. Public approval of an issue is 
timely only if the issuer obtains the public approval within one year 
before the issue date of the issue. Public approval of a plan of 
financing is timely only if the issuer obtains public approval for the 
plan of financing within one year before the issue date of the first 
issue issued under the plan of financing and the issuer issues all 
issues under the plan of financing within three years after the issue 
date of such first issue.
    (g) Definitions. The definitions in this paragraph (g) apply for 
purposes of this section. In addition, the general definitions in Sec.  
1.150-1 apply for purposes of this section.
    (1) Geographic jurisdiction means the area encompassed by the 
boundaries prescribed by State or local law for a governmental unit or, 
if there are no such boundaries, the area in which a unit may exercise 
such sovereign powers that make that unit a governmental unit for 
purposes of Sec.  1.103-1 and this section.
    (2) Governmental unit has the meaning of ``State or local 
governmental unit'' as defined in Sec.  1.103-1. Thus, a governmental 
unit is a State, territory, a possession of the United States, the 
District of Columbia, or any political subdivision thereof.
    (3) Host approval is defined in paragraph (b)(3) of this section.
    (4) Issuer approval is defined in paragraph (b)(2) of this section.
    (5) Mortgage revenue bonds mean qualified mortgage bonds as defined 
in section 143(a), qualified veterans' mortgage bonds as defined in 
section 143(b), or refunding bonds issued to finance mortgages of owner-
occupied residences pursuant to applicable law in effect prior to 
enactment of section 143(a) or section 143(b).
    (6) Proceeds means ``proceeds'' as defined in Sec.  1.141-1(b), 
except that it does not include disposition proceeds.
    (7) Project generally means one or more capital projects or 
facilities, including land, buildings, equipment, and other property, to 
be financed with an issue, that are located on the same site, or 
adjacent or proximate sites used for similar purposes, and that are 
subject to the public approval requirement of section 147(f). Capital 
projects or facilities that are not located on the same site or adjacent 
or proximate sites may be treated as one project if those capital 
projects or facilities are used in an integrated operation. For an issue 
of mortgage revenue bonds or an issue of qualified student loan bonds as

[[Page 84]]

defined in section 144(b), the term project means the mortgage loans or 
qualified student loans to be financed with the proceeds of the issue. 
For an issue of qualified 501(c)(3) bonds as defined in section 145, the 
term project means a project as defined in the first sentence of this 
definition, and also is deemed to include working capital expenditures 
to be financed with proceeds of the issue.
    (8) Public approval information is defined in paragraph (f)(6)(i) of 
this section.
    (9) Public hearing is defined in paragraph (d)(1) of this section.
    (10) Reasonable public notice is defined in paragraph (d)(4) of this 
section.
    (11) Voter referendum means a vote by the voters of the affected 
governmental unit conducted in the same manner and time as voter 
referenda on matters relating to governmental spending or bond issuances 
by the governmental unit under applicable State and local law.
    (h) Applicability date. This section applies to bonds issued 
pursuant to a public approval occurring on or after April 1, 2019. For 
bonds issued pursuant to a public approval occurring before April 1, 
2019, see Sec.  5f.103-2 as contained in 26 CFR part 5f, revised as of 
April 1, 2018. In addition, an issuer may apply the provisions of 
paragraph (f)(6) of this section in whole, but not in part, to bonds 
issued pursuant to a public approval occurring before April 1, 2019.

[T.D. 9845, 83 FR 67690, Dec. 31, 2018]



Sec.  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 Sec. Sec.  
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 Sec. Sec.  1.148-1, 1.148-2, 1.148-3, 1.148-4, 1.148-5, 
1.148-6, 1.148-7, 1.148-8, 1.148-9, 1.148-10 and 1.148-11.

                Sec.  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.
    (e) Investment-type property.
    (1) In general.
    (2) Prepayments.
    (3) Certain hedges.
    (f) Definition of issue price.
    (1) In general.
    (2) Bonds issued for money.
    (3) Definitions.
    (4) Other special rules.

        Sec.  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 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.

[[Page 85]]

    (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.

              Sec.  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.
    (4) Cost-of-living adjustment.
    (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 Sec.  1.148-7.
    (i) Recovery of overpayment of rebate.
    (1) In general.
    (2) Limitations on recovery.
    (3) Time and manner for requesting refund.
    (j) Examples.
    (k) Bona fide debt service fund exception.

                Sec.  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) Special aggregation rule treating certain bonds as a single 
fixed yield bond.
    (6) 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 bonds treated as fixed yield bonds.
    (5) Contracts entered into before issue date of hedged bond.
    (6) Authority of the Commissioner.

            Sec.  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 certain 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.

         Sec.  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.

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    (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.

      Sec.  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 1\1/2\ 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.

       Sec.  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--treatment of conduit borrowers.
    (e) Refunding issues.
    (1) In general.
    (2) Multipurpose issues.

           Sec.  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.

[[Page 87]]

    (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.

     Sec.  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 prevent transactions that are 
inconsistent with the purpose of the arbitrage investment restrictions.
    (f) Authority of the Commissioner to require an earlier date for 
payment of rebate.
    (g) Authority of the Commissioner to waive regulatory limitations.

              Sec.  1.148-11 Effective/applicability dates.

    (a) In general.
    (b) Elective retroactive application in whole.
    (1) In general.
    (2) No elective retroactive application for 18-month spending 
exception.
    (3) No elective retroactive application for hedges of fixed rate 
issues.
    (4) No elective retroactive application for safe harbor for 
establishing fair market value for guaranteed investment contracts and 
investments purchased for a yield restricted defeasance escrow.
    (c) Elective retroactive application of certain provisions.
    (1) Retroactive application of overpayment recovery provisions.
    (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) Provisions applicable to certain bonds sold before effective 
date.
    (h) Safe harbor for establishing fair market value for guaranteed 
investment contracts and investments purchased for a yield restricted 
defeasance escrow.
    (i) Special rule for certain broker's commissions and similar fees.
    (j) Certain prepayments.
    (k) Certain arbitrage guidance updates.
    (1) In general.
    (2) Valuation of investments in refunding transactions.
    (3) Rebate overpayment recovery.
    (4) Hedge identification.
    (5) Hedge modifications and termination.
    (6) Small issuer exception to rebate requirement for conduit 
borrowers of pooled financings.
    (l) Permissive application of certain arbitrage updates.
    (1) In general.
    (2) Computation credit.
    (3) Yield reduction payments.
    (4) External commingled funds.
    (m) Definition of issue price.

[T.D. 8476, 58 FR 33515, June 18, 1993, as amended by T.D. 8538, 59 FR 
24041, May 10, 1994; T.D. 8718, 62 FR 25506, May 9, 1997; T.D. 9085, 68 
FR 45775, Aug. 4, 2003; T.D. 9097, 68 FR 69022, Dec. 11, 2003; T.D. 
9701, 79 FR 67351, Nov. 13, 2014; T.D. 9777, 81 FR 46592, July 18, 2016; 
T.D. 9801, 81 FR 89003, Dec. 9, 2016]



Sec.  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 Sec. Sec.  
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

[[Page 88]]

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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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

[[Page 89]]

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 is defined in paragraph (e) of this 
section.
    Issue price means issue price as defined in paragraph (f) of this 
section.
    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 Sec.  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 Sec.  1.148-3(d) for purposes 
of computing the rebate amount, and a payment as defined in Sec.  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 Sec.  1.148-2(d) or section 143(g) or to qualified administrative 
costs recoverable under Sec.  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

[[Page 90]]

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 Sec.  1.148-5(e).
    Qualified guarantee means a qualified guarantee as defined in Sec.  
1.148-4(f).
    Qualified hedge means a qualified hedge as defined in Sec.  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 Sec.  1.148-3.
    Receipt means a receipt as defined in Sec.  1.148-3(d) for purposes 
of computing the rebate amount, and a receipt as defined in Sec.  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.
    Replacement proceeds is defined in paragraph (c) of this section.
    Restricted working capital expenditures means working capital 
expenditures that are subject to the proceeds-spent-last rule in Sec.  
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. Sale proceeds also include, but are not limited to, 
amounts derived from the sale of a right that is associated with a bond, 
and that is described in Sec.  1.148-4(b)(4). See also Sec.  1.148-
4(h)(5) treating amounts received upon the termination of certain hedges 
as sale proceeds.
    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 Sec.  
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

[[Page 91]]

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 Sec.  1.148-4(e) for a bond, and 
value determined under Sec.  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 Sec.  1.148-4 for an issue, and 
yield computed under Sec.  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 Sec.  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 Sec.  1.148-10. 
Replacement proceeds

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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 
working capital expenditures, if that portion is not outstanding longer 
than the temporary period under Sec.  1.148-2(e)(3) for which the 
proceeds qualify;
    (2) For the portion of an issue (including a refunding issue) that 
is to be used to finance or refinance 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);
    (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; or
    (4) For the portion of an issue (including a refunding issue) that 
is to be used to finance working capital expenditures, if that portion 
satisfies paragraph (c)(4)(ii) of this section.
    (ii) Safe harbor for longer-term working capital financings. A 
portion of an issue used to finance working capital expenditures 
satisfies this paragraph (c)(4)(ii) if the issuer meets the requirements 
of paragraphs (c)(4)(ii)(A) through (E) of this section.
    (A) Determine first testing year. On the issue date, the issuer must 
determine the first fiscal year following the applicable temporary 
period under Sec.  1.148-2(e) in which it reasonably expects to have 
available amounts (first testing year), but in no event can the first 
day of the first testing year be later than five years after the issue 
date.
    (B) Application of available amount to reduce burden on tax-exempt 
bond market. Beginning with the first testing year and for each 
subsequent fiscal year for which the portion of the issue that is the 
subject of this safe harbor remains outstanding, the issuer must 
determine the available amount as of the first day of each fiscal year. 
Then, except as provided in paragraph (c)(4)(ii)(D) of this section, 
within the first 90 days of that fiscal year, the issuer must apply that 
amount (or if less, the available amount on the date of the required 
redemption or investment) to redeem or to invest in eligible tax-exempt 
bonds (as defined in paragraph (c)(4)(ii)(E) of this section). For this 
purpose, available amounts in a bona fide debt service fund are not 
treated as available amounts.
    (C) Continuous investment requirement. Except as provided in this 
paragraph (c)(4)(ii)(C), any amounts invested in eligible tax-exempt 
bonds under paragraph (c)(4)(ii)(B) of this section must be invested 
continuously in such tax-exempt bonds to the extent provided in 
paragraph (c)(4)(ii)(D) of this section.
    (1) Exception for reinvestment period. Amounts previously invested 
in eligible tax-exempt bonds under paragraph (c)(4)(ii)(B) of this 
section that are held for not more than 30 days in a fiscal year pending 
reinvestment in eligible tax-exempt bonds are treated as invested in 
eligible tax-exempt bonds.
    (2) Limited use of invested amounts. An issuer may spend amounts 
previously invested in eligible tax-exempt bonds under paragraph 
(c)(4)(ii)(B) of this section within 30 days of the date on which they 
cease to be so invested to make expenditures for a governmental purpose 
on any date on which the issuer has no other available amounts for such 
purpose, or to redeem eligible tax-exempt bonds.
    (D) Cap on applied or invested amounts. The maximum amount that an 
issuer is required to apply under paragraph (c)(4)(ii)(B) of this 
section or to invest continuously under paragraph (c)(4)(ii)(C) of this 
section with respect to the portion of an issue that is the subject of 
this safe harbor is the outstanding principal amount of such portion. 
For purposes of this cap, an issuer receives credit towards its 
requirement to invest available amounts in eligible tax-exempt bonds for 
amounts previously invested under paragraph (c)(4)(ii)(B) of this 
section that remain

[[Page 93]]

continuously invested under paragraph (c)(4)(ii)(C) of this section.
    (E) Definition of eligible tax-exempt bonds. For purposes of 
paragraph (c)(4)(ii) of this section, eligible tax-exempt bonds means 
any of the following:
    (1) A bond the interest on which is excludable from gross income 
under section 103 and that is not a specified private activity bond (as 
defined in section 57(a)(5)(C)) subject to the alternative minimum tax;
    (2) 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 on a bond that is excludable from gross income under section 
103 and that is not interest on a specified private activity bond (as 
defined in section 57(a)(5)(C)) subject to the alternative minimum tax; 
or
    (3) A certificate of indebtedness issued by the United States 
Treasury pursuant to the Demand Deposit State and Local Government 
Series program described in 31 CFR part 344.
    (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.
    (e) Investment-type property--(1) In general. 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. For this purpose, production of 
income includes any benefit based on the time value of money.
    (2) Prepayments--(i) In general--(A) Generally. Except as otherwise 
provided in this paragraph (e)(2), a prepayment for property or 
services, including a prepayment for property or services that is made 
after the date that the contract to buy the property or services is 
entered into, also gives rise to 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 does not give rise to investment-type property if--
    (1) 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;
    (2) The prepayment is made within 90 days of the reasonably expected 
date of delivery to the issuer of all of the property or services for 
which the prepayment is made; or
    (3) The prepayment meets the requirements of paragraph 
(e)(2)(iii)(A) or (B) of this section.
    (B) Example. The following example illustrates an application of 
this paragraph (e)(2)(i):

    Example. Prepayment after contract is executed. In 1998, City A 
enters into a ten-year contract with Company Y. Under the contract, 
Company Y is to provide services to City A over the term of the contract 
and in return City A will pay Company Y for its services as they are 
provided. In 2004, City A issues bonds to finance a lump sum payment to 
Company Y in satisfaction of City A's obligation to pay for Company Y's 
services to be provided over the remaining term of the contract. The use 
of bond proceeds to make the lump sum payment constitutes a prepayment 
for services under paragraph (e)(2)(i) of this section, even though the 
payment is made after the date that the contract is executed.

    (ii) Customary prepayments. The determination of whether a 
prepayment satisfies paragraph (e)(2)(i)(A)(1) of this section is 
generally made based on all the facts and circumstances. In addition, a 
prepayment is deemed to satisfy paragraph (e)(2)(i)(A)(1) of this 
section if--
    (A) The prepayment is made for--
    (1) Maintenance, repair, or an extended warranty with respect to 
personal property (for example, automobiles or electronic equipment); or
    (2) Updates or maintenance or support services with respect to 
computer software; and
    (B) The same maintenance, repair, extended warranty, updates or 
maintenance or support services, as applicable, are regularly provided 
to nongovernmental persons on the same terms.
    (iii) Certain prepayments to acquire a supply of natural gas or 
electricity--(A) Natural gas prepayments. A prepayment meets the 
requirements of this paragraph (e)(2)(iii)(A) if--

[[Page 94]]

    (1) It is made by or for one or more utilities that are owned by a 
governmental person, as defined in Sec.  1.141-1(b) (each of which is 
referred to in this paragraph (e)(2)(iii)(A) as the issuing municipal 
utility), to purchase a supply of natural gas; and
    (2) At least 90 percent of the prepaid natural gas financed by the 
issue is used for a qualifying use. Natural gas is used for a qualifying 
use if it is to be--
    (i) Furnished to retail gas customers of the issuing municipal 
utility who are located in the natural gas service area of the issuing 
municipal utility, provided, however, that gas used to produce 
electricity for sale shall not be included under this paragraph 
(e)(2)(iii)(A)(2)(i);
    (ii) Used by the issuing municipal utility to produce electricity 
that will be furnished to retail electric customers of the issuing 
municipal utility who are located in the electricity service area of the 
issuing municipal utility;
    (iii) Used by the issuing municipal utility to produce electricity 
that will be sold to a utility that is owned by a governmental person 
and furnished to retail electric customers of the purchaser who are 
located in the electricity service area of the purchaser;
    (iv) Sold to a utility that is owned by a governmental person if the 
requirements of paragraph (e)(2)(iii)(A)(2)(i), (ii) or (iii) of this 
section are satisfied by the purchaser (treating the purchaser as the 
issuing municipal utility); or
    (v) Used to fuel the pipeline transportation of the prepaid gas 
supply acquired in accordance with this paragraph (e)(2)(iii)(A).
    (B) Electricity prepayments. A prepayment meets the requirements of 
this paragraph (e)(2)(iii)(B) if--
    (1) It is made by or for one or more utilities that are owned by a 
governmental person (each of which is referred to in this paragraph 
(e)(2)(iii)(B) as the issuing municipal utility) to purchase a supply of 
electricity; and
    (2) At least 90 percent of the prepaid electricity financed by the 
issue is used for a qualifying use. Electricity is used for a qualifying 
use if it is to be--
    (i) Furnished to retail electric customers of the issuing municipal 
utility who are located in the electricity service area of the issuing 
municipal utility; or
    (ii) Sold to a utility that is owned by a governmental person and 
furnished to retail electric customers of the purchaser who are located 
in the electricity service area of the purchaser.
    (C) Service area. For purposes of this paragraph (e)(2)(iii), the 
service area of a utility owned by a governmental person consists of--
    (1) Any area throughout which the utility provided, at all times 
during the 5-year period ending on the issue date--
    (i) In the case of a natural gas utility, natural gas transmission 
or distribution service; and
    (ii) In the case of an electric utility, electricity distribution 
service; and
    (2) Any area recognized as the service area of the utility under 
state or Federal law.
    (D) Retail customer. For purposes of this paragraph (e)(2)(iii), a 
retail customer is a customer that purchases natural gas or electricity, 
as applicable, other than for resale.
    (E) Commodity swaps. A prepayment does not fail to meet the 
requirements of this paragraph (e)(2)(iii) by reason of any commodity 
swap contract that may be entered into between the issuer and an 
unrelated party (other than the gas or electricity supplier), or between 
the gas or electricity supplier and an unrelated party (other than the 
issuer), so long as each swap contract is an independent contract. A 
swap contract is an independent contract if the obligation of each party 
to perform under the swap contract is not dependent on performance by 
any person (other than the other party to the swap contract) under 
another contract (for example, a gas or electricity supply contract or 
another swap contract); provided, however, that a commodity swap 
contract will not fail to be an independent contract solely because the 
swap contract may terminate in the event of a failure of a gas or 
electricity supplier to deliver gas or electricity for which the swap 
contract is a hedge.
    (F) Remedial action. Issuers may apply principles similar to the 
rules of

[[Page 95]]

Sec.  1.141-12, including Sec.  1.141-12(d) (relating to redemption or 
defeasance of nonqualified bonds) and Sec.  1.141-12(e) (relating to 
alternative use of disposition proceeds), to cure a violation of 
paragraph (e)(2)(iii)(A)(2) or (e)(2)(iii)(B)(2) of this section. For 
this purpose, the amount of nonqualified bonds is determined in the same 
manner as for output contracts taken into account under the private 
business tests, including the principles of Sec.  1.141-7(d), treating 
nonqualified sales of gas or electricity under this paragraph 
(e)(2)(iii) as satisfying the benefits and burdens test under Sec.  
1.141-7(c)(1).
    (iv) Additional prepayments as permitted by the Commissioner. The 
Commissioner may, by published guidance, set forth additional 
circumstances in which a prepayment does not give rise to investment-
type property.
    (3) Certain hedges. Investment-type property also includes the 
investment element of a contract that is a hedge (within the meaning of 
Sec.  1.148-4(h)(2)(i)(A)) and that contains a significant investment 
element because a payment by the issuer relates to a conditional or 
unconditional obligation by the hedge provider to make a payment on a 
later date. See Sec.  1.148-4(h)(2)(ii) relating to hedges with a 
significant investment element.
    (f) Definition of issue price--(1) In general. Except as otherwise 
provided in this paragraph (f), ``issue price'' is defined in sections 
1273 and 1274 and the regulations under those sections.
    (2) Bonds issued for money--(i) General rule. Except as otherwise 
provided in this paragraph (f)(2), the issue price of bonds issued for 
money is the first price at which a substantial amount of the bonds is 
sold to the public. If a bond is issued for money in a private placement 
to a single buyer that is not an underwriter or a related party (as 
defined in Sec.  1.150-1(b)) to an underwriter, the issue price of the 
bond is the price paid by that buyer. Issue price is not reduced by any 
issuance costs (as defined in Sec.  1.150-1(b)).
    (ii) Special rule for use of initial offering price to the public. 
The issuer may treat the initial offering price to the public as of the 
sale date as the issue price of the bonds if the requirements of 
paragraphs (f)(2)(ii)(A) and (B) of this section are met.
    (A) The underwriters offered the bonds to the public for purchase at 
a specified initial offering price on or before the sale date, and the 
lead underwriter in the underwriting syndicate or selling group (or, if 
applicable, the sole underwriter) provides, on or before the issue date, 
a certification to that effect to the issuer, together with reasonable 
supporting documentation for that certification, such as a copy of the 
pricing wire or equivalent communication.
    (B) Each underwriter agrees in writing that it will neither offer 
nor sell the bonds to any person at a price that is higher than the 
initial offering price to the public during the period starting on the 
sale date and ending on the earlier of the following:
    (1) The close of the fifth (5th) business day after the sale date; 
or
    (2) The date on which the underwriters have sold a substantial 
amount of the bonds to the public at a price that is no higher than the 
initial offering price to the public.
    (iii) Special rule for competitive sales. For bonds issued for money 
in a competitive sale, an issuer may treat the reasonably expected 
initial offering price to the public as of the sale date as the issue 
price of the bonds if the issuer obtains from the winning bidder a 
certification of the bonds' reasonably expected initial offering price 
to the public as of the sale date upon which the price in the winning 
bid is based.
    (iv) Choice of rule for determining issue price. If more than one 
rule for determining the issue price of the bonds is available under 
this paragraph (f)(2), at any time on or before the issue date, the 
issuer may select the rule it will use to determine the issue price of 
the bonds. On or before the issue date of the bonds, the issuer must 
identify the rule selected in its books and records maintained for the 
bonds.
    (3) Definitions. For purposes of this paragraph (f), the following 
definitions apply:
    (i) Competitive sale means a sale of bonds by an issuer to an 
underwriter that is the winning bidder in a bidding process in which the 
issuer offers the

[[Page 96]]

bonds for sale to underwriters at specified written terms, if that 
process meets the following requirements:
    (A) The issuer disseminates the notice of sale to potential 
underwriters in a manner that is reasonably designed to reach potential 
underwriters (for example, through electronic communication that is 
widely circulated to potential underwriters by a recognized publisher of 
municipal bond offering documents or by posting on an Internet-based Web 
site or other electronic medium that is regularly used for such purpose 
and is widely available to potential underwriters);
    (B) All bidders have an equal opportunity to bid (within the meaning 
of Sec.  1.148-5(d)(6)(iii)(A)(6));
    (C) The issuer receives bids from at least three underwriters of 
municipal bonds who have established industry reputations for 
underwriting new issuances of municipal bonds; and
    (D) The issuer awards the sale to the bidder who submits a firm 
offer to purchase the bonds at the highest price (or lowest interest 
cost).
    (ii) Public means any person (as defined in section 7701(a)(1)) 
other than an underwriter or a related party (as defined in Sec.  1.150-
1(b)) to an underwriter.
    (iii) Underwriter means:
    (A) Any person (as defined in section 7701(a)(1)) that agrees 
pursuant to a written contract with the issuer (or with the lead 
underwriter to form an underwriting syndicate) to participate in the 
initial sale of the bonds to the public; and
    (B) Any person that agrees pursuant to a written contract directly 
or indirectly with a person described in paragraph (f)(3)(iii)(A) of 
this section to participate in the initial sale of the bonds to the 
public (for example, a retail distribution agreement between a national 
lead underwriter and a regional firm under which the regional firm 
participates in the initial sale of the bonds to the public).
    (4) Other special rules. For purposes of this paragraph (f), the 
following special rules apply:
    (i) Separate determinations. The issue price of bonds in an issue 
that do not have the same credit and payment terms is determined 
separately. The issuer need not apply the same rule to determine issue 
price for all of the bonds in the issue.
    (ii) Substantial amount. Ten percent is a substantial amount.
    (iii) Bonds issued for property. If a bond is issued for property, 
the adjusted applicable Federal rate, as determined under section 1288 
and Sec.  1.1288-1, is used in lieu of the applicable Federal rate to 
determine the bond's issue price under section 1274.

[T.D. 8476, 58 FR 33517, June 18, 1993; 58 FR 44452, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24041, May 10, 1994; T.D. 8718, 62 FR 25507, 
May 9, 1997; T.D. 9085, 68 FR 45775, Aug. 4, 2003; T.D. 9777, 81 FR 
46592, July 18, 2016; T.D. 9801, 81 FR 89003, Dec. 9, 2016]



Sec.  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

[[Page 97]]

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 $1,000,000.
    (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 Sec.  1.148-4. The yield on investments 
is determined under Sec.  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 Sec.  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

[[Page 98]]

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 Sec.  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 working capital expenditures--(i) General 
rule. The proceeds of an issue that are reasonably expected to be 
allocated to 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. Except as provided in 
paragraph (e)(4)(iv) of this section, 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 is 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 Sec.  1.148-7(b)(6), 
paragraph (e)(4)(i) of this section is applied by substituting ``2 
years'' for ``6 months.''
    (iv) Amounts re-loaned for qualified mortgage loans. The temporary 
period under this paragraph (e)(4) for proceeds from the sale, 
prepayment, or repayment of any qualified mortgage loan that are 
reasonably expected to be used to make or finance new qualified mortgage 
loans is 3 years.
    (5) Temporary period for replacement proceeds--(i) In general. 
Except as otherwise provided, replacement proceeds qualify for a 
temporary period of 30

[[Page 99]]

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 Sec.  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 Sec.  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

[[Page 100]]

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.

[T.D. 8476, 58 FR 33520, June 18, 1993; 58 FR 44452, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24042, May 10, 1994; T.D. 8718, 62 FR 25507, 
May 9, 1997; T.D. 9777, 81 FR 46593, July 18, 2016]



Sec.  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 $1,400 for any bond year ending in 2007 and, for bond years ending 
after 2007, a computation credit in the amount determined under 
paragraph (d)(4) of this section; and
    (v) Yield reduction payments on nonpurpose investments made pursuant 
to Sec.  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

[[Page 101]]

allocable to transferred proceeds of another issue or that ceases to be 
allocable to the issue pursuant to the universal cap under Sec.  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.
    (4) Cost-of-living adjustment. For any calendar year after 2007, the 
$1,400 computation credit set forth in paragraph (d)(1)(iv) of this 
section shall be increased by an amount equal to such dollar amount 
multiplied by the cost-of-living adjustment determined under section 
1(f)(3) for such year, as modified by this paragraph (d)(4). In applying 
section 1(f)(3) to determine this cost-of-living adjustment, the 
reference to ``calendar year 1992'' in section 1(f)(3)(B) shall be 
changed to ``calendar year 2006.'' If any such increase determined under 
this paragraph (d)(4) is not a multiple of $10, such increase shall be 
rounded to the nearest multiple thereof.
    (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 
Sec.  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

[[Page 102]]

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. For purposes 
of this paragraph (h)(3), willful neglect does not include a failure 
that is attributable solely to the permissible retroactive selection of 
a short first bond year if the rebate amount that the issuer failed to 
pay is paid within 60 days of the selection of that bond year.
    (4) Application to alternative penalty under Sec.  1.148-7. 
Paragraphs (h) (1), (2), and (3) of this section apply to failures to 
pay penalty payments under Sec.  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 Sec.  1.148-7(k), an overpayment of less 
than $5,000 may not be recovered before the final computation date.
    (3) Time and manner for requesting refund. (i) An issuer must 
request a refund of an overpayment (claim) no later than the date that 
is two years after the final computation date for the issue to which the 
overpayment relates (the filing deadline). The claim must be made using 
the form provided by the Commissioner for this purpose.
    (ii) The Commissioner may request additional information to support 
a claim. The issuer must file the additional information by the date 
specified in the Commissioner's request, which date may be extended by 
the Commissioner if unusual circumstances warrant. An issuer will be 
given at least 21 calendar days to respond to a request for additional 
information.
    (iii) A claim described in either paragraph (i)(3)(iii)(A) or (B) of 
this section that has been denied by the Commissioner may be appealed to 
the Office of Appeals under this paragraph (i)(3)(iii). Upon a 
determination in favor of the issuer, the Office of Appeals must return 
the undeveloped case to the Commissioner for further consideration of 
the substance of the claim.
    (A) A claim is described in this paragraph (i)(3)(iii)(A) if the 
Commissioner asserts that the claim was filed after the filing deadline.
    (B) A claim is described in this paragraph (i)(3)(iii)(B) if the 
Commissioner asserts that additional information to support the claim 
was not submitted within the time specified in the request

[[Page 103]]

for information or in any extension of such specified time period.
    (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
------------------------------------------------------------------------
2/1/94..................................................      $3,000,000
5/1/94..................................................       5,000,000
1/1/95..................................................       5,000,000
9/1/95..................................................      20,000,000
3/1/96..................................................      22,000,000
------------------------------------------------------------------------

    (ii) First computation date. (A) City A chooses January 1, 1999, as 
its first computation date. This date is the latest date that may be 
used to compute the first required rebate installment payment. 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:

------------------------------------------------------------------------
                                            Receipts        FV (7.0000
                 Date                      (payments)        percent)
------------------------------------------------------------------------
1/1/94................................    ($49,000,000)    ($69,119,339)
2/1/94................................       3,000,000        4,207,602
5/1/94................................       5,000,000        6,893,079
1/1/95................................       5,000,000        6,584,045
1/1/95................................          (1,000)          (1,317)
9/1/95................................      20,000,000       25,155,464
1/1/96................................          (1,000)           1,229)
3/1/96................................      22,000,000       26,735,275
1/1/97................................          (1,000)          (1,148)
                                       ---------------------------------
Rebate amount (1/01/99)...............  ...............         452,432
------------------------------------------------------------------------

    (B) City A pays 90 percent of the rebate amount ($407,189) 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:

------------------------------------------------------------------------
                                                  Receipts    FV (7.0000
                     Date                        (payments)    percent)
------------------------------------------------------------------------
1/1/99........................................     $452,432     $638,200
                                               -------------------------
Rebate amount (1/01/04).......................  ...........      638,200
------------------------------------------------------------------------

    (B) As of this computation date, the future value of the payment 
treated as made on January 1, 1999, is $574,380, which equals at least 
90 percent of the rebate amount as of this computation date ($638,200 x 
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:

------------------------------------------------------------------------
                                                Receipts     FV (7.0000
                    Date                       (payments)     percent)
------------------------------------------------------------------------
1/1/04......................................     $638,200      $900,244
1/1/09......................................       (1,000)       (1,000)
                                             ---------------------------
Rebate amount (1/01/09).....................  ............      899,244
------------------------------------------------------------------------

    (B) As of this computation date, the future value of the payment 
made on January 1, 1999, is $810,220 and thus an additional rebate 
payment of $89,024 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:

[[Page 104]]



------------------------------------------------------------------------
                                          Receipts         FV (6.0000
                 Date                    (payments)         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:

------------------------------------------------------------------------
                                                 Receipts    FV (5.0000
                     Date                       (payments)    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.
    (D) If the yield during the second computation period were, instead, 
7.0000 percent, the rebate amount computed as of July 1, 2004, would be 
$1,320,891. The future value of the payment made on July 1, 1999, would 
be $1,471,007. Although the future value of the payment made on July 1, 
1999 ($1,471,007), exceeds the rebate amount computed as of July 1, 2004 
($1,320,891), Sec.  1.148-3(i) limits the amount recoverable as a 
defined overpayment of rebate under section 148 to the excess of the 
total ``amount paid'' over the sum of the amount determined under the 
future value method to be the ``rebate amount'' as of the most recent 
computation date and all other amounts that are otherwise required to be 
paid under section 148 as of the date the recovery is requested. Because 
the total amount that the issuer paid on July 1, 1999 ($1,042,824.60), 
does not exceed the rebate amount as of July 1, 2004 ($1,320,891), the 
issuer would not be entitled to recover any overpayment of rebate in 
this case.

    (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).

[T.D. 8476, 58 FR 33522, June 18, 1993; 58 FR 44452, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24042, May 10, 1994; T.D. 8476, 59 FR 24350, 
May 11, 1994; T.D. 8718, 62 FR 25507, May 9, 1997; T.D. 9701, 79 FR 
67351, Nov. 13, 2014; T.D. 9777, 81 FR 46593, July 18, 2016]



Sec.  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 (for 
example, 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.
    (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,

[[Page 105]]

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 Sec.  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 that 
bond.
    (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;

[[Page 106]]

    (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 Sec.  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) Special aggregation rule treating certain bonds as a single 
fixed yield bond. Two variable yield bonds of an issue are treated in 
the aggregate as a single fixed yield bond if--
    (i) Aggregate treatment would result in the single bond being a 
fixed yield bond; and
    (ii) The terms of the bonds do not contain any features that could 
distort the aggregate fixed yield from what the yield would be if a 
single fixed yield bond were issued. For example, if an issue contains a 
bond bearing interest at a floating rate and a related bond bearing 
interest at a rate equal to a fixed rate minus that floating rate, those 
two bonds are treated as a single fixed yield bond only if neither bond 
may be redeemed unless the other bond is also redeemed at the same time.
    (6) 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 Sec.  
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:

------------------------------------------------------------------------
                                                             PV (5.8731
                     Date                        Payments     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 Sec.  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:

------------------------------------------------------------------------
                                                             PV (5.8678
                     Date                        Payments     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
------------------------------------------------------------------------


[[Page 107]]

    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:

------------------------------------------------------------------------
                                                             PV (6.0834
                     Date                        Payments     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:

------------------------------------------------------------------------
                                                             PV (5.9126
                     Date                        Payments     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

[[Page 108]]

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. For 
purposes of determining yield under this section, 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 Sec.  
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.

[[Page 109]]

    (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 Sec.  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

[[Page 110]]

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 
section 148 and section 143(g) with respect to purpose investments 
allocable to a variable yield issue of qualified mortgage bonds, 
qualified veterans' mortgage bonds, or qualified student loan bonds that 
is reasonably expected as of the issue date to convert to a fixed yield 
issue, the yield may be computed over the term of the issue, and, if the 
yield is so computed, paragraph (d) of this section does not apply to 
the issue. As of any date, the yield over the term of the issue is based 
on--
    (1) With respect to any bond of the issue that has not converted to 
a fixed and determinable yield on or before that date, the actual 
amounts paid or received to that date and the amounts that are 
reasonably expected (as of that date) to be paid or received with 
respect to that bond over the remaining term of the issue (taking into 
account prepayment assumptions under section 143(g)(2)(B)(iv), if 
applicable); and
    (2) With respect to any bond of the issue that has converted to a 
fixed and determinable yield on or before that date, the actual amounts 
paid or received before that bond converted, if any, and the amount that 
was reasonably expected (on the date that bond converted) to be paid or 
received with respect to that bond over the remaining term of the issue 
(taking into account prepayment assumptions under section 
143(g)(2)(B)(iv), if applicable).
    (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 paragraphs (h)(4) and 
(h)(5)(ii)(E) of this section, the bonds to which a qualified hedge 
relates are treated as variable yield bonds from the issue date of the 
bonds. This paragraph (h) applies solely for purposes of sections 
143(g), 148, and 149(d).
    (2) Qualified hedge defined. Except as provided in paragraph (h)(5) 
of this section, the term qualified hedge means a contract that 
satisfies each of the following requirements:
    (i) Hedge--(A) In general. The contract is entered into primarily to 
modify the issuer's risk of interest rate changes with respect to a bond 
(a hedge). For example, the contract may be an interest rate swap, an 
interest

[[Page 111]]

rate cap, a futures contract, a forward contract, or an option.
    (B) Special rule for fixed rate issues. If the contract modifies the 
issuer's risk of interest rate changes with respect to a bond that is 
part of an issue that, absent the contract, would be a fixed rate issue, 
the contract must be entered into--
    (1) No later than 15 days after the issue date (or the deemed issue 
date under paragraph (d) of this section) of the issue; or
    (2) No later than the expiration of a qualified hedge with respect 
to bonds of that issue that satisfies paragraph (h)(2)(i)(B)(1) of this 
section; or
    (3) No later than the expiration of a qualified hedge with respect 
to bonds of that issue that satisfies either paragraph (h)(2)(i)(B)(2) 
of this section or this paragraph (h)(2)(i)(B)(3).
    (C) Contracts with certain acquisition payments. If a hedge provider 
makes a single payment to the issuer (e.g., a payment for an off-market 
swap) in connection with the acquisition of a contract, the issuer may 
treat a portion of that contract as a hedge provided--
    (1) The hedge provider's payment to the issuer and the issuer's 
payments under the contract in excess of those that it would make if the 
contract bore rates equal to the on-market rates for the contract 
(determined as of the date the parties enter into the contract) are 
separately identified in a certification of the hedge provider; and
    (2) The payments described in paragraph (h)(2)(i)(C)(1) of this 
section are not treated as payments on the hedge.
    (ii) No significant investment element--(A) In general. The contract 
does not contain a significant investment element. Except as provided in 
paragraph (h)(2)(ii)(B) of this section, a contract contains a 
significant investment element if a significant portion of any payment 
by one party relates to a conditional or unconditional obligation by the 
other party to make a payment on a different date. Examples of contracts 
that contain a significant investment element are a debt instrument held 
by the issuer; an interest rate swap requiring any payments other than 
periodic payments, within the meaning of Sec.  1.446-3 (periodic 
payments) (e.g., a payment for an off-market swap or prepayment of part 
or all of one leg of a swap); and an interest rate cap requiring the 
issuer's premium for the cap to be paid in a single, up-front payment. 
Solely for purposes of determining if a hedge is a qualified hedge under 
this section, payments that an issuer receives pursuant to the terms of 
a hedge that are equal to the issuer's cost of funds are treated as 
periodic payments under Sec.  1.446-3 without regard to whether the 
payments are calculated by reference to a ``specified index'' described 
in Sec.  1.446-3(c)(2). Accordingly, a hedge does not have a significant 
investment element under this paragraph (h)(2)(ii)(A) solely because an 
issuer receives payments pursuant to the terms of a hedge that are 
computed to be equal to the issuer's cost of funds, such as the issuer's 
actual market-based tax-exempt variable interest rate on its bonds.
    (B) Special level payment rule for interest rate caps. An interest 
rate cap does not contain a significant investment element if--
    (1) All payments to the issuer by the hedge provider are periodic 
payments;
    (2) The issuer makes payments for the cap at the same time as 
periodic payments by the hedge provider must be made if the specified 
index (within the meaning of Sec.  1.446-3) of the cap is above the 
strike price of the cap; and
    (3) Each payment by the issuer bears the same ratio to the notional 
principal amount (within the meaning of Sec.  1.446-3) that is used to 
compute the hedge provider's payment, if any, on that date.
    (iii) 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).
    (iv) Hedged bonds. The contract covers, in whole or in part, 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). 
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

[[Page 112]]

in an issue for the first 5 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 covered by a 
hedge.
    (v) Interest-based contract and size and scope of hedge. The 
contract is primarily interest-based (for example, a hedge based on a 
debt index, including a tax-exempt debt index or a taxable debt index, 
rather than an equity index). In addition, the size and scope of the 
hedge under the contract is limited to that which is reasonably 
necessary to hedge the issuer's risk with respect to interest rate 
changes on the hedged bonds. For example, a contract is limited to 
hedging an issuer's risk with respect to interest rate changes on the 
hedged bonds if the hedge is based on the principal amount and the 
reasonably expected interest payments of the hedged bonds. For 
anticipatory hedges under paragraph (h)(5) of this section, the size and 
scope limitation applies based on the reasonably expected terms of the 
hedged bonds to be issued. A contract is not primarily interest based 
unless--
    (A) The hedged bond, without regard to the contract, is either a 
fixed rate bond, a variable rate debt instrument within the meaning of 
Sec.  1.1275-5 provided the rate is not based on an objective rate other 
than a qualified inverse floating rate or a qualified inflation rate, a 
tax-exempt obligation described in Sec.  1.1275-4(d)(2), or an 
inflation-indexed debt instrument within the meaning of Sec.  1.1275-7; 
and
    (B) As a result of treating all payments on (and receipts from) the 
contract as additional payments on (and receipts from) the hedged bond, 
the resulting bond would be substantially similar to either a fixed rate 
bond, a variable rate debt instrument within the meaning of Sec.  
1.1275-5 provided the rate is not based on an objective rate other than 
a qualified inverse floating rate or a qualified inflation rate, a tax-
exempt obligation described in Sec.  1.1275-4(d)(2), or an inflation-
indexed debt instrument within the meaning of Sec.  1.1275-7. For this 
purpose, differences that would not prevent the resulting bond from 
being substantially similar to another type of bond include: a 
difference between the interest rate used to compute payments on the 
hedged bond and the interest rate used to compute payments on the hedge 
where one interest rate is substantially similar to the other; the 
difference resulting from the payment of a fixed premium for a cap (for 
example, payments for a cap that are made in other than level 
installments); and the difference resulting from the allocation of a 
termination payment where the termination was not expected as of the 
date the contract was entered into.
    (vi) Payments closely correspond. The payments received by the 
issuer from the hedge provider under the contract correspond closely in 
time to either the specific payments being hedged on the hedged bonds or 
specific payments required to be made pursuant to the bond documents, 
regardless of the hedge, to a sinking fund, debt service fund, or 
similar fund maintained for the issue of which the hedged bond is a 
part. For this purpose, such payments will be treated as corresponding 
closely in time under this paragraph (h)(2)(vi) if they are made within 
90 calendar days of each other.
    (vii) 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.
    (viii) Identification--(A) In general. The actual issuer must 
identify the contract on its books and records maintained for the hedged 
bonds not later than 15 calendar days after the date on which there is a 
binding agreement to enter into a hedge contract (for example, the date 
of a hedge pricing confirmation, as distinguished from the closing date 
for the hedge or start date for payments on the hedge, if different). 
The identification must specify the name of the hedge provider, the 
terms of the contract, the hedged bonds, and include a hedge provider's 
certification as described in paragraph (h)(2)(viii)(B) of this section. 
The identification must contain sufficient detail to establish that the 
requirements of this paragraph (h)(2) and, if applicable, paragraph 
(h)(4) of this section are satisfied. In addition, the existence of

[[Page 113]]

the hedge must be noted on the first form relating to the issue of which 
the hedged bonds are a part that is filed with the Internal Revenue 
Service on or after the date on which the contract is identified 
pursuant to this paragraph (h)(2)(viii).
    (B) Hedge provider's certification. The hedge provider's 
certification must--
    (1) Provide that the terms of the hedge were agreed to between a 
willing buyer and willing seller in a bona fide, arm's-length 
transaction;
    (2) Provide that the hedge provider has not made, and does not 
expect to make, any payment to any third party for the benefit of the 
issuer in connection with the hedge, except for any such third-party 
payment that the hedge provider expressly identifies in the documents 
for the hedge;
    (3) Provide that the amounts payable to the hedge provider pursuant 
to the hedge do not include any payments for underwriting or other 
services unrelated to the hedge provider's obligations under the hedge, 
except for any such payment that the hedge provider expressly identifies 
in the documents for the hedge; and
    (4) Contain any other statements that the Commissioner may provide 
in guidance published in the Internal Revenue Bulletin. See Sec.  
601.601(d)(2)(ii) of this chapter.
    (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 
modification 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. If any payment for services or other 
items under the contract is not expressly treated by paragraph (h)(3)(i) 
of this section as a payment under the qualified hedge, the payment is 
not a payment with respect to a qualified hedge.
    (iii) Timing and allocation of payments. Except as provided in 
paragraphs (h)(3)(iv) and (h)(5) of this section, payments made or 
received by the issuer under a qualified hedge are taken into account in 
the same period in which those amounts would be treated as income or 
deductions under Sec.  1.446-4 (without regard to Sec.  1.446-
4(a)(2)(iv)) and are adjusted as necessary to reflect the end of a 
computation period and the start of a new computation period.
    (iv) Accounting for modifications and terminations--(A) Modification 
defined. A modification of a qualified hedge includes, without 
limitation, a change in the terms of the hedge or an issuer's 
acquisition of another hedge with terms that have the effect of 
modifying an issuer's risk of interest rate changes or other terms of an 
existing qualified hedge. For example, if the issuer enters into a 
qualified hedge that is an interest rate swap under which it receives 
payments based on the Securities Industry and Financial Market 
Association (SIFMA) Municipal Swap Index and subsequently enters a 
second hedge (with the same or different provider) that limits the 
issuer's exposure under the existing qualified hedge to variations in 
the SIFMA Municipal Swap Index, the new hedge modifies the qualified 
hedge.
    (B) Termination defined. A termination means either an actual 
termination or a deemed termination of a qualified hedge. Except as 
otherwise provided, an actual termination of a qualified hedge occurs to 
the extent that the issuer sells, disposes of, or otherwise actually 
terminates all or a portion of the hedge. A deemed termination of a 
qualified hedge occurs if the hedge ceases to meet the requirements for 
a qualified hedge; the issuer makes a modification (as defined in 
paragraph (h)(3)(iv)(A) of this section) that is material either in kind 
or in extent and, therefore, results in a deemed exchange of the hedge 
and a realization event to the issuer under section 1001;

[[Page 114]]

or the issuer redeems all or a portion of the hedged bonds.
    (C) Special rules for certain modifications when the hedge remains 
qualified. A modification of a qualified hedge that otherwise would 
result in a deemed termination under paragraph (h)(3)(iv)(B) of this 
section does not result in such a termination if the modified hedge is 
re-tested for qualification as a qualified hedge as of the date of the 
modification, the modified hedge meets the requirements for a qualified 
hedge as of such date, and the modified hedge is treated as a qualified 
hedge prospectively in determining the yield on the hedged bonds. For 
purposes of this paragraph (h)(3)(iv)(C), when determining whether the 
modified hedge is qualified, the fact that the existing qualified hedge 
is off-market as of the date of the modification is disregarded and the 
identification requirement in paragraph (h)(2)(viii) of this section 
applies by measuring the time period for identification from the date of 
the modification and without regard to the requirement for a hedge 
provider's certification.
    (D) Continuations of certain qualified hedges in refundings. If 
hedged bonds are redeemed using proceeds of a refunding issue, the 
qualified hedge for the refunded bonds is not actually terminated, and 
the hedge meets the requirements for a qualified hedge for the refunding 
bonds as of the issue date of the refunding bonds, then no termination 
of the hedge occurs and the hedge instead is treated as a qualified 
hedge for the refunding bonds. For purposes of this paragraph 
(h)(3)(iv)(D), when determining whether the hedge is a qualified hedge 
for the refunding bonds, the fact that the hedge is off-market with 
respect to the refunding bonds as of the issue date of the refunding 
bonds is disregarded and the identification requirement in paragraph 
(h)(2)(viii) of this section applies by measuring the time period for 
identification from the issue date of the refunding bonds and without 
regard to the requirement for a hedge provider's certification.
    (E) General allocation rules for hedge termination payments. Except 
as otherwise provided in paragraphs (h)(3)(iv)(F), (G), and (H) of this 
section, a payment made or received by an issuer to terminate a 
qualified hedge, or a payment deemed made or received for a deemed 
termination, is treated as a payment made or received, as appropriate, 
on the hedged bonds. Upon an actual termination or a deemed termination 
of a qualified hedge, the amount that an issuer may treat as a 
termination payment made or received on the hedged bonds is the fair 
market value of the qualified hedge on its termination date, based on 
all of the facts and circumstances. Except as otherwise provided, a 
termination 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.
    (F) Special rule for terminations when bonds are redeemed. Except as 
otherwise provided in this paragraph (h)(3)(iv)(F) and in paragraph 
(h)(3)(iv)(G) of this section, when a qualified hedge is deemed 
terminated because the hedged bonds are redeemed, the termination 
payment as determined under paragraph (h)(3)(iv)(E) of this section is 
treated as 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 not below zero, the interest payments made by the issuer on 
the hedged bonds in the computation period ending on the termination 
date. The remainder of the payment, 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.
    (G) Special rules for refundings. When there is a termination of a 
qualified hedge because there is a refunding of the hedged bonds, 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)(E) of this section by treating it as a payment on 
the refunding issue, rather than the hedged bonds. In addition, to the 
extent that the refunding issue is redeemed during the period to which 
the termination payment has been allocated to that issue, paragraph

[[Page 115]]

(h)(3)(iv)(F) of this section applies to the termination payment by 
treating it as a payment on the redeemed refunding issue.
    (H) Safe harbor for allocation of certain termination payments. A 
payment to terminate a qualified hedge does not result in that hedge 
failing to satisfy the applicable provisions of paragraph (h)(3)(iv)(E) 
of this section if that payment is allocated in accordance with this 
paragraph (h)(3)(iv)(H). For an issue that is a variable yield issue 
after termination of a qualified hedge, an amount must be allocated to 
each date on which the hedge provider's payment, if any, would have been 
made had the hedge not been terminated. The amounts allocated to each 
date must bear the same ratio to the notional principal amount (within 
the meaning of Sec.  1.446-3) that would have been used to compute the 
hedge provider's payment, if any, on that date, and the sum of the 
present values of those amounts must equal the present value of the 
termination payment. Present value is computed as of the day the 
qualified hedge is terminated, using the yield on the hedged bonds, 
determined without regard to the termination payment. The yield used for 
this purpose is computed for the period beginning on the first date the 
qualified hedge is in effect and ending on the date the qualified hedge 
is terminated. On the other hand, for an issue that is a fixed yield 
issue after termination of a qualified hedge, the termination payment is 
taken into account as a single payment on the date it is paid.
    (4) Certain variable yield bonds treated as fixed yield bonds--(i) 
In general. Except as otherwise provided in this paragraph (h)(4), if 
the issuer of variable yield bonds enters into a qualified hedge, the 
hedged bonds are treated as fixed yield bonds paying a fixed interest 
rate if:
    (A) Maturity. The term of the hedge is equal to the entire period 
during which the hedged bonds bear interest at variable interest rates, 
and the issuer does not reasonably expect that the hedge will be 
terminated before the end of that period.
    (B) Payments closely correspond. Payments to be received under the 
hedge correspond closely in time to the hedged portion of payments on 
the hedged bonds. Hedge payments received within 15 days of the related 
payments on the hedged bonds generally so correspond.
    (C) Aggregate payments fixed. Taking into account all payments made 
and received under the hedge and all payments on the hedged bonds (i.e., 
after netting all payments), the issuer's aggregate payments are fixed 
and determinable as of a date not later than 15 days after the issue 
date of the hedged bonds. Payments on bonds are treated as fixed for 
purposes of this paragraph (h)(4)(i)(C) if payments on the bonds are 
based, in whole or in part, on one interest rate, payments on the hedge 
are based, in whole or in part, on a second interest rate that is 
substantially the same as, but not identical to, the first interest rate 
and payments on the bonds would be fixed if the two rates were 
identical. 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 may be substantially the same as an 
issuer's individual 30-day interest rate. A hedge based on a taxable 
interest rate or taxable interest index cannot meet the requirements of 
this paragraph (h)(4)(i)(C) unless either--
    (1) The hedge is an anticipatory hedge that is terminated or 
otherwise closed substantially contemporaneously with the issuance of 
the hedged bond in accordance with paragraph (h)(5)(ii) or (iii) of this 
section; or
    (2) The issuer's payments on the hedged bonds and the hedge 
provider's payments on the hedge are based on identical interest rates.
    (ii) Accounting. Except as otherwise provided in this paragraph 
(h)(4)(ii), in determining yield on the hedged bonds, all the issuer's 
payments on the hedged bonds and all payments made and received on a 
hedge described in paragraph (h)(4)(i) of this section are taken into 
account. If payments on the bonds and payments on the hedge are based, 
in whole or in part, on variable interest rates that are substantially 
the same within the meaning of paragraph

[[Page 116]]

(h)(4)(i)(C) of this section (but not identical), yield on the issue is 
determined by treating the variable interest rates as identical. For 
example, if variable rate bonds bearing interest at a weekly rate equal 
to the rate necessary to remarket the bonds at par are hedged with an 
interest rate swap under which the issuer receives payments based on a 
short-term floating rate index that is substantially the same as, but 
not identical to, the weekly rate on the bonds, the interest payments on 
the bonds are treated as equal to the payments received by the issuer 
under the swap for purposes of computing the yield on the bonds.
    (iii) Effect of termination--(A) In general. Except as otherwise 
provided in this paragraph (h)(4)(iii) and paragraph (h)(5) of this 
section, the issue of which the hedged bonds are a part is treated as if 
it were reissued as of the termination date of the qualified hedge 
covered by paragraph (h)(4)(i) of this section in determining yield on 
the hedged bonds for purposes of Sec.  1.148-3. 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 for this purpose, 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 new issue under this paragraph (h)(4)(iii).
    (B) Effect of early termination. Except as otherwise provided in 
this paragraph (h)(4)(iii), the general rules of paragraph (h)(4)(i) of 
this section do not apply in determining the yield on the hedged bonds 
for purposes of Sec.  1.148-3 if the hedge is terminated or deemed 
terminated within 5 years after the issue date of the issue of which the 
hedged bonds are a part. Thus, the hedged bonds are treated as variable 
yield bonds for purposes of Sec.  1.148-3 from the issue date.
    (C) Certain terminations disregarded. This paragraph (h)(4)(iii) 
does not apply to a termination if, based on the facts and circumstances 
(e.g., taking into account both the termination and any qualified hedge 
that immediately replaces the terminated hedge), there is no change in 
the yield.
    (iv) Consequences of certain modifications. The special rules under 
paragraph (h)(4)(iii) of this section regarding the effects of 
termination of a qualified hedge of fixed yield hedged bonds apply to a 
modification described in paragraph (h)(3)(iv)(C) of this section. Thus, 
such a modification is treated as a termination for purposes of 
paragraph (h)(4)(iii) of this section unless the rule in paragraph 
(h)(4)(iii)(C) applies.
    (5) Contracts entered into before issue date of hedged bond--(i) In 
general. A contract does not fail to be a hedge under paragraph 
(h)(2)(i) of this section solely because it is entered into before the 
issue date of the hedged bond. However, that contract must be one to 
which either paragraph (h)(5)(ii) or (h)(5)(iii) of this section 
applies.
    (ii) Contracts expected to be closed substantially contemporaneously 
with the issue date of hedged bond--(A) Application. This paragraph 
(h)(5)(ii) applies to a contract if, on the date the contract is 
identified, the issuer reasonably expects to terminate or otherwise 
close (terminate) the contract substantially contemporaneously with the 
issue date of the hedged bond.
    (B) Contract terminated. If a contract to which this paragraph 
(h)(5)(ii) applies is terminated substantially contemporaneously with 
the issue date of the hedged bond, the amount paid or received, or 
deemed to be paid or received, by the issuer in connection with the 
issuance of the hedged bond to terminate the contract is treated as an 
adjustment to the issue price of the hedged bond and as an adjustment to 
the sale proceeds of the hedged bond for purposes of section 148. 
Amounts paid or received, or deemed to be paid or received, before the 
issue date of the hedged bond are treated as paid or received on the 
issue date in an amount equal to the future value of the payment or 
receipt on that date. For this purpose, future value is computed using 
yield on the hedged bond without taking into account amounts paid or 
received (or deemed paid or received) on the contract.
    (C) Contract not terminated. If a contract to which this paragraph 
(h)(5)(ii) applies is not terminated substantially contemporaneously 
with the issue date

[[Page 117]]

of the hedged bond, the contract is deemed terminated for its fair 
market value as of the issue date of the hedged bond. Once a contract 
has been deemed terminated pursuant to this paragraph (h)(5)(ii)(C), 
payments on and receipts from the contract are no longer taken into 
account under this paragraph (h) for purposes of determining yield on 
the hedged bond.
    (D) Relation to other requirements of a qualified hedge. Payments 
made in connection with the issuance of a bond to terminate a contract 
to which this paragraph (h)(5)(ii) applies do not prevent the contract 
from satisfying the requirements of paragraph (h)(2)(vi) of this 
section.
    (E) Fixed yield treatment. A bond that is hedged with a contract to 
which this paragraph (h)(5)(ii) applies does not fail to be a fixed 
yield bond if, taking into account payments on the contract and the 
payments to be made on the bond, the bond satisfies the definition of 
fixed yield bond. See also paragraph (h)(4) of this section.
    (iii) Contracts expected not to be closed substantially 
contemporaneously with the issue date of hedged bond--(A) Application. 
This paragraph (h)(5)(iii) applies to a contract if, on the date the 
contract is identified, the issuer does not reasonably expect to 
terminate the contract substantially contemporaneously with the issue 
date of the hedge bond.
    (B) Contract terminated. If a contract to which this paragraph 
(h)(5)(iii) applies is terminated in connection with the issuance of the 
hedged bond, the amount paid or received, or deemed to be paid or 
received, by the issuer to terminate the contract is treated as an 
adjustment to the issue price of the hedged bond and as an adjustment to 
the sale proceeds of the hedged bond for purposes of section 148.
    (C) Contract not terminated. If a contract to which this paragraph 
(h)(5)(iii) applies is not terminated substantially contemporaneously 
with the issue date of the hedged bond, no payments with respect to the 
hedge made by the issuer before the issue date of the hedged bond are 
taken into account under this section.
    (iv) Identification. The identification required under paragraph 
(h)(2)(viii) of this section must specify the reasonably expected 
governmental purpose, issue price, maturity, and issue date of the 
hedged bond, the manner in which interest is reasonably expected to be 
computed, and whether paragraph (h)(5)(ii) or (h)(5)(iii) of this 
section applies to the contract. If an issuer identifies a contract 
under this paragraph (h)(5)(iv) that would be a qualified hedge with 
respect to the anticipated bond, but does not issue the anticipated bond 
on the identified issue date, the contract is taken into account as a 
qualified hedge of any bond of the issuer that is issued for the 
identified governmental purpose within a reasonable interval around the 
identified issue date of the anticipated bond.
    (6) Authority of the Commissioner. The Commissioner, by publication 
of a revenue ruling or revenue procedure (see Sec.  601.601(d)(2) of 
this chapter), may specify contracts that, although they do not meet the 
requirements of paragraph (h)(2) of this section, are qualified hedges 
or, although they do not meet the requirements of paragraph (h)(4) of 
this section, cause the hedged bonds to be treated as fixed yield bonds.

[T.D. 8476, 58 FR 33524, June 18, 1993; 58 FR 44452, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24042, May 10, 1994; T.D. 8718, 62 FR 25507, 
May 9, 1997; T.D. 8838, 64 FR 48547, Sept. 7, 1999; T.D. 9777, 81 FR 
46593, July 18, 2016; 83 FR 14175, Apr. 3, 2018]



Sec.  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

[[Page 118]]

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 Sec.  
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 Sec.  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. For all 
purposes of section 148, if an issuer reasonably expects as of the issue 
date to establish and maintain a sinking fund solely to reduce the yield 
on the investments in a refunding escrow, then the issuer may treat all 
of the yield restricted nonpurpose investments in the refunding escrow 
and that sinking fund as a single investment having a single yield, 
determined under this paragraph (b)(2). Thus, an issuer may not treat 
the nonpurpose investments in a reasonably required reserve fund and a 
refunding escrow as a single investment having a single yield under this 
paragraph (b)(2)(iii).
    (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 Sec.  1.148-2, for 
purposes of Sec.  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

[[Page 119]]

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 Sec.  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. For 
example, yield reduction payments must be made on or before the date of 
required rebate installment payments as described in Sec. Sec.  1.148-
3(f), (g), and (h). The provisions of Sec.  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. Paragraph (c) 
applies only to investments that are described in at least one of 
paragraphs (c)(3)(i) through (ix) of this section and, except as 
otherwise expressly provided in paragraphs (c)(3)(i) through (ix) of 
this section, that are allocated to proceeds of an issue other than 
gross proceeds of an advance refunding issue.
    (i) Nonpurpose investments allocated to proceeds of an issue that 
qualified for certain temporary periods. Nonpurpose investments 
allocable to proceeds of an issue that qualified for one of the 
temporary periods available for capital projects, working capital 
expenditures, pooled financings, or investment proceeds under Sec.  
1.148-2(e)(2), (3), (4), or (6), respectively.
    (ii) Investments allocable to certain variable yield issues. 
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)).
    (iii) Nonpurpose investments allocable to certain transferred 
proceeds. Nonpurpose investments allocable to transferred proceeds of--
    (A) A current refunding issue to the extent necessary to reduce the 
yield on those investments to satisfy yield restrictions under section 
148(a); or
    (B) 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).
    (iv) Purpose investments allocable to qualified student loans and 
qualified mortgage loans. Purpose investments allocable to qualified 
student loans and qualified mortgage loans.
    (v) Nonpurpose investments allocable to gross proceeds in certain 
reserve funds. Nonpurpose investments allocable to gross proceeds of an 
issue in a reasonably required reserve or replacement fund or a fund 
that, except for its failure to satisfy the size limitation in Sec.  
1.148-2(f)(2)(ii), would qualify as a reasonably required reserve or 
replacement fund, but only to the extent the requirements in paragraphs 
(c)(3)(v)(A) or (B) of this section are met. This paragraph (c)(3)(v) 
includes nonpurpose investments described in this paragraph that are 
allocable to transferred proceeds of an advance refunding issue,

[[Page 120]]

but only to the extent necessary to satisfy yield restriction under 
section 148(a) on those proceeds treating all investments allocable to 
those proceeds as a separate class.
    (A) 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 Sec.  1.148-2(f)(2)(ii).
    (B) The amounts in the fund (other than investment earnings) are not 
reasonably expected to be used to pay debt service on the issue other 
than in connection with reductions in the amount required to be in that 
fund (for example, a reserve fund for a revolving fund loan program).
    (vi) Nonpurpose investments allocable to certain replacement 
proceeds of refunded issues. Nonpurpose investments allocated to 
replacement proceeds of a refunded issue, including a refunded issue 
that is an advance refunding issue, as a result of the application of 
the universal cap to amounts in a refunding escrow.
    (vii) Investments allocable to replacement proceeds under a certain 
transition rule. Investments described in Sec.  1.148-11(f).
    (viii) Nonpurpose investments allocable to proceeds when State and 
Local Government Series Securities are unavailable. Nonpurpose 
investments allocable to proceeds of an issue, including an advance 
refunding issue, that an issuer purchases if, on the date the issuer 
enters into the agreement to purchase such investments, the issuer is 
unable to subscribe for State and Local Government Series Securities 
because the U.S. Department of the Treasury, Bureau of the Fiscal 
Service, has suspended sales of those securities.
    (ix) Nonpurpose investments allocable to proceeds of certain 
variable yield advance refunding issues. Nonpurpose investments 
allocable to proceeds of the portion of a variable yield issue used for 
advance refunding purposes that are deposited in a yield restricted 
defeasance escrow if--
    (A) The issuer has entered into a qualified hedge under Sec.  1.148-
4(h)(2) with respect to all of the variable yield bonds of the issue 
allocable to the yield restricted defeasance escrow and that hedge is in 
the form of a variable-to-fixed interest rate swap under which the 
issuer pays the hedge provider a fixed interest rate and receives from 
the hedge provider a floating interest rate;
    (B) Such qualified hedge covers a period beginning on the issue date 
of the hedged bonds and ending on or after the date on which the final 
payment is to be made from the yield restricted defeasance escrow; and
    (C) The issuer restricts the yield on the yield restricted 
defeasance escrow to a yield that is not greater than the yield on the 
issue, determined by taking into account the issuer's fixed payments to 
be made under the hedge and by assuming that the issuer's variable yield 
payments to be paid on the hedged bonds are equal to the floating 
payments to be received by the issuer under the qualified hedge and are 
paid on the same dates (that is, such yield reduction payments can only 
be made to address basis risk differences between the variable yield 
payments on the hedged bonds and the floating payments received on the 
hedge).
    (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 certain yield restricted investments at 
present value. A purpose investment must be valued at present value, and 
except as otherwise provided in paragraphs (b)(3) and (d)(3) of this 
section, a yield restricted nonpurpose investment must be valued at 
present value.
    (3) Mandatory valuation of certain investments at fair market 
value--(i) In general. Except as otherwise provided

[[Page 121]]

in paragraphs (d)(3)(ii) and (d)(4) of this section, a nonpurpose 
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 nonpurpose 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, certain universal cap allocations, and commingled 
funds. Paragraph (d)(3)(i) of this section does not apply if the 
investment is allocated from one issue to another as a result of the 
transferred proceeds allocation rule under Sec.  1.148-9(b) or is 
deallocated from one issue as a result of the universal cap rule under 
Sec.  1.148-6(b)(2) and reallocated to another issue as a result of a 
preexisting pledge of the investment to secure that other issue, 
provided that, in either circumstance (that is, transferred proceeds 
allocations or universal cap deallocations), the issue from which the 
investment is allocated (that is, the first issue in an allocation from 
one issue to another issue) consists of tax-exempt bonds. In addition, 
paragraph (d)(3)(i) of this section does not apply to investments in a 
commingled fund (other than a bona fide debt service fund) unless it is 
an investment being initially deposited in or withdrawn from a 
commingled fund described in Sec.  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. On 
the purchase date, the fair market value of a United States Treasury 
obligation that is purchased directly from the United States Treasury, 
including a State and Local Government Series Security, is its purchase 
price. The fair market value of a State and Local Government Series 
Security on any date other than the purchase date is the redemption 
price for redemption on that date.
    (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 and investments purchased for a yield restricted 
defeasance escrow. The purchase price of a guaranteed investment 
contract and the purchase price

[[Page 122]]

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 
disseminated to potential providers. For purposes of this paragraph 
(d)(6)(iii)(A)(1), a writing may be in electronic form and may be 
disseminated by fax, email, an internet-based Web site, or other 
electronic medium that is similar to an internet-based Web site and 
regularly used to post bid specifications.
    (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. If the 
bidding process affords any opportunity for a potential provider to 
review other bids before providing a bid, then providers have an equal 
opportunity to bid only if all potential providers have an equal 
opportunity to review other bids. Thus, no potential provider may be 
given an opportunity to review other bids that is not equally given to 
all potential providers (that is, no exclusive ``last look'').
    (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

[[Page 123]]

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) 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

[[Page 124]]

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 widely held commingled fund in 
which no investor in the fund owns more than 10 percent of the 
beneficial interest in the fund. For purposes of this paragraph 
(e)(2)(ii)(B), a fund is treated as widely held only if, during the 
immediately preceding fixed, semiannual period chosen by the fund (for 
example, semiannual periods ending June 30 and December 31), the fund 
had a daily average of more than 15 investors that were not related 
parties, and at least 16 of the unrelated investors each maintained a 
daily average amount invested in the fund that was not less than the 
lesser of $500,000 and one percent (1%) of the daily average of the 
total amount invested in the fund (with it being understood that 
additional smaller investors will not disqualify the fund). For purposes 
of this paragraph (e)(2)(ii)(B), an investor will be treated as owning 
not more than 10 percent of the beneficial interest in the fund if, on 
the date of each deposit by the investor into the fund, the total amount 
the investor and any related parties have on deposit in the fund is not 
more than 10 percent of the total amount that all investors have on 
deposit in the fund. For purposes of the preceding sentence, the total 
amount that all investors have on deposit in the fund is equal to the 
sum of all deposits made by the investor and any related parties on the 
date of those deposits and the closing balance in the fund on the day 
before those deposits. If any investor in the fund owns more than 10 
percent of the beneficial interest in the fund, the fund does not 
qualify under this paragraph (e)(2)(ii)(B) until that investor makes 
sufficient withdrawals from the fund to reduce its beneficial interest 
in the fund to 10 percent or less.
    (iii) Special rule for guaranteed investment contracts and 
investments purchased for a yield restricted defeasance escrow--(A) In 
general. An amount paid for a broker's commission or similar fee with 
respect to a guaranteed investment contract or investments purchased for 
a yield restricted defeasance escrow is a qualified administrative cost 
if the fee is reasonable within the meaning of paragraph (e)(2)(i) of 
this section.
    (B) Safe harbor--(1) In general. A broker's commission or similar 
fee with respect to the acquisition of a guaranteed investment contract 
or investments purchased for a yield restricted defeasance escrow is 
reasonable within the meaning of paragraph (e)(2)(i) of this section to 
the extent that--
    (i) The amount of the fee that the issuer treats as a qualified 
administrative cost does not exceed the lesser of:
    (A) $30,000 and
    (B) 0.2% of the computational base or, if more, $3,000; and
    (ii) For any issue, the issuer does not treat as qualified 
administrative costs

[[Page 125]]

more than $85,000 in brokers' commissions or similar fees with respect 
to all guaranteed investment contracts and investments for yield 
restricted defeasance escrows purchased with gross proceeds of the 
issue.
    (2) Computational base. For purposes of paragraph (e)(2)(iii)(B)(1) 
of this section, computational base shall mean--
    (i) For a guaranteed investment contract, the amount of gross 
proceeds the issuer reasonably expects, as of the date the contract is 
acquired, to be deposited in the guaranteed investment contract over the 
term of the contract, and
    (ii) For investments (other than guaranteed investment contracts) to 
be deposited in a yield restricted defeasance escrow, the amount of 
gross proceeds initially invested in those investments.
    (3) Cost-of-living adjustment. In the case of a calendar year after 
2004, each of the dollar amounts in paragraph (e)(2)(iii)(B)(1) of this 
section shall be increased by an amount equal to--
    (i) Such dollar amount; multiplied by
    (ii) The cost-of-living adjustment determined under section 1(f)(3) 
for such calendar year by using the language ``calendar year 2003'' 
instead of ``calendar year 1992'' in section 1(f)(3)(B).
    (4) Rounding. If any increase determined under paragraph 
(e)(2)(iii)(B)(3) of this section is not a multiple of $1,000, such 
increase shall be rounded to the nearest multiple thereof.
    (5) Applicable year for cost-of-living adjustment. The cost-of-
living adjustments under paragraph (e)(2)(iii)(B)(3) of this section 
shall apply to the safe harbor amounts under paragraph (e)(2)(iii)(B)(1) 
of this section based on the year the guaranteed investment contract or 
the investments for the yield restricted defeasance escrow, as 
applicable, are acquired.
    (6) Cost-of-living adjustment to determine remaining amount of per-
issue safe harbor--(i) In general. This paragraph (e)(2)(iii)(B)(6) 
applies to determine the portion of the safe harbor amount under 
paragraph (e)(2)(iii)(B)(1)(ii) of this section, as modified by 
paragraph (e)(2)(iii)(B)(3) of this section (the per-issue safe harbor), 
that is available (the remaining amount) for any year (the determination 
year) if the per-issue safe harbor was partially used in one or more 
prior years.
    (ii) Remaining amount of per-issue safe harbor. The remaining amount 
of the per-issue safe harbor for any determination year is equal to the 
per-issue safe harbor for that year, reduced by the portion of the per-
issue safe harbor used in one or more prior years.
    (iii) Portion of per-issue safe harbor used in prior years. The 
portion of the per-issue safe harbor used in any prior year (the prior 
year) is equal to the total amount of broker's commissions or similar 
fees paid in connection with guaranteed investment contracts or 
investments for a yield restricted defeasance escrow acquired in the 
prior year that the issuer treated as qualified administrative costs for 
the issue, multiplied by a fraction the numerator of which is the per-
issue safe harbor for the determination year and the denominator of 
which is the per-issue safe harbor for the prior year. See paragraph 
(e)(2)(iii)(C) Example 2 of this section.
    (C) Examples. The following examples illustrate the application of 
the safe harbor in paragraph (e)(2)(iii)(B) of this section:

    Example 1. Multipurpose issue. In 2003, the issuer of a multipurpose 
issue uses brokers to acquire the following investments with gross 
proceeds of the issue: a guaranteed investment contract for amounts to 
be deposited in a construction fund (construction GIC), Treasury 
securities to be deposited in a yield restricted defeasance escrow 
(Treasury investments) and a guaranteed investment contract that will be 
used to earn a return on what otherwise would be idle cash balances from 
maturing investments in the yield restricted defeasance escrow (the 
float GIC). The issuer deposits $22,000,000 into the construction GIC 
and reasonably expects that no further deposits will be made over its 
term. The issuer uses $8,040,000 of the proceeds to purchase the 
Treasury investments. The issuer reasonably expects that it will make 
aggregate deposits of $600,000 to the float GIC over its term. The 
brokers' fees are $30,000 for the construction GIC, $16,080 for the 
Treasury investments and $3,000 for the float GIC. The issuer has not 
previously treated any brokers' commissions or similar fees as qualified 
administrative costs. The issuer may claim all $49,080 in brokers' fees 
for these investments as qualified administrative costs because the fees 
do not exceed the safe harbors in paragraph (e)(2)(iii)(B) of

[[Page 126]]

this section. Specifically, each of the brokers' fees equals the lesser 
of $30,000 and 0.2% of the computational base (or, if more, $3,000) 
(i.e., lesser of $30,000 and 0.2% x $22,000,000 for the construction 
GIC; lesser of $30,000 and 0.2% x $8,040,000 for the Treasury 
investments; and lesser of $30,000 and $3,000 for the float GIC). In 
addition, the total amount of brokers' fees claimed by the issuer as 
qualified administrative costs ($49,080) does not exceed the per-issue 
safe harbor of $85,000.
    Example 2. Cost-of-living adjustment. In 2003, an issuer issues 
bonds and uses gross proceeds of the issue to acquire two guaranteed 
investment contracts. The issuer pays a total of $50,000 in brokers' 
fees for the two guaranteed investment contracts and treats these fees 
as qualified administrative costs. In a year subsequent to 2003 (Year 
Y), the issuer uses gross proceeds of the issue to acquire two 
additional guaranteed investment contracts, paying a total of $20,000 in 
broker's fees for the two guaranteed investment contracts, and treats 
those fees as qualified administrative costs. For Year Y, applying the 
cost-of-living adjustment under paragraph (e)(2)(iii)(B)(3) of this 
section, the safe harbor dollar limits under paragraph (e)(2)(iii)(B)(1) 
of this section are $3,000, $32,000 and $90,000. The remaining amount of 
the per-issue safe harbor for Year Y is $37,059 ($90,000-[$50,000 x 
$90,000/$85,000]). The broker's fees in Year Y do not exceed the per-
issue safe harbor under paragraph (e)(2)(iii)(B)(1)(ii) (as modified by 
paragraph (e)(2)(iii)(B)(3)) of this section because the broker's fees 
do not exceed the remaining amount of the per-issue safe harbor 
determined under paragraph (e)(2)(iii)(B)(6) of this section for Year Y. 
In a year subsequent to Year Y (Year Z), the issuer uses gross proceeds 
of the issue to acquire an additional guaranteed investment contract, 
pays a broker's fee of $15,000 for the guaranteed investment contract, 
and treats the broker's fee as a qualified administrative cost. For Year 
Z, applying the cost-of-living adjustment under paragraph 
(e)(2)(iii)(B)(3) of this section, the safe harbor dollar limits under 
paragraph (e)(2)(iii)(B)(1) of this section are $3,000, $33,000 and 
$93,000. The remaining amount of the per-issue safe harbor for Year Z is 
$17,627 ($93,000--[($50,000 x $93,000/$85,000) + ($20,000 x $93,000/
$90,000)]). The broker's fee incurred in Year Z does not exceed the per-
issue safe harbor under paragraph (e)(2)(iii)(B)(1)(ii) (as modified by 
paragraph (e)(2)(iii)(B)(3)) of this section because the broker's fee 
does not exceed the remaining amount of the per-issue safe harbor 
determined under paragraph (e)(2)(iii)(B)(6) of this section for Year Z. 
See paragraph (e)(2)(iii)(B)(6) of this section.

    (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.

[T.D. 8476, 58 FR 33529, June 18, 1993; 58 FR 44452, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24044, May 10, 1994; T.D. 8718, 62 FR 25511, 
May 9, 1997; T.D. 8801, 63 FR 71751, Dec. 30, 1998; T.D. 9097, 68 FR 
69022, Dec. 11, 2003; T.D. 9777, 81 FR 46595, July 17, 2016]



Sec.  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

[[Page 127]]

include special State law restrictions imposed on specific funds or 
actions to avoid grant forfeitures.
    (3) Absence of allocation and accounting methods. If an issuer fails 
to maintain books and records sufficient to establish the accounting 
method for an issue and the allocation of the proceeds of that issue, 
the rules of this section are applied using the specific tracing method. 
This paragraph (a)(3) applies to bonds issued on or after May 16, 1997.
    (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 Sec.  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 Sec.  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 
Sec.  1.148-4(e) and Sec.  1.148-5(d), respectively. The value of all 
outstanding bonds of the issue is referred to as the universal cap. 
Thus, for

[[Page 128]]

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 Sec.  
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 
Sec.  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.
    (iii) Timing. An issuer must account for the allocation of proceeds 
to expenditures not later than 18 months after the later of the date the 
expenditure is paid or the date the project, if any, that is financed by 
the issue is placed in service. This allocation must be made in any 
event by the date 60 days after the fifth anniversary of the issue date 
or the date 60 days after the

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retirement of the issue, if earlier. This paragraph (d)(1)(iii) applies 
to bonds issued on or after May 16, 1997.
    (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 Sec.  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 issuance costs of the issue or any qualified administrative 
costs within the meaning of Sec. Sec.  1.148-5(e)(2) (i) or (ii), or 
Sec.  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 Sec. Sec.  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

[[Page 130]]

rise to replacement proceeds. For example, if a purported reimbursement 
allocation of proceeds of a reimbursement bond does not result in an 
expenditure under Sec.  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 any 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, 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 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.
    (5) Expenditures for reimbursement purposes. In allocating gross 
proceeds of issues of reimbursement bonds (as defined in Sec.  1.150-2)) 
to certain expenditures, Sec.  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

[[Page 131]]

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

[[Page 132]]

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 Sec.  
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.

[T.D. 8476, 58 FR 33532, June 18, 1993; 58 FR 44452, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24045, May 10, 1994; T.D. 8712, 62 FR 2304, 
Jan. 16, 1997; T.D. 8718, 62 FR 25512, May 9, 1997; T.D. 9777, 81 FR 
46597, July 18, 2016]



Sec.  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

[[Page 133]]

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 Sec.  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 
Sec.  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 Sec.  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 1\1/2\ percent penalty for other 
conduit loans from the same pooled financing issue. The 1\1/2\ 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

[[Page 134]]

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 1\1/2\ 
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 
1\1/2\ 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 exception 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 Sec.  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 Sec.  
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 Sec.  1.150-
1(f)) 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 Sec.  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 Sec.  1.148-
2(e)(2).
    (2) Extension for reasonable retainage. An issue does not fail to 
satisfy the spending requirement for the third

[[Page 135]]

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, except that this election 
does not apply for purposes of

[[Page 136]]

determining whether an issue is a construction issue under paragraph 
(f)(1) of this section if the 1\1/2\ percent penalty election is made 
under paragraph (k) of this section.
    (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 Sec.  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

[[Page 137]]

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 Sec.  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

[[Page 138]]

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 Sec.  1.150-1(f)) 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

[[Page 139]]

$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 x $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 is 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 Sec.  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 1\1/2\ 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 1\1/2\ 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 1\1/2\ 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 1\1/2\ 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 (l) 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 1\1/2\ 
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 1\1/2\ percent penalty is paid in accordance with this 
section.
    (l) Termination of 1\1/2\ percent penalty--(1)Termination after 
initial temporary period. The issuer may terminate the 1\1/2\ 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 1\1/2\ 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

[[Page 140]]

    (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 1\1/2\ 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 1\1/2\ 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 1\1/2\ 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 1\1/2\ 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 1\1/2\ 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 1\1/2\ 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 1\1/2\ 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 Sec.  1.148-3(g). See Sec.  
1.148-3(h) for rules on failures to pay penalties under this section.

[T.D. 8476, 58 FR 33535, June 18, 1993; 58 FR 44452, Aug. 23, 1993; T.D. 
9777, 81 FR 46597, July 18, 2016]



Sec.  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.

[[Page 141]]

    (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 Sec.  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--treatment of conduit borrowers. A loan to a 
conduit

[[Page 142]]

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--
    (1) The bonds of the pooled financing are not private activity 
bonds;
    (2) None of the loans to conduit borrowers are private activity 
bonds; and
    (3) 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 
Sec.  1.148-9(h) apply for purposes of determining whether refunding 
bonds meet the requirements of section 148(f)(4)(D)(v).

[T.D. 8476, 58 FR 33540, June 18, 1993, as amended by T.D. 9777, 81 FR 
46597, July 18, 2016]



Sec.  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 Sec.  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 Sec.  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 Sec.  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

[[Page 143]]

yield equal to the yield on the refunding escrow allocated to the second 
generation issue (i.e., as determined under Sec.  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. During the period that the prior issue has unspent proceeds, 
however, these allocations must be ratable (with reasonable adjustments 
for rounding) 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).

[[Page 144]]

    (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 maturing investments in 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 maturing investments in the mixed escrow, 
provided that those investments mature and the proceeds thereof are 
expended 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 Sec.  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 Sec.  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 
Sec.  1.148-2 (f)(2) and (f)(3), measured by reference to the refunding

[[Page 145]]

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 Sec.  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 Sec.  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 or replacement fund 
under section 148(d); and
    (v) Effective date. Applying the provisions of Sec.  1.148-11(b) 
(relating to elective retroactive application of Sec. Sec.  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 Sec.  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 Sec.  
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

[[Page 146]]

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;

[[Page 147]]

    (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 Sec.  1.148-11(c)(2).)
    (vi) Exception for refundings of interim notes. Paragraph (h)(4)(v) 
of this section need not be applied to refunding bonds issued to provide 
permanent financing for one or more projects 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.
    (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.

[T.D. 8476, 58 FR 33541, June 18, 1993; 58 FR 44453, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24045, May 10, 1994; T.D. 8718, 62 FR 25512, 
May 9, 1997]



Sec.  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 Sec.  1.148-0. 
Except as otherwise provided in paragraph (c) of this section, any 
action that is expressly permitted by section 148 or

[[Page 148]]

Sec. Sec.  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 issuance of bonds that do 
not qualify for a temporary period under Sec.  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 Sec.  1.148-1(c)(4)(i)(B). These 
factors may be outweighed by other factors, such as bona fide cost 
underruns, an issuer's bona fide need to finance extraordinary working 
capital items, or an issuer's 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 Sec.  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 Sec.  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 
Sec.  1.148-5(c) (relating to yield reduction payments) and Sec.  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 Sec.  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 Sec.  1.148-6(d)(3)(iii)(B).
    (2) Application. The provisions of this paragraph (b) only apply to 
the portion of an issue that, as a result of actions taken (or actions 
not taken) after the issue date, overburdens the market for tax-exempt 
bonds, except that for an issue that is reasonably expected as of

[[Page 149]]

the issue date to overburden the market, those 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 that will be used or maintained for the 
governmental purpose of the prior issue;
    (vii) Interest on purpose investments;
    (viii) Replacement proceeds in a sinking fund for the refunding 
issue;
    (ix) Qualified guarantee fees for the refunding issue or the prior 
issue; and
    (x) Fees for a qualified hedge for the refunding 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

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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 1994 
issue have different prepayment terms. The City does not reasonably 
expect to treat prepayments of the Bank note as gross proceeds of the 
1994 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 principal 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

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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 unspent 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

[[Page 152]]

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 Sec.  1.148-6(a). 
Moreover, since the proceeds of the 1990 issue were set aside 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 prevent transactions that are 
inconsistent with the purpose of the arbitrage investment restrictions. 
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 the 
Commissioner's discretion to depart from the rules of Sec.  1.148-1 
through Sec.  1.148-11 as necessary to reflect the economics of the 
transaction to prevent such financial advantage. 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, treat a hedge as either a qualified hedge or not a 
qualified hedge, or otherwise adjust any item whatsoever bearing upon 
the investments and expenditures of gross proceeds of an issue. For 
example, if the amount paid for a hedge is specifically based on the 
amount of arbitrage earned or expected to be earned on the hedged bonds, 
a principal purpose of entering into the contract is to obtain 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.
    (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 Sec.  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 Sec. Sec.  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.

[T.D. 8476, 58 FR 33544, June 18, 1993; 58 FR 44453, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24046, May 10, 1994; T.D. 8476, 59 FR 24351, 
May 11, 1994; T.D. 8718, 62 FR 25512, May 9, 1997; T.D. 9777, 81 FR 
46597, July 18, 2016]



Sec.  1.148-11  Effective/applicability dates.

    (a) In general. Except as otherwise provided in this section, 
Sec. Sec.  1.148-1 through 1.148-11 apply to bonds sold on or after July 
8, 1997.

[[Page 153]]

    (b) Elective retroactive application in whole--(1) In general. 
Except as otherwise provided in this section, and subject to the 
applicable effective dates for the corresponding statutory provisions, 
an issuer may apply the provisions of Sec. Sec.  1.148-1 through 1.148-
11 in whole, but not in part, to any issue that is outstanding on July 
8, 1997, 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 Sec.  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.
    (3) No elective retroactive application for hedges of fixed rate 
issues. The provisions of Sec.  1.148-4(h)(2)(i)(B) (relating to hedges 
of fixed rate issues) may not be applied to any bond sold on or before 
July 8, 1997.
    (4) No elective retroactive application for safe harbor for 
establishing fair market value for guaranteed investment contracts and 
investments purchased for a yield restricted defeasance escrow. The 
provisions of Sec. Sec.  1.148-5(d)(6)(iii) (relating to the safe harbor 
for establishing fair market value of guaranteed investment contracts 
and yield restricted defeasance escrow investments) and 1.148-
5(e)(2)(iv) (relating to a special rule for yield restricted defeasance 
escrow investments) may not be applied to any bond sold before December 
30, 1998.
    (c) Elective retroactive application of certain provisions and 
special rules--(1) Retroactive application of overpayment recovery 
provisions. An issuer may apply the provisions of Sec.  1.148-3(i) to 
any issue that is subject to section 148(f) or to sections 103(c)(6) or 
103A(i) of the Internal Revenue Code of 1954.
    (2) Certain allocations of multipurpose issues. An allocation of 
bonds to a refunding purpose under Sec.  1.148-9(h) may be adjusted as 
necessary to reflect allocations made between May 18, 1992, and August 
15, 1993, if the allocations satisfied the corresponding prior provision 
of Sec.  1.148-11(j)(4) under applicable prior regulations.
    (3) Special limitation. The provisions of Sec.  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. 
(i) 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--
    (A) Substantially all of the corpus of the fund consists of 
nonfinancial assets, revenues derived from these assets, gifts, and 
bequests;
    (B) 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 or public elementary and public secondary schools;
    (C) Substantially all of the available income of the fund is 
required to be applied annually to support designated functions;
    (D) The issue guaranteed consists of obligations that are not 
private activity bonds (other than qualified 501(c)(3) bonds) 
substantially all of the proceeds of which are to be used for designated 
functions;
    (E) The fund satisfied each of the requirements of paragraphs 
(d)(1)(i) through (d)(1)(iii) of this section on August 16, 1986; and
    (F) As of the sale date of the bonds to be guaranteed, the amount of 
the bonds to be guaranteed by the fund plus the then-outstanding amount 
of bonds previously guaranteed by the fund does not exceed a total 
amount equal to 500 percent of the total costs of the assets held by the 
fund as of December 16, 2009.

[[Page 154]]

    (ii) The Commissioner may, by published guidance, set forth 
additional circumstances under which guarantees by certain perpetual 
trust funds will not cause amounts in the fund to be treated as 
replacement proceeds.
    (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), but only if Sec.  1.148-
2(d)(2)(iv) is applied by substituting 1 and one-half percentage points 
for 2 percentage points.
    (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) Provisions applicable to certain bonds sold before effective 
date. Except for bonds to which paragraph (b)(1) of this section 
applies--
    (1) Section 1.148-11A provides rules applicable to bonds sold after 
June 6, 1994, and before July 8, 1997; and
    (2) Sections 1.148-1 through 1.148-11 as in effect on July 1, 1993 
(see 26 CFR part 1 as revised April 1, 1994), and Sec.  1.148-11A(i) 
(relating to elective retroactive application of certain provisions) 
provide rules applicable to certain issues issued before June 7, 1994.
    (h) Safe harbor for establishing fair market value for guaranteed 
investment contracts and investments purchased for a yield restricted 
defeasance escrow. The provisions of Sec.  1.148-5(d)(6)(iii) are 
applicable to bonds sold on or after March 1, 1999. Issuers may apply 
these provisions to bonds sold on or after December 30, 1998, and before 
March 1, 1999.
    (i) Special rule for certain broker's commissions and similar fees. 
Section 1.148-5(e)(2)(iii) applies to bonds sold on or after February 9, 
2004. In the case of bonds sold before February 9, 2004, that are 
subject to Sec.  1.148-5 (pre-effective date bonds), issuers may apply 
Sec.  1.148-5(e)(2)(iii), in whole but not in part, with respect to 
transactions entered into on or after December 11, 2003. If an issuer 
applies Sec.  1.148-5(e)(2)(iii) to pre-effective date bonds, the per-
issue safe harbor in Sec.  1.148-5(e)(2)(iii)(B)(1)(ii) is applied by 
taking into account all brokers' commissions or similar fees with 
respect to guaranteed investment contracts and investments for yield 
restricted defeasance escrows that the issuer treats as qualified 
administrative costs for the issue, including all such commissions or 
fees paid before February 9, 2004. For purposes of Sec. Sec.  1.148-
5(e)(2)(iii)(B)(3) and 1.148-5(e)(2)(iii)(B)(6) (relating to cost-of-
living adjustments), transactions entered into before 2003 are treated 
as entered into in 2003.
    (j) Certain prepayments. Section 1.148-1(e)(1) and (2) apply to 
bonds sold on or after October 3, 2003. Issuers may apply Sec.  1.148-
1(e)(1) and (2), in whole but not in part, to bonds sold before October 
3, 2003, that are subject to Sec.  1.148-1.
    (k) Certain arbitrage guidance updates--(1) In general. Sections 
1.148-1(c)(4)(i)(B)(1); 1.148-1(c)(4)(i)(B)(4); 1.148-1(c)(4)(ii); 
1.148-2(e)(3)(i); 1.148-3(d)(1)(iv); 1.148-3(d)(4); 1.148-4(a); 1.148-
4(b)(3)(i); 1.148-4(h)(2)(ii)(A); 1.148-4(h)(2)(v); 1.148-4(h)(2)(vi); 
1.148(h)(4)(i)(C); 1.148-5(c)(3); 1.148-5(d)(2); 1.148-5(d)(3); 1.148-
5(d)(6)(i); 1.148-5(d)(6)(iii)(A); 1.148-5(e)(2)(ii)(B); 1.148-
6(d)(3)(iii)(A); 1.148-6(d)(4); 1.148-7(c)(3)(v); 1.148-7(i)(6)(ii); 
1.148-10(a)(4); 1.148-10(e); 1.148-11(d)(1)(i)(B); 1.148-11(d)(1)(i)(D); 
1.148-11(d)(1)(i)(F); and

[[Page 155]]

1.148-11(d)(1)(ii) apply to bonds sold on or after October 17, 2016.
    (2) Valuation of investments in refunding transactions. Section 
1.148-5(d)(3) also applies to bonds refunded by bonds sold on or after 
October 17, 2016.
    (3) Rebate overpayment recovery. (i) Section 1.148-3(i)(3)(i) 
applies to claims arising from an issue of bonds to which Sec.  1.148-
3(i) applies and for which the final computation date is after June 24, 
2008. For purposes of this paragraph (k)(3)(i), issues for which the 
actual final computation date is on or before June 24, 2008, are deemed 
to have a final computation date of July 1, 2008, for purposes of 
applying Sec.  1.148-3(i)(3)(i).
    (ii) Section 1.148-3(i)(3)(ii) and (iii) apply to claims arising 
from an issue of bonds to which Sec.  1.148-3(i) applies and for which 
the final computation date is after September 16, 2013.
    (iii) Section 1.148-3(j) applies to bonds subject to Sec.  1.148-
3(i).
    (4) Hedge identification. Section 1.148-4(h)(2)(viii) applies to 
hedges that are entered into on or after October 17, 2016.
    (5) Hedge modifications and termination. Section 1.148-
4(h)(3)(iv)(A) through (H) and (h)(4)(iv) apply to--
    (i) Hedges that are entered into on or after October 17, 2016;
    (ii) Qualified hedges that are modified on or after October 17, 2016 
with respect to modifications on or after such date; and
    (iii) Qualified hedges on bonds that are refunded on or after 
October 17, 2016 with respect to the refunding on or after such date.
    (6) Small issuer exception to rebate requirement for conduit 
borrowers of pooled financings. Section 1.148-8(d) applies to bonds 
issued after May 17, 2006.
    (l) Permissive application of certain arbitrage updates--(1) In 
general. Except as otherwise provided in this paragraph (l), issuers may 
apply the provisions described in paragraph (k)(1), (2), and (5) in 
whole, but not in part, to bonds sold before October 17, 2016.
    (2) Computation credit. Issuers may apply Sec.  1.148-3(d)(1)(iv) 
and (d)(4) for bond years ending on or after July 18, 2016.
    (3) Yield reduction payments. Issuers may apply Sec.  1.148-5(c)(3) 
for investments purchased on or after July 18, 2016.
    (4) External commingled funds. Issuers may apply Sec.  1.148-
5(e)(2)(ii)(B) with respect to costs incurred on or after July 18, 2016.
    (m) Definition of issue price. The definition of issue price in 
Sec.  1.148-1(b) and (f) applies to bonds that are sold on or after June 
7, 2017.

[T.D. 8476, 58 FR 33547, June 18, 1993; 58 FR 44453, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24046, May 10, 1994; T.D. 8718, 62 FR 25512, 
May 9, 1997; T.D. 8476, 64 FR 37037, July 9, 1999; T.D. 9085, 68 FR 
45777, Aug. 4, 2003; T.D. 9097, 68 FR 69023, Dec. 11, 2003; T.D. 9701, 
79 FR 67351, Nov. 13, 2014; T.D. 9777, 81 FR 46597, July 18, 2016; 81 FR 
57459, Aug. 23, 2016; T.D. 9801, 81 FR 89004, Dec. 9, 2016; 82 FR 37817, 
Aug. 14, 2017]



Sec.  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 Sec.  21B(d)(3) of 
the Federal Home Loan Bank Act, as amended by Sec.  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 Sec.  1.148-1).
    (c) Effective date. This section applies to investments made after 
June 30, 1993.

[T.D. 8476, 58 FR 33548, June 18, 1993]



Sec.  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).

[[Page 156]]

    (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 Sec.  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 Sec.  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 Sec.  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 Sec.  1.148-9(h) apply, except that the limitation in Sec.  
1.148-9(h)(5) is disregarded.
    (2) General mixed escrow rules. For purposes of section 149(d), the 
provisions of Sec.  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),

[[Page 157]]

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) Application of savings test to multipurpose issues. Except as 
otherwise provided in this paragraph (f)(3), the multipurpose issue 
rules in Sec.  1.148-9(h) apply for purposes of the savings test. If any 
separate issue in a multipurpose issue increases the aggregate present 
value debt service savings on the entire multipurpose issue or reduces 
the present value debt service losses on that entire multipurpose issue, 
that separate issue satisfies the savings test.
    (g) Limitation on advance refundings of private activity bonds. 
Under section 149(d)(2) and this section, interest on a bond is not 
excluded from gross income if any portion of the issue of which the bond 
is a part is issued to advance refund a private activity bond (other 
than a qualified 501(c)(3) bond). For this purpose, the term private 
activity bond--
    (1) Includes a qualified bond described in section 141(e) (other 
than a qualified 501(c)(3) bond), regardless of whether the refunding 
issue consists of private activity bonds under Sec.  1.141-13; and
    (2) Does not include a taxable bond.
    (h) Effective dates--(1) In general. Except as provided in this 
paragraph (h), this section applies to bonds issued after June 30, 1993, 
to which Sec. Sec.  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 Sec.  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.
    (3) Special effective date for paragraph (f)(3). Paragraph (f)(3) of 
this section applies to bonds sold on or after July 8, 1997 and to any 
issue to which the election described in Sec.  1.148-11(b)(1) is made. 
See Sec.  1.148-11A(i) for rules relating to certain bonds sold before 
July 8, 1997.
    (4) Special effective date for paragraph (g). See Sec.  1.141-15 for 
the applicability date of paragraph (g) of this section.

[T.D. 8476, 58 FR 33548, June 18, 1993; 58 FR 44453, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24046, May 10, 1994; T.D. 8718, 62 FR 25513, 
May 9, 1997; T.D. 9234, 70 FR 75035, Dec. 19, 2005]



Sec.  1.149(e)-1  Information reporting requirements for tax-exempt bonds.

    (a) General rule. Interest on a bond is included in gross income 
unless certain information with respect to the issue of which the bond 
is a part is reported to the Internal Revenue Service in accordance with 
the requirements of this section. This section applies to any bond if 
the issue of which the bond is a part is issued after December 31, 1986 
(including any bond issued to refund a bond issued on or before December 
31, 1986).
    (b) Requirements for private activity bonds--(1) In general. If the 
issue of which the bond is a part is an issue of private activity bonds, 
the issuer must comply with the following requirements--
    (i) Not later than the 15th day of the second calendar month after 
the close of the calendar quarter in which the issue is issued, the 
issuer must file with the Internal Revenue Service a completed 
information reporting form prescribed for this purpose;

[[Page 158]]

    (ii) If any bond that is part of the issue is taken into account 
under section 146 (relating to volume cap on private activity bonds), 
the state certification requirement of paragraph (b)(2) of this section 
must be satisfied; and
    (iii) If any bond that is part of the issue is a qualified mortgage 
bond or qualified veterans' mortgage bond (within the meaning of section 
143 (a) or (b) or section 103A(c) (1) or (3) as in effect on the day 
before enactment of the Tax Reform Act of 1986), the issuer must submit 
the annual report containing information on the borrowers of the 
original proceeds of the issue as required under Sec.  1.103A-2 
(k)(2)(ii) and (k)(3) through (k)(6).
    (2) State certification with respect to volume cap--(i) In general. 
If an issue is subject to the volume cap under section 146, a state 
official designated by state law (if there is no such official, then the 
governor or the governor's delegate) must certify that the issue meets 
the requirements of section 146, and a copy of this certification must 
be attached to the information reporting form filed with respect to the 
issue. In the case of any constitutional home rule city (as defined in 
section 146(d)(3)(C)), the preceding sentence is applied by substituting 
``city'' for ``state'' and ``chief executive officer'' for ``governor.''
    (ii) Certification. The certifying official need not perform an 
independent investigation in order to certify that the issue meets the 
requirements of section 146. For example, if the certifying official 
receives an affidavit that was executed by an officer of the issuer who 
is responsible for issuing the bonds and that sets forth, in brief and 
summary terms, the facts necessary to determine that the issue meets the 
requirements of section 146 and if the certifying official has compared 
the information in that affidavit to other readily available information 
with respect to that issuer (e.g., previous affidavits and 
certifications for other private activity bonds issued by that issuer), 
the certifying official may rely on the affidavit.
    (c) Requirements for governmental bonds--(1) Issue price of $100,000 
or more. If the issue of which the bond is a part has an issue price of 
$100,000 or more and is not an issue of private activity bonds, then, 
not later than the 15th day of the second calendar month after the close 
of the calendar quarter in which the issue is issued, the issuer must 
file with the Internal Revenue Service a completed information reporting 
form prescribed for this purpose.
    (2) Issue price of less than $100,000--(i) In general. If the issue 
of which the bond is a part has an issue price of less than $100,000 and 
is not an issue of private activity bonds, the issuer must file with the 
Internal Revenue Service one of the following information reporting 
forms within the prescribed period--
    (A) Separate return. Not later than the 15th day of the second 
calendar month after the close of the calendar quarter in which the 
issue is issued, a completed information reporting form prescribed for 
this purpose with respect to that issue; or
    (B) Consolidated return. Not later than February 15 of the calendar 
year following the calendar year in which the issue is issued, a 
completed information form prescribed for this purpose with respect to 
all issues to which this paragraph (c)(2) applies that were issued by 
the issuer during the calendar year and for which information was not 
reported on a separate information return pursuant to paragraph 
(c)(2)(i)(A) of this section.
    (ii) Bond issues issued before January 1, 1992. Paragraph 
(c)(2)(i)(A) of this section does not apply if the issue of which the 
bond is a part is issued before January 1, 1992.
    (iii) Extended filing date for first and second calendar quarters of 
1992. If the issue of which the bond is a part is issued during the 
first or second calendar quarter of 1992, the prescribed period for 
filing an information reporting form with respect to that issue pursuant 
to paragraph (c)(2)(i)(A) of this section is extended until November 16, 
1992.
    (d) Filing of forms and special rules--(1) Completed form. For 
purposes of this section--
    (i) Good faith effort. An information reporting form is treated as 
completed if the issuer (or a person acting on behalf of the issuer) has 
made a good

[[Page 159]]

faith effort to complete the form (taking into account the instructions 
to the form).
    (ii) Information. In general, information reporting forms filed 
pursuant to this section must be completed on the basis of available 
information and reasonable expectations as of the date the issue is 
issued. Forms that are filed on a consolidated basis pursuant to 
paragraph (c)(2)(i)(B) of this section, however, may be completed on the 
basis of information readily available to the issuer at the close of the 
calendar year to which the form relates, supplemented by estimates made 
in good faith.
    (iii) Certain information not required. An issuer need not report to 
the Internal Revenue Service any information specified in the first 
sentence of section 149(e)(2) that is not required to be reported to the 
Internal Revenue Service pursuant to the information reporting forms 
prescribed under that section and the instructions to those forms.
    (2) Manner of filing--(i) Place for filing. The information 
reporting form must be filed with the Internal Revenue Service at the 
address specified on the form or in the instructions to the form.
    (ii) Extension of time. The Commissioner may grant an extension of 
time to file any form or attachment required under this section if the 
Commissioner determines that the failure to file in a timely manner was 
not due to willful neglect. The Commissioner may make this determination 
with respect to an issue or to a class of issues.
    (e) Definitions. For purposes of this section only--(1) Private 
activity bond. The term ``private activity bond'' has the meaning given 
that term in section 141(a) of the Internal Revenue Code, except that 
the term does not include any bond described in section 1312(c) of the 
Tax Reform Act of 1986 to which section 1312 or 1313 of the Tax Reform 
Act of 1986 applies.
    (2) Issue--(i) In general. Except as otherwise provided in this 
paragraph (e)(2), bonds are treated as part of the same issue only if 
the bonds are issued--
    (A) By the same issuer;
    (B) On the same date; and
    (C) Pursuant to a single transaction or to a series of related 
transactions.
    (ii) Draw-down loans, commercial paper, etc. (A) Bonds issued during 
the same calendar year may be treated as part of the same tissue if the 
bonds are issued--
    (1) Pursuant to a loan agreement under which amounts are to be 
advanced periodically (``draw-down loan''); or
    (2) With a term not exceeding 270 days.
    (B) In addition, the bonds must be equally and ratably secured under 
a single indenture or loan agreement and issued pursuant to a common 
financing arrangement (e.g., pursuant to the same official statement 
that is periodically updated to reflect changing factual circumstances). 
In the case of bonds issued pursuant to a draw-down loan that meets the 
requirements of the preceding sentence, bonds issued during different 
calendar years may be treated as part of the same issue if all the 
amounts to be advanced pursuant to the draw-down loan are reasonably 
expected to be advanced within three years of the date of issue of the 
first bond.
    (iii) Leases and installment sales. Bonds other than private 
activity bonds may be treated as part of the same issue if--
    (A) The bonds are issued pursuant to a single agreement that is in 
the form of a lease or installment sales agreement; and
    (B) All of the property covered by that agreement is reasonably 
expected to be delivered within three years of the date of issue of the 
first bond.
    (iv) Qualified 501(c)(3) bonds. If an issuer elects under section 
141(b)(9) to treat a portion of an issue as a qualified 501(c)(3) bond, 
that portion is treated as a separate issue.
    (3) Date of issue--(i) Bond. The date of issue of a bond is 
determined under Sec.  1.150-1.
    (ii) Issue. The date of issue of an issue of bonds is the date of 
issue of the first bond that is part of the issue. See paragraphs (e)(2) 
(ii) and (iii) of this section for rules relating to draw-down loans, 
commercial paper, etc., and leases and installment sales.
    (iii) Bonds to which prior law applied. Notwithstanding the 
provisions of this paragraph (e)(3), an issue for which an

[[Page 160]]

information report was required to be filed under section 103(l) or 
section 103A(j)(3) is treated as issued prior to January 1, 1987.
    (4) Issue price. The term ``issue price'' has the same meaning given 
the term under Sec.  1.148-1(b).

[T.D. 8425, 57 FR 36002, Aug. 12, 1992, as amended at 59 FR 24351, May 
11, 1994]



Sec.  1.149(g)-1  Hedge bonds.

    (a) Certain definitions. Except as otherwise provided, the 
definitions set forth in Sec.  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 
Sec.  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 Sec.  
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 Sec. Sec.  1.148-1 through 1.148-11 apply. In 
addition, this section applies to any issue to which the election 
described in Sec.  1.148-11(b)(1) is made.

[T.D. 8476, 58 FR 33549, June 18, 1993]



Sec.  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/applicability date--(i) In general. Except as 
otherwise provided in this paragraph (a)(2), this section applies to 
issues issued after June 30, 1993 to which Sec. Sec.  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 
Sec.  1.148-11(b)(1) is made.
    (ii) Special effective date for paragraphs (c)(1), (c)(4)(iii), and 
(c)(6). Paragraphs (c)(1), (c)(4)(iii), and (c)(6) of this section apply 
to bonds sold on or after July 8, 1997 and to any issue to which the 
election described in Sec.  1.148-11(b)(1) is made. See Sec.  1.148-
11A(i) for rules relating to certain bonds sold before July 8, 1997.
    (iii) Special effective date for definitions of tax-advantaged bond, 
issue, and grant. The definition of tax-advantaged bond in paragraph (b) 
of this section, the revisions to the definition of issue in paragraph 
(c)(2) of this section, and the definition and rules regarding the 
treatment of grants in paragraph (f) of this section apply to bonds that 
are sold on or after October 17, 2016.
    (3) Exceptions to general effective date. See Sec.  1.141-15 for the 
applicability date of the definition of bond documents contained in 
paragraph (b) of this section and the effective date of paragraph 
(c)(3)(ii) of this section.
    (4) Additional exception to the general applicability date. Section 
1.150-1(b), Issuance costs, applies on and after July 6, 2011.
    (b) Certain general definitions. The following definitions apply:
    Bond means any obligation of a State or political subdivision 
thereof under section 103(c)(1).
    Bond documents means the bond indenture or resolution, transcript of 
proceedings, and any related documents.
    Capital expenditure means any cost of a type that is properly 
chargeable to

[[Page 161]]

capital account (or would be so chargeable with a proper election or 
with the application of the definition of placed in service under Sec.  
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 Sec.  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 Sec.  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; fees paid to an organization to evaluate the credit quality of an 
issue; 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 Sec.  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-advantaged bond means a tax-exempt bond, a taxable bond that 
provides a federal tax credit to the investor with respect to the 
issuer's borrowing costs, a taxable bond that provides a refundable 
federal tax credit payable directly to the issuer of the bond for its 
borrowing costs under section 6431, or any future similar bond that 
provides a federal tax benefit that reduces an issuer's borrowing costs. 
Examples of tax-advantaged bonds include qualified tax credit bonds 
under section 54A(d)(1) and build America bonds under section 54AA.

[[Page 162]]

    Tax-exempt bond means any bond the interest on which is excludable 
from gross income under section 103(a). For purposes of section 148, 
tax-exempt bond includes:
    (1) 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; and
    (2) A certificate of indebtedness issued by the United States 
Treasury pursuant to the Demand Deposit State and Local Government 
Series program described in 31 CFR part 344.
    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. Except as otherwise 
provided in this paragraph (c), the term issue means two or more bonds 
that meet all of the following requirements:
    (i) Sold at substantially the same time. The bonds are sold at 
substantially the same time. Bonds are treated as sold at substantially 
the same time if they are sold less than 15 days apart.
    (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 parties unrelated to the 
obligor.
    (2) Exceptions for different types of tax-advantaged bonds and 
taxable bonds. Each type of tax-advantaged bond that has a different 
structure for delivery of the tax benefit that reduces the issuer's 
borrowing costs or different program eligibility requirements is treated 
as part of a different issue under this paragraph (c). Further, tax-
advantaged bonds and bonds that are not tax-advantaged bonds are treated 
as part of different issues under this paragraph (c). The issuance of 
tax-advantaged bonds in a transaction with other bonds that are not tax-
advantaged bonds must be tested under the arbitrage anti-abuse rules 
under Sec.  1.148-10(a) and other applicable anti-abuse rules (for 
example, limitations against window maturity structures 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 
Sec.  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, 144(a), 148, 149(d) and 149(g).
    (4) Special rules for certain financings--(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.

[[Page 163]]

    (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.
    (iii) Certain general obligation bonds. Except as otherwise provided 
in paragraph (c)(2) of this section, bonds that are secured by a pledge 
of the issuer's full faith and credit (or a substantially similar 
pledge) and sold and issued on the same dates pursuant to a single 
offering document may be treated as part of the same issue if the issuer 
so elects on or before the issue date.
    (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.
    (6) Sale date. The sale date of a bond is the first day on which 
there is a binding contract in writing for the sale or exchange of the 
bond.
    (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 
Sec.  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 
Sec.  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 Sec.  1.148-1) does not 
include the ultimate recipient of the loan (e.g., the homeowner, the 
student).

[[Page 164]]

    (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 Sec.  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--

[[Page 165]]

    (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) if 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.
    (f) Definition and treatment of grants--(1) Definition. 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 or a related party. 
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.
    (2) Treatment. Except as otherwise provided (for example, Sec.  
1.148-6(d)(4), which treats proceeds used for grants as spent for 
arbitrage purposes when the grant is made), the character and nature of 
a grantee's use of proceeds are taken into account in determining which 
rules are applicable to the bond issue and whether the applicable 
requirements for the bond issue are met. For example, a grantee's use of 
proceeds generally determines whether the proceeds are used for capital 
projects or working capital expenditures under section 148 and whether 
the qualified purposes for the specific type of bond issue are met.

[T.D. 8476, 58 FR 33549, June 18, 1993; 58 FR 44453, Aug. 23, 1993, as 
amended by T.D. 8538, 59 FR 24046, May 10, 1994; T.D. 8712, 62 FR 2304, 
Jan. 16, 1997; T.D. 8718, 62 FR 25513, May 9, 1997; T.D. 9234, 70 FR 
75036, Dec. 19, 2005; T.D. 9533, 76 FR 39280, July 6, 2011; T.D. 9637, 
78 FR 54759, Sept. 6, 2013; T.D. 9777, 81 FR 46598, July 18, 2016]



Sec.  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 Sec.  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.
    (3) Nature of expenditure.

    (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

[[Page 166]]

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 
Sec.  1.148-6(d)(3)(ii)(B) (relating to certain extraordinary working 
capital items), a grant (as defined in Sec.  1.150-1(f)), 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

[[Page 167]]

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 Sec.  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 or to reimburse an original 
expenditure paid by another obligation. Instead, such an allocation is 
analyzed under rules on refunding issues. See Sec.  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 Sec.  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 Sec.  
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 Sec.  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

[[Page 168]]

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 Sec.  
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. Except as otherwise provided, 
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 Sec.  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 Sec.  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 Sec.  601.601(d)(2)(ii)(b)) of this chapter, the 
requirements of that section may be applied in lieu of this section.
    (3) Nature of expenditure. Paragraph (d)(3) of this section applies 
to bonds that are sold on or after October 17, 2016.

[T.D. 8476, 58 FR 33551, June 18, 1993; 58 FR 44453, Aug. 23, 1993; T.D. 
9777, 81 FR 46598, July 18, 2016]



Sec.  1.150-4  Change in use of facilities financed with tax-exempt 
private activity bonds.

    (a) Scope. This section applies for purposes of the rules for change 
of use of facilities financed with private activity bonds under sections 
150(b)(3) (relating to qualified 501(c)(3) bonds), 150(b)(4) (relating 
to certain exempt facility bonds and small issue bonds), 150(b)(5) 
(relating to facilities required to be owned by governmental units or 
501(c)(3) organizations), and 150(c).
    (b) Effect of remedial actions--(1) In general. Except as provided 
in this section, the change of use provisions of sections 150(b) (3) 
through (5), and 150(c) apply even if the issuer takes a remedial action 
described in Sec. Sec.  1.142-2, 1.144-2, or 1.145-2.
    (2) Exceptions--(i) Redemption. If nonqualified bonds are redeemed 
within 90 days of a deliberate action under Sec.  1.145-2(a) or within 
90 days of the date on which a failure to properly use proceeds occurs 
under Sec.  1.142-2 or Sec.  1.144-2, sections 150(b) (3) through (5) do 
not apply during the period between that date and the date on which the 
nonqualified bonds are redeemed.
    (ii) Alternative qualifying use of facility. If a bond-financed 
facility is used for an alternative qualifying use under Sec. Sec.  
1.145-2 and 1.141-12(f), sections 150(b) (3) and (5) do not apply 
because of the alternative use.
    (iii) Alternative use of disposition proceeds. If disposition 
proceeds are used for a qualifying purpose under Sec. Sec.  1.145-2 and 
1.141-12(e), 1.142-2(c)(4), or 1.144-2, sections 150(b) (3) through (5) 
do not apply because of the deliberate action that gave rise to the 
disposition proceeds after the date on which all of the disposition 
proceeds have been expended on the qualifying purpose. If all of the 
disposition proceeds are so expended within 90 days of the date of the 
deliberate action, however, sections 150(b) (3) through (5) do not apply 
because of the deliberate action.
    (c) Allocation rules--(1) In general. If a change in use of a 
portion of the property financed with an issue of qualified private 
activity bonds causes section 150 (b)(3), (b)(4), or (b)(5) to apply to 
an issue, the bonds of the issue allocable to that portion under section 
150(c)(3) are the same as the nonqualified bonds determined for purposes 
of Sec. Sec.  1.142-1, 1.144-1, and 1.145-1, except that bonds allocable 
to all common areas are also allocated to that portion.
    (2) Special rule when remedial action is taken. If an issuer takes a 
remedial action with respect to an issue of private activity bonds under 
Sec. Sec.  1.142-2, 1.144-2,

[[Page 169]]

or 1.145-2, the bonds of the issue allocable to a portion of property 
are the same as the nonqualified bonds determined for purposes of those 
sections.
    (d) Effective dates. For effective dates of this section, see Sec.  
1.141-16.

[T.D. 8712, 62 FR 2304, Jan. 16, 1997]



Sec.  1.150-5  Filing notices and elections.

    (a) In general. Notices and elections under the following sections 
must be filed with the Internal Revenue Service, 1111 Constitution 
Avenue, NW, Attention: T:GE:TEB:O, Washington, DC 20224 or such other 
place designated by publication of a notice in the Internal Revenue 
Bulletin--
    (1) Section 1.141-12(d)(4);
    (2) Section 1.142(f)(4)-1; and
    (3) Section 1.142-2(c)(2).
    (b) Effective dates. This section applies to notices and elections 
filed on or after January 19, 2001.

[T.D. 8941, 66 FR 4671, Jan. 18, 2001, as amended by T.D. 9741, 80 FR 
65646, Oct. 27, 2015]

   Regulations Applicable to Certain Bonds Sold Prior to July 8, 1997

    Editorial Note: IRS redesignated the following sections to appear 
below the undesignated center heading ``Regulations Applicable to 
Certain Bonds Sold Prior to July 8, 1997'' and preceding the 
undesignated center heading ``Deductions for Personal Exemptions.'' See 
62 FR 25507 and 25513, May 9, 1997 for the specific sections involved in 
the redesignation.



Sec. Sec.  1.148-1A--1.148-6A  [Reserved]



Sec. Sec.  1.148-9A--1.148-10A  [Reserved]



Sec.  1.148-11A  Effective dates.

    (a) through (c)(3) [Reserved]. For guidance see Sec.  1.148-11.
    (c)(4) Retroactive application of overpayment recovery provisions. 
An issuer may apply the provisions of Sec.  1.148-3(i) to any issue that 
is subject to section 148(f) or to sections 103(c)(6) or 103A(i) of the 
Internal Revenue Code of 1954.
    (d) through (h) [Reserved]. For guidance see Sec.  1.148-11.
    (i) Transition rules for certain amendments--(1) In general. Section 
1.103-8(a)(5), Sec. Sec.  1.148-1, 1.148-2, 1.148-3, 1.148-4, .148-5, 
1.148-6, 1.148-7, 1.148-8, 1.148-9, 1.148-10, 1.148-11, 1.149(d)-1, and 
1.150-1 as in effect on June 7, 1994 (see 26 CFR part 1 as revised April 
1, 1997), and Sec. Sec.  1.148-1A through 1.148-11A, 1.149(d)-1A, and 
1.150-1A apply, in whole, but not in part--
    (i) To bonds sold after June 6, 1994, and before July 8, 1997;
    (ii) To bonds issued before July 1, 1993, that are outstanding on 
June 7, 1994, if the first time the issuer applies Sec. Sec.  1.148-1 
through 1.148-11 as in effect on June 7, 1994 (see 26 CFR part 1 as 
revised April 1, 1997), to the bonds under Sec.  1.148-11 (b) or (c) is 
after June 6, 1994, and before July 8, 1997;
    (iii) At the option of the issuer, to bonds to which Sec. Sec.  
1.148-1 through 1.148-11, as in effect on July 1, 1993 (see 26 CFR part 
1 as revised April 1, 1994), apply, if the bonds are outstanding on June 
7, 1994, and the issuer applies Sec.  1.103-8(a)(5), Sec. Sec.  1.148-1, 
1.148-2, 1.148-3, 1.148-4, 1.148-5, 1.148-6, 1.148-7, 1.148-8, 1.148-9, 
1.148-10, 1.148-11, 1.149(d)-1, and 1.150-1 as in effect on June 7, 1994 
(see 26 CFR part 1 as revised April 1, 1997), and Sec. Sec.  1.148-1A 
through 1.148-11A, 1.149(d)-1A, and 1.150-1A to the bonds before July 8, 
1997.
    (2) Special rule. For purposes of paragraph (i)(1) of this section, 
any reference to a particular paragraph of Sec. Sec.  1.148-1T, 1.148-
2T, 1.148-3T, 1.148-4T, 1.148-5T, 1.148-6T, 1.148-9T, 1.148-10T, 1.148-
11T, 1.149(d)-1T, or 1.150-1T shall be applied as a reference to the 
corresponding paragraph of Sec. Sec.  1.148-1A, 1.148-2A, 1.148-3A, 
1.148-4A, 1.148-5A, 1.148-6A, 1.148-9A, 1.148-10A, 1.148-11A, 1.149(d)-
1A, or 1.150-1A, respectively.
    (3) Identification of certain hedges. For any hedge entered into 
after June 18, 1993, and on or before June 6, 1994, that would be a 
qualified hedge within the meaning of Sec.  1.148-4(h)(2), as in effect 
on June 7, 1994 (see 26 CFR part 1 as revised April 1, 1997), except 
that the hedge does not meet the requirements of Sec.  1.148-
4A(h)(2)(ix) because the issuer failed to identify the hedge not later 
than 3 days after which the issuer and the provider entered into the 
contract, the requirements of Sec.  1.148-4A(h)(2)(ix) are treated as 
met if the contract is identified by the actual issuer on its books and 
records maintained for the

[[Page 170]]

hedged bonds not later than July 8, 1997.

[T.D. 8538, 59 FR 24046, May 10, 1994. Redesignated and amended by T.D. 
8718, 62 FR 25507, 25513, May 9, 1997]

                   Deductions for Personal Exemptions



Sec.  1.151-1  Deductions for personal exemptions.

    (a) In general. (1) In computing taxable income, an individual is 
allowed a deduction for the exemptions specified in section 151. Such 
exemptions are: (i) The exemptions for an individual taxpayer and spouse 
(the so-called personal exemptions); (ii) the additional exemptions for 
a taxpayer attaining the age of 65 years and spouse attaining the age of 
65 years (the so-called old-age exemptions); (iii) the additional 
exemptions for a blind taxpayer and a blind spouse; and (iv) the 
exemptions for dependents of the taxpayer.
    (2) A nonresident alien individual who is a bona fide resident of 
Puerto Rico during the entire taxable year and subject to tax under 
section 1 or 1201(b) is allowed as deductions the exemptions specified 
in section 151, even though as to the United States such individual is a 
nonresident alien. See section 876 and the regulations thereunder, 
relating to alien residents of Puerto Rico.
    (b) Exemptions for individual taxpayer and spouse (so-called 
personal exemptions). Section 151(b) allows an exemption for the 
taxpayer and an additional exemption for the spouse of the taxpayer if a 
joint return is not made by the taxpayer and his spouse, and if the 
spouse, for the calendar year in which the taxable year of the taxpayer 
begins, has no gross income and is not the dependent of another 
taxpayer. Thus, a husband is not entitled to an exemption for his wife 
on his separate return for the taxable year beginning in a calendar year 
during which she has any gross income (though insufficient to require 
her to file a return). Since, in the case of a joint return, there are 
two taxpayers (although under section 6013 there is only one income for 
the two taxpayers on such return, i.e., their aggregate income), two 
exemptions are allowed on such return, one for each taxpayer spouse. If 
in any case a joint return is made by the taxpayer and his spouse, no 
other person is allowed an exemption for such spouse even though such 
other person would have been entitled to claim an exemption for such 
spouse as a dependent if such joint return had not been made.
    (c) Exemptions for taxpayer attaining the age of 65 and spouse 
attaining the age of 65 (so-called old-age exemptions). (1) Section 
151(c) provides an additional exemption for the taxpayer if he has 
attained the age of 65 before the close of his taxable year. An 
additional exemption is also allowed to the taxpayer for his spouse if a 
joint return is not made by the taxpayer and his spouse and if the 
spouse has attained the age of 65 before the close of the taxable year 
of the taxpayer and, for the calendar year in which the taxable year of 
the taxpayer begins, the spouse has no gross income and is not the 
dependent of another taxpayer. If a husband and wife make a joint 
return, an old-age exemption will be allowed as to each taxpayer spouse 
who has attained the age of 65 before the close of the taxable year for 
which the joint return is made. The exemptions under section 151(c) are 
in addition to the exemptions for the taxpayer and spouse under section 
151(b).
    (2) In determining the age of an individual for the purposes of the 
exemption for old age, the last day of the taxable year of the taxpayer 
is the controlling date. Thus, in the event of a separate return by a 
husband, no additional exemption for old age may be claimed for his 
spouse unless such spouse has attained the age of 65 on or before the 
close of the taxable year of the husband. In no event shall the 
additional exemption for old age be allowed with respect to a spouse who 
dies before attaining the age of 65 even though such spouse would have 
attained the age of 65 before the close of the taxable year of the 
taxpayer. For the purposes of the old-age exemption, an individual 
attains the age of 65 on the first moment of the day preceding his 
sixty-fifth birthday. Accordingly, an individual whose sixty-fifth 
birthday falls on January 1 in a given year attains the age of 65 on the 
last day of the calendar year immediately preceding.

[[Page 171]]

    (d) Exemptions for the blind. (1) Section 151(d) provides an 
additional exemption for the taxpayer if he is blind at the close of his 
taxable year. An additional exemption is also allowed to the taxpayer 
for his spouse if the spouse is blind and, for the calendar year in 
which the taxable year of the taxpayer begins, has no gross income and 
is not the dependent of another taxpayer. The determination of whether 
the spouse is blind shall be made as of the close of the taxable year of 
the taxpayer, unless the spouse dies during such taxable year, in which 
case such determination shall be made as of the time of such death.
    (2) The exemptions for the blind are in addition to the exemptions 
for the taxpayer and spouse under section 151(b) and are also in 
addition to the exemptions under section 151(c) for taxpayers and 
spouses attaining the age of 65 years. Thus, a single individual who has 
attained the age of 65 before the close of his taxable year and who is 
blind at the close of his taxable year is entitled, in addition to the 
so-called personal exemption, to two further exemptions, one by reason 
of his age and the other by reason of his blindness. If a husband and 
wife make a joint return, an exemption for the blind will be allowed as 
to each taxpayer spouse who is blind at the close of the taxable year 
for which the joint return is made.
    (3) A taxpayer claiming an exemption allowed by section 151(d) for a 
blind taxpayer and a blind spouse shall, if the individual for whom the 
exemption is claimed is not totally blind as of the last day of the 
taxable year of the taxpayer (or, in the case of a spouse who dies 
during such taxable year, as of the time of such death), attach to his 
return a certificate from a physician skilled in the diseases of the eye 
or a registered optometrist stating that as of the applicable status 
determination date in the opinion of such physician or optometrist (i) 
the central visual acuity of the individual for whom the exemption is 
claimed did not exceed 20/200 in the better eye with correcting lenses 
or (ii) such individual's visual acuity was accompanied by a limitation 
in the fields of vision such that the widest diameter of the visual 
field subtends an angle no greater than 20 degrees. If such individual 
is totally blind as of the status determination date there shall be 
attached to the return a statement by the person or persons making the 
return setting forth such fact.
    (4) Notwithstanding subparagraph (3) of this paragraph, this 
subparagraph may be applied where the individual for whom an exemption 
under section 151(d) is claimed is not totally blind, and in the 
certified opinion of an examining physician skilled in the diseases of 
the eye there is no reasonable probability that the individual's visual 
acuity will ever improve beyond the minimum standards described in 
subparagraph (3) of this paragraph. In this event, if the examination 
occurs during a taxable year for which the exemption is claimed, and the 
examining physician certifies that, in his opinion, the condition is 
irreversible, and a copy of this certification is filed with the return 
for that taxable year, then a statement described in subparagraph (3) of 
this paragraph need not be attached to such individual's return for 
subsequent taxable years so long as the condition remains irreversible. 
The taxpayer shall retain a copy of the certified opinion in his 
records, and a statement referring to such opinion shall be attached to 
future returns claiming the section 151(d) exemption.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7114, 36 FR 
9018, May 18, 1971; T.D. 7230, 37 FR 28288, Dec. 22, 1972]



Sec.  1.151-2  Additional exemptions for dependents.

    (a) Section 151(e) allows to a taxpayer an exemption for each 
dependent (as defined in section 152) whose gross income (as defined in 
section 61) for the calendar year in which the taxable year of the 
taxpayer begins is less than the amount provided in section 151(e)(1)(A) 
applicable to the taxable year of the taxpayer, or who is a child of the 
taxpayer and who--
    (1) The taxable year of the taxpayer begins, or
    (2) Is a student, as defined in paragraph (b) of Sec.  1.151-3.

No exemption shall be allowed under section 151(e) for any dependent who 
has made a joint return with his spouse under section 6013 for the 
taxable year

[[Page 172]]

beginning in the calendar year in which the taxable year of the taxpayer 
begins. The amount provided in section 151(e)(1)(A) is $750 in the case 
of a taxable year beginning after December 31, 1972; $700 in the case of 
a taxable year beginning after December 31, 1971, and before January 1, 
1973; $650 in the case of a taxable year beginning after December 31, 
1970, and before January 1, 1972; $625 in the case of a taxable year 
beginning after December 31, 1969, and before January 1, 1971; and $600 
in the case of a taxable year beginning before January 1, 1970. For 
special rules in the case of a taxpayer whose taxable year is a fiscal 
year ending after December 31, 1969, and beginning before January 1, 
1973, see section 21(d) and the regulations thereunder.
    (b) The only exemption allowed for a dependent of the taxpayer is 
that provided by section 151(e). The exemptions provided by section 
151(c) (old-age exemptions) and section 151(d) (exemptions for the 
blind) are allowed only for the taxpayer or his spouse. For example, 
where a taxpayer provides the entire support for his father who meets 
all the requirements of a dependent, he is entitled to only one 
exemption for his father (section 151(e)), even though his father is 
over the age of 65.

[T.D. 7114, 36 FR 9019, May 18, 1971]



Sec.  1.151-3  Definitions.

    (a) Child. For purposes of sections 151(e), 152, and the regulations 
thereunder, the term ``child'' means a son, stepson, daughter, 
stepdaughter, adopted son, adopted daughter, or for taxable years 
beginning after December 31, 1958, a child who is a member of an 
individual's household if the child was placed with the individual by an 
authorized placement agency for legal adoption pursuant to a formal 
application filed by the individual with the agency (see paragraph 
(c)(2) of Sec.  1.152-2), or, for taxable years beginning after December 
31, 1969, a foster child (if such foster child satisfies the 
requirements set forth in paragraph (b) of Sec.  1.152-1 with respect to 
the taxpayer) of the taxpayer.
    (b) Student. For purposes of section 151(e) and section 152(d), and 
the regulations thereunder, the term ``student'' means an individual who 
during each of 5 calendar months during the calendar year in which the 
taxable year of the taxpayer begins is a full-time student at an 
educational institution or is pursuing a full-time course of 
institutional on-farm training under the supervision of an accredited 
agent of an educational institution or of a State or political 
subdivision of a State. An example of ``institutional on-farm training'' 
is that authorized by 38 U.S.C. 1652 (formerly section 252 of the 
Veterans' Readjustment Assistance Act of 1952), as described in section 
252 of such act. A full-time student is one who is enrolled for some 
part of 5 calendar months for the number of hours or courses which is 
considered to be full-time attendance. The 5 calendar months need not be 
consecutive. School attendance exclusively at night does not constitute 
full-time attendance. However, full-time attendance at an educational 
institution may include some attendance at night in connection with a 
full-time course of study.
    (c) Educational institution. For purposes of sections 151(e) and 
152, and the regulations thereunder, the term ``educational 
institution'' means a school maintaining a regular faculty and 
established curriculum, and having an organized body of students in 
attendance. It includes primary and secondary schools, colleges, 
universities, normal schools, technical schools, mechanical schools, and 
similar institutions, but does not include noneducational institutions, 
on-the-job training, correspondence schools, night schools, and so 
forth.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7051, 35 FR 
11020, July 9, 1970]



Sec.  1.151-4  Amount of deduction for each exemption under section 151.

    The amount allowed as a deduction for each exemption under section 
151 is (a) $750 in the case of a taxable year beginning after December 
31, 1972; (b) $700 in the case of a taxable year beginning after 
December 31, 1971, and before January 1, 1973; (c) $650 in the case of a 
taxable year beginning after December 31, 1970, and before January 1, 
1972; (d) $625 in the case of a taxable year beginning after December 
31, 1969, and before January 1, 1971; and (e) $600 in the case

[[Page 173]]

of a taxable year beginning before January 1, 1970. For special rules in 
the case of a fiscal year ending after December 31, 1969, and beginning 
before January 1, 1973, see section 21(d) and the regulations 
thereunder.

[T.D. 7114, 36 FR 9019, May 18, 1971]



Sec.  1.152-1  General definition of a dependent.

    (a)(1) For purposes of the income taxes imposed on individuals by 
chapter 1 of the Code, the term ``dependent'' means any individual 
described in paragraphs (1) through (10) of section 152(a) over half of 
whose support, for the calendar year in which the taxable year of the 
taxpayer begins, was received from the taxpayer.
    (2)(i) For purposes of determining whether or not an individual 
received, for a given calendar year, over half of his support from the 
taxpayer, there shall be taken into account the amount of support 
received from the taxpayer as compared to the entire amount of support 
which the individual received from all sources, including support which 
the individual himself supplied. The term ``support'' includes food, 
shelter, clothing, medical and dental care, education, and the like. 
Generally, the amount of an item of support will be the amount of 
expense incurred by the one furnishing such item. If the item of support 
furnished an individual is in the form of property or lodging, it will 
be necessary to measure the amount of such item of support in terms of 
its fair market value.
    (ii) In computing the amount which is contributed for the support of 
an individual, there must be included any amount which is contributed by 
such individual for his own support, including income which is 
ordinarily excludable from gross income, such as benefits received under 
the Social Security Act (42 U.S.C. ch. 7). For example, a father 
receives $800 social security benefits, $400 interest, and $1,000 from 
his son during 1955, all of which sums represent his sole support during 
that year. The fact that the social security benefits of $800 are not 
includible in the father's gross income does not prevent such amount 
from entering into the computation of the total amount contributed for 
the father's support. Consequently, since the son's contribution of 
$1,000 was less than one-half of the father's support ($2,200) he may 
not claim his father as a dependent.
    (iii)(a) For purposes of determining the amount of support furnished 
for a child (or children) by a taxpayer for a given calendar year, an 
arrearage payment made in a year subsequent to a calendar year for which 
there is an unpaid liability shall not be treated as paid either during 
that calendar year or in the year of payment, but no amount shall be 
treated as an arrearage payment to the extent that there is an unpaid 
liability (determined without regard to such payment) with respect to 
the support of a child for the taxable year of payment; and
    (b) Similarly, payments made prior to any calendar year (whether or 
not made in the form of a lump sum payment in settlement of the parent's 
liability for support) shall not be treated as made during such calendar 
year, but payments made during any calendar year from amounts set aside 
in trust by a parent in a prior year, shall be treated as made during 
the calendar year in which paid.
    (b) Section 152(a)(9) applies to any individual (other than an 
individual who at any time during the taxable year was the spouse, 
determined without regard to section 153, of the taxpayer) who lives 
with the taxpayer and is a member of the taxpayer's household during the 
entire taxable year of the taxpayer. An individual is not a member of 
the taxpayer's household if at any time during the taxable year of the 
taxpayer the relationship between such individual and the taxpayer is in 
violation of local law. It is not necessary under section 152(a)(9) that 
the dependent be related to the taxpayer. For example, foster children 
may qualify as dependents. It is necessary, however, that the taxpayer 
both maintain and occupy the household. The taxpayer and dependent will 
be considered as occupying the household for such entire taxable year 
notwithstanding temporary absences from the household due to special 
circumstances. A nonpermanent failure to occupy the common abode by 
reason of illness, education, business, vacation, military service, or a 
custody agreement under

[[Page 174]]

which the dependent is absent for less than six months in the taxable 
year of the taxpayer, shall be considered temporary absence due to 
special circumstances. The fact that the dependent dies during the year 
shall not deprive the taxpayer of the deduction if the dependent lived 
in the household for the entire part of the year preceding his death. 
Likewise, the period during the taxable year preceding the birth of an 
individual shall not prevent such individual from qualifying as a 
dependent under section 152(a)(9). Moreover, a child who actually 
becomes a member of the taxpayer's household during the taxable year 
shall not be prevented from being considered a member of such household 
for the entire taxable year, if the child is required to remain in a 
hospital for a period following its birth, and if such child would 
otherwise have been a member of the taxpayer's household during such 
period.

    (c) In the case of a child of the taxpayer who is under 19 or who is 
a student, the taxpayer may claim the dependency exemption for such 
child provided he has furnished more than one-half of the support of 
such child for the calendar year in which the taxable year of the 
taxpayer begins, even though the income of the child for such calendar 
year may be equal to or in excess of the amount determined pursuant to 
Sec.  1.151-2 applicable to such calendar year. In such a case, there 
may be two exemptions claimed for the child: One on the parent's (or 
stepparent's) return, and one on the child's return. In determining 
whether the taxpayer does in fact furnish more than one-half of the 
support of an individual who is a child, as defined in paragraph (a) of 
Sec.  1.151-3, of the taxpayer and who is a student, as defined in 
paragraph (b) of Sec.  1.151-3, a special rule regarding scholarships 
applies. Amounts received as scholarships, as defined in paragraph (a) 
of Sec.  1.117-3, for study at an educational institution shall not be 
considered in determining whether the taxpayer furnishes more than one-
half the support of such individual. For example, A has a child who 
receives a $1,000 scholarship to the X college for 1 year. A contributes 
$500, which constitutes the balance of the child's support for that 
year. A may claim the child as a dependent, as the $1,000 scholarship is 
not counted in determining the support of the child. For purposes of 
this paragraph, amounts received for tuition payments and allowances by 
a veteran under the provisions of the Servicemen's Readjustment Act of 
1944 (58 Stat. 284) or the Veterans' Readjustment Assistance Act of 1952 
(38 U.S.C. ch. 38) are not amounts received as scholarships. See also 
Sec.  1.117-4. For definition of the terms ``child'', ``student'', and 
``educational institution'', as used in this paragraph, see Sec.  1.151-
3.


[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6603, 28 FR 
7094, July 11, 1963; T.D. 7099, 36 FR 5337, Mar. 20, 1971; T.D. 7114, 36 
FR 9019, May 18, 1971]



Sec.  1.152-2  Rules relating to general definition of dependent.

    (a)(1) Except as provided in subparagraph (2) of this paragraph, to 
qualify as a dependent an individual must be a citizen or resident of 
the United States or be a resident of the Canal Zone, the Republic of 
Panama, Canada, or Mexico, or, for taxable years beginning after 
December 31, 1971, a national of the United States, at some time during 
the calendar year in which the taxable year of the taxpayer begins. A 
resident of the Republic of the Philippines who was born to or legally 
adopted by the taxpayer in the Philippine Islands before January 1, 
1956, at a time when the taxpayer was a member of the Armed Forces of 
the United States, may also be claimed as a dependent if such resident 
otherwise qualifies as a dependent. For definition of ``Armed Forces of 
the United States,'' see section 7701(a)(15).

    (2)(i) For any taxable year beginning after December 31, 1957, a 
taxpayer who is a citizen, or, for any taxable year beginning after 
December 31, 1971, a national, of the United States is permitted under 
section 152(b)(3)(B) to

[[Page 175]]

treat as a dependent his legally adopted child who lives with him, as a 
member of his household, for the entire taxable year and who, but for 
the citizenship, nationality, or residence requirements of section 
152(b)(3) and subparagraph (1) of this paragraph, would qualify as a 
dependent of the taxpayer for such taxable year.
    (ii) Under section 152(b)(3)(B) and this subparagraph, it is 
necessary that the taxpayer both maintain and occupy the household. The 
taxpayer and his legally adopted child will be considered as occupying 
the household for the entire taxable year of the taxpayer 
notwithstanding temporary absences from the household due to special 
circumstances. A nonpermanent failure to occupy the common abode by 
reason of illness, education, business, vacation, military service, or a 
custody agreement under which the legally adopted child is absent for 
less than six months in the taxable year of the taxpayer shall be 
considered temporary absence due to special circumstances. The fact that 
a legally adopted child dies during the year shall not deprive the 
taxpayer of the deduction if the child lived in the household for the 
entire part of the year preceding his death. The period during the 
taxable year preceding the birth of a child shall not prevent such child 
from qualifying as a dependent under this subparagraph. Moreover, a 
legally adopted child who actually becomes a member of the taxpayer's 
household during the taxable year shall not be prevented from being 
considered a member of such household for the entire taxable year, if 
the child is required to remain in a hospital for a period following its 
birth and if such child would otherwise have been a member of the 
taxpayer's household during such period.
    (iii) For purposes of section 152(b)(3)(B) and this subparagraph, 
any child whose legal adoption by the taxpayer (a citizen or national of 
the United States) becomes final at any time before the end of the 
taxable year of the taxpayer shall not be disqualified as a dependent of 
such taxpayer by reason of his citizenship, nationality, or residence, 
provided the child lived with the taxpayer and was a member of the 
taxpayer's household for the entire taxable year in which the legal 
adoption became final. For example, A, a citizen of the United States 
who makes his income tax returns on the basis of the calendar year, is 
employed in Brazil by an agency of the United States Government. In 
October 1958 he takes into his household C, a resident of Brazil who is 
not a citizen of the United States, for the purpose of initiating 
adoption proceedings. C lives with A and is a member of his household 
for the remainder of 1958 and for the entire calendar year 1959. On July 
1, 1959, the adoption proceedings were completed and C became the 
legally adopted child of A. If C otherwise qualifies as a dependent, he 
may be claimed as a dependent by A for 1959.
    (b) A payment to a wife which is includible in her gross income 
under section 71 or section 682 shall not be considered a payment by her 
husband for the support of any dependent.
    (c)(1) For purposes of determining the existence of any of the 
relationships specified in section 152 (a) or (b)(1), a legally adopted 
child of an individual shall be treated as a child of such individual by 
blood.
    (2) For any taxable year beginning after December 31, 1958, a child 
who is a member of an individual's household also shall be treated as a 
child of such individual by blood if the child was placed with the 
individual by an authorized placement agency for legal adoption pursuant 
to a formal application filed by the individual with the agency. For 
purposes of this subparagraph an authorized placement agency is any 
agency which is authorized by a State, the District of Columbia, a 
possession of the United States, a foreign country, or a political 
subdivision of any of the foregoing to place children for adoption. A 
taxpayer who claims as a dependent a child placed with him for adoption 
shall attach to his income tax return a statement setting forth the name 
of the child for whom the dependency deduction is claimed, the name and 
address of the authorized placement agency, and the date the formal 
application was filed with the agency.
    (3) The application of this paragraph may be illustrated by the 
following example:


[[Page 176]]


    Example. On March 1, 1959, D, a resident of the United States, made 
formal application to an authorized child placement agency for the 
placement of E, a resident of the United States, with him for legal 
adoption. On June 1, 1959, E was placed with D for legal adoption. 
During the year 1959 E received over one-half of his support from D. D 
may claim E as a dependent for 1959. Since E was a resident of the 
United States, his qualification as a dependent is in no way based on 
the provisions of section 152(b)(3)(B). Therefore, it is immaterial that 
E was not a member of D's household during the entire taxable year.

    (4) For purposes of determining the existence of any of the 
relationships specified in section 152 (a) or (b)(1), a foster child of 
an individual (if such foster child satisfies the requirements set forth 
in paragraph (b) of Sec.  1.152-1 with respect to such individual) 
shall, for taxable years beginning after December 31, 1969, be treated 
as a child of such individual by blood. For purposes of this 
subparagraph, a foster child is a child who is in the care of a person 
or persons (other than the parents or adopted parents of the child) who 
care for the child as their own child. Status as a foster child is not 
dependent upon or affected by the circumstances under which the child 
became a member of the household.
    (d) In the case of a joint return it is not necessary that the 
prescribed relationship exist between the person claimed as a dependent 
and the spouse who furnishes the support; it is sufficient if the 
prescribed relationship exists with respect to either spouse. Thus, a 
husband and wife making a joint return may claim as a dependent a 
daughter of the wife's brother (wife's niece) even though the husband is 
the one who furnishes the chief support. The relationship of affinity 
once existing will not terminate by divorce or the death of a spouse. 
For example, a widower may continue to claim his deceased wife's father 
(his father-in-law) as a dependent provided he meets the other 
requirements of section 151.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6603, 28 FR 
7094, July 11, 1963; T.D. 7051, 35 FR 11020, July 9, 1970; T.D. 7291, 38 
FR 33396, Dec. 4, 1973]



Sec.  1.152-3  Multiple support agreements.

    (a) Section 152(c) provides that a taxpayer shall be treated as 
having contributed over half of the support of an individual for the 
calendar year (in cases where two or more taxpayers contributed to the 
support of such individual) if--
    (1) No one person contributed over half of the individual's support,
    (2) Each member of the group which collectively contributed more 
than half of the support of the individual would have been entitled to 
claim the individual as a dependent but for the fact that he did not 
contribute more than one-half of such support.
    (3) The member of the group claiming the individual as a dependent 
contributed more than 10 percent of the individual's support, and
    (4) Each other person in the group who contributed more than 10 
percent of such support furnishes to the taxpayer claiming the dependent 
a written declaration that such other person will not claim the 
individual as a dependent for any taxable year beginning in such 
calendar year.
    (b) Examples. Application of the rule contained in paragraph (a) of 
this section may be illustrated by the following examples:

    Example 1. During the taxable year, brothers A, B, C, and D 
contributed the entire support of their mother in the following 
percentages: A, 30 percent; B, 20 percent; C, 29 percent; and D, 21 
percent. Any one of the brothers, except for the fact that he did not 
contribute more than half of her support, would have been entitled to 
claim his mother as a dependent. Consequently, any one of the brothers 
could claim a deduction for the exemption of the mother if he obtained a 
written declaration (as provided in paragraph (a)(4) of this section) 
from each of the other brothers. Even though A and D together 
contributed more than one-half the support of the mother, A, if he 
wished to claim his mother as a dependent, would be required to obtain 
written declarations from B, C, and D, since each of those three 
contributed more than 10 percent of the support and, but for the failure 
to contribute more than half of the mother's support, would have been 
entitled to claim his mother as a dependent.
    Example 2. During the taxable year, E, an individual who resides 
with his son, S, received his entire support for that year as follows:

------------------------------------------------------------------------
                                                              Percentage
                           Source                              of total
------------------------------------------------------------------------
Social Security............................................           25

[[Page 177]]

 
N, an unrelated neighbor...................................           11
B, a brother...............................................           14
D, a daughter..............................................           10
S, a son...................................................           40
    Total received by E....................................          100
------------------------------------------------------------------------

    B, D, and S are persons each of whom, but for the fact that none 
contributed more than half of E's support, could claim E as a dependent 
for the taxable year. The three together contributed 64 percent of E's 
support, and, thus, each is a member of the group to be considered for 
the purpose of section 152(c). B and S are the only members of such 
group who can meet all the requirements of section 152(c), and either 
one could claim E as a dependent for his taxable year if he obtained a 
written declaration (as provided in paragraph (a)(4) of this section) 
signed by the other, and furnished the other information required by the 
return with respect to all the contributions to E. Inasmuch as D did not 
contribute more than 10 percent of E's support, she is not entitled to 
claim E as a dependent for the taxable year nor is she required to 
furnish a written declaration with respect to her contributions to E. N 
contributed over 10 percent of the support of E, but, since he is an 
unrelated neighbor, he does not qualify as a member of the group for the 
purpose of the multiple support agreement under section 152(c).

    (c)(1) The member of a group of contributors who claims an 
individual as a dependent for a taxable year beginning before January 1, 
2002, under the multiple support agreement provisions of section 152(c) 
must attach to the member's income tax return for the year of the 
deduction a written declaration from each of the other persons who 
contributed more than 10 percent of the support of such individual and 
who, but for the failure to contribute more than half of the support of 
the individual, would have been entitled to claim the individual as a 
dependent.
    (2) The taxpayer claiming an individual as a dependent for a taxable 
year beginning after December 31, 2001, under the multiple support 
agreement provisions of section 152(c) must provide with the income tax 
return for the year of the deduction--
    (i) A statement identifying each of the other persons who 
contributed more than 10 percent of the support of the individual and 
who, but for the failure to contribute more than half of the support of 
the individual, would have been entitled to claim the individual as a 
dependent; and
    (ii) A statement indicating that the taxpayer obtained a written 
declaration from each of the persons described in section 152(c)(2) 
waiving the right to claim the individual as a dependent.
    (3) The taxpayer claiming the individual as a dependent for a 
taxable year beginning after December 31, 2001, must retain the waiver 
declarations and should be prepared to furnish the waiver declarations 
and any other information necessary to substantiate the claim, which may 
include a statement showing the names of all contributors (whether or 
not members of the group described in section 152(c)(2)) and the amount 
contributed by each to the support of the claimed dependent.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6603, 28 FR 
7094, July 11, 1963; T.D. 8989, 67 FR 20031, Apr. 24, 2002; T.D. 9040, 
68 FR 4920, Jan. 31, 2003]



Sec.  1.152-4  Special rule for a child of divorced or separated parents 
or parents who live apart.

    (a) In general. A taxpayer may claim a dependency deduction for a 
child (as defined in section 152(f)(1)) only if the child is the 
qualifying child of the taxpayer under section 152(c) or the qualifying 
relative of the taxpayer under section 152(d). Section 152(c)(4)(B) 
provides that a child who is claimed as a qualifying child by parents 
who do not file a joint return together is treated as the qualifying 
child of the parent with whom the child resides for a longer period of 
time during the taxable year or, if the child resides with both parents 
for an equal period of time, of the parent with the higher adjusted 
gross income. However, a child is treated as the qualifying child or 
qualifying relative of the noncustodial parent if the custodial parent 
releases a claim to the exemption under section 152(e) and this section.
    (b) Release of claim by custodial parent--(1) In general. Under 
section 152(e)(1), notwithstanding section 152(c)(1)(B), (c)(4), or 
(d)(1)(C), a child is treated as the qualifying child or qualifying 
relative of the noncustodial parent (as defined in paragraph (d) of this

[[Page 178]]

section) if the requirements of paragraphs (b)(2) and (b)(3) of this 
section are met.
    (2) Support, custody, and parental status--(i) In general. The 
requirements of this paragraph (b)(2) are met if the parents of the 
child provide over one-half of the child's support for the calendar 
year, the child is in the custody of one or both parents for more than 
one-half of the calendar year, and the parents--
    (A) Are divorced or legally separated under a decree of divorce or 
separate maintenance;
    (B) Are separated under a written separation agreement; or
    (C) Live apart at all times during the last 6 months of the calendar 
year whether or not they are or were married.
    (ii) Multiple support agreement. The requirements of this paragraph 
(b)(2) are not met if over one-half of the support of the child is 
treated as having been received from a taxpayer under section 152(d)(3).
    (3) Release of claim to child. The requirements of this paragraph 
(b)(3) are met for a calendar year if--
    (i) The custodial parent signs a written declaration that the 
custodial parent will not claim the child as a dependent for any taxable 
year beginning in that calendar year and the noncustodial parent 
attaches the declaration to the noncustodial parent's return for the 
taxable year; or
    (ii) A qualified pre-1985 instrument, as defined in section 
152(e)(3)(B), applicable to the taxable year beginning in that calendar 
year, provides that the noncustodial parent is entitled to the 
dependency exemption for the child and the noncustodial parent provides 
at least $600 for the support of the child during the calendar year.
    (c) Custody. A child is in the custody of one or both parents for 
more than one-half of the calendar year if one or both parents have the 
right under state law to physical custody of the child for more than 
one-half of the calendar year.
    (d) Custodial parent--(1) In general. The custodial parent is the 
parent with whom the child resides for the greater number of nights 
during the calendar year, and the noncustodial parent is the parent who 
is not the custodial parent. A child is treated as residing with neither 
parent if the child is emancipated under state law. For purposes of this 
section, a child resides with a parent for a night if the child sleeps--
    (i) At the residence of that parent (whether or not the parent is 
present); or
    (ii) In the company of the parent, when the child does not sleep at 
a parent's residence (for example, the parent and child are on vacation 
together).
    (2) Night straddling taxable years. A night that extends over two 
taxable years is allocated to the taxable year in which the night 
begins.
    (3) Absences. (i) Except as provided in paragraph (d)(3)(ii) of this 
section, for purposes of this paragraph (d), a child who does not reside 
(within the meaning of paragraph (d)(1) of this section) with a parent 
for a night is treated as residing with the parent with whom the child 
would have resided for the night but for the absence.
    (ii) A child who does not reside (within the meaning of paragraph 
(d)(1) of this section) with a parent for a night is treated as not 
residing with either parent for that night if it cannot be determined 
with which parent the child would have resided or if the child would not 
have resided with either parent for the night.
    (4) Special rule for equal number of nights. If a child is in the 
custody of one or both parents for more than one-half of the calendar 
year and the child resides with each parent for an equal number of 
nights during the calendar year, the parent with the higher adjusted 
gross income for the calendar year is treated as the custodial parent.
    (5) Exception for a parent who works at night. If, in a calendar 
year, due to a parent's nighttime work schedule, a child resides for a 
greater number of days but not nights with the parent who works at 
night, that parent is treated as the custodial parent. On a school day, 
the child is treated as residing at the primary residence registered 
with the school.
    (e) Written declaration--(1) Form of declaration--(i) In general. 
The written declaration under paragraph (b)(3)(i) of this section must 
be an unconditional release of the custodial parent's claim to the child 
as a dependent for the year

[[Page 179]]

or years for which the declaration is effective. A declaration is not 
unconditional if the custodial parent's release of the right to claim 
the child as a dependent requires the satisfaction of any condition, 
including the noncustodial parent's meeting of an obligation such as the 
payment of support. A written declaration must name the noncustodial 
parent to whom the exemption is released. A written declaration must 
specify the year or years for which it is effective. A written 
declaration that specifies all future years is treated as specifying the 
first taxable year after the taxable year of execution and all 
subsequent taxable years.
    (ii) Form designated by IRS. A written declaration may be made on 
Form 8332, Release/Revocation of Release of Claim to Exemption for Child 
by Custodial Parent, or successor form designated by the IRS. A written 
declaration not on the form designated by the IRS must conform to the 
substance of that form and must be a document executed for the sole 
purpose of serving as a written declaration under this section. A court 
order or decree or a separation agreement may not serve as a written 
declaration.
    (2) Attachment to return. A noncustodial parent must attach a copy 
of the written declaration to the parent's return for each taxable year 
in which the child is claimed as a dependent.
    (3) Revocation of written declaration--(i) In general. A parent may 
revoke a written declaration described in paragraph (e)(1) of this 
section by providing written notice of the revocation to the other 
parent. The parent revoking the written declaration must make reasonable 
efforts to provide actual notice to the other parent. The revocation may 
be effective no earlier than the taxable year that begins in the first 
calendar year after the calendar year in which the parent revoking the 
written declaration provides, or makes reasonable efforts to provide, 
the written notice.
    (ii) Form of revocation. The revocation may be made on Form 8332, 
Release/Revocation of Release of Claim to Exemption for Child by 
Custodial Parent, or successor form designated by the IRS whether or not 
the written declaration was made on a form designated by the IRS. A 
revocation not on that form must conform to the substance of the form 
and must be a document executed for the sole purpose of serving as a 
revocation under this section. The revocation must specify the year or 
years for which the revocation is effective. A revocation that specifies 
all future years is treated as specifying the first taxable year after 
the taxable year the revocation is executed and all subsequent taxable 
years.
    (iii) Attachment to return. The parent revoking the written 
declaration must attach a copy of the revocation to the parent's return 
for each taxable year for which the parent claims a child as a dependent 
as a result of the revocation. The parent revoking the written 
declaration must keep a copy of the revocation and evidence of delivery 
of the notice to the other parent, or of the reasonable efforts to 
provide actual notice.
    (4) Ineffective declaration or revocation. A written declaration or 
revocation that fails to satisfy the requirements of this paragraph (e) 
has no effect.
    (5) Written declaration executed in a taxable year beginning on or 
before July 2, 2008. A written declaration executed in a taxable year 
beginning on or before July 2, 2008, that satisfies the requirements for 
the form of a written declaration in effect at the time the written 
declaration is executed, will be treated as meeting the requirements of 
paragraph (e)(1) of this section. Paragraph (e)(3) of this section 
applies without regard to whether a custodial parent executed the 
written declaration in a taxable year beginning on or before July 2, 
2008.
    (f) Coordination with other sections. If section 152(e) and this 
section apply, a child is treated as the dependent of both parents for 
purposes of sections 105(b), 132(h)(2)(B), and 213(d)(5).
    (g) Examples. The provisions of this section are illustrated by the 
following examples that assume, unless otherwise provided, that each 
taxpayer's taxable year is the calendar year, one or both of the child's 
parents provide over one-half of the child's support for the calendar 
year, one or both parents have the right under state law to physical 
custody of the child for more than one-half of the calendar year, and 
the child otherwise meets the requirements

[[Page 180]]

of a qualifying child under section 152(c) or a qualifying relative 
under section 152(d). In addition, in each of the examples, no qualified 
pre-1985 instrument or multiple support agreement is in effect. The 
examples are as follows:

    Example 1. (i) B and C are the divorced parents of Child. In 2009, 
Child resides with B for 210 nights and with C for 155 nights. B 
executes a Form 8332 for 2009 releasing B's right to claim Child as a 
dependent for that year, which C attaches to C's 2009 return.
    (ii) Under paragraph (d) of this section, B is the custodial parent 
of Child in 2009 because B is the parent with whom Child resides for the 
greater number of nights in 2009. Because the requirements of paragraphs 
(b)(2) and (3) of this section are met, C may claim Child as a 
dependent.
    Example 2. The facts are the same as in Example 1 except that B does 
not execute a Form 8332 or similar declaration for 2009. Therefore, 
section 152(e) and this section do not apply. Whether Child is the 
qualifying child or qualifying relative of B or C is determined under 
section 152(c) or (d).
    Example 3. (i) D and E are the divorced parents of Child. Under a 
custody decree, Grandmother has the right under state law to physical 
custody of Child from January 1 to July 31, 2009.
    (ii) Because D and E do not have the right under state law to 
physical custody of Child for over one-half of the 2009 calendar year, 
under paragraph (c) of this section, Child is not in the custody of one 
or both parents for over one-half of the calendar year. Therefore, 
section 152(e) and this section do not apply, and whether Child is the 
qualifying child or qualifying relative of D, E, or Grandmother is 
determined under section 152(c) or (d).
    Example 4. (i) The facts are the same as in Example 3, except that 
Grandmother has the right to physical custody of Child from January 1 to 
March 31, 2009, and, as a result, Child resides with Grandmother during 
this period. D and E jointly have the right to physical custody of Child 
from April 1 to December 31, 2009. During this period, Child resides 
with D for 180 nights and with E for 95 nights. D executes a Form 8332 
for 2009 releasing D's right to claim Child as a dependent for that 
year, which E attaches to E's 2009 return.
    (ii) Under paragraph (c) of this section, Child is in the custody of 
D and E for over one-half of the calendar year, because D and E have the 
right under state law to physical custody of Child for over one-half of 
the calendar year.
    (iii) Under paragraph (d)(3)(ii) of this section, the nights that 
Child resides with Grandmother are not allocated to either parent. Child 
resides with D for a greater number of nights than with E during the 
calendar year and, under paragraph (d)(1) of this section, D is the 
custodial parent.
    (iv) Because the requirements of paragraphs (b)(2) and (3) of this 
section are met, section 152(e) and this section apply, and E may claim 
Child as a dependent.
    Example 5. (i) The facts are the same as in Example 4, except that D 
is away on military service from April 10 to June 15, 2009, and 
September 6 to October 20, 2009. During these periods Child resides with 
Grandmother in Grandmother's residence. Child would have resided with D 
if D had not been away on military service. Grandmother claims Child as 
a dependent on Grandmother's 2009 return.
    (ii) Under paragraph (d)(3)(i) of this section, Child is treated as 
residing with D for the nights that D is away on military service. 
Because the requirements of paragraphs (b)(2) and (3) of this section 
are met, section 152(e) and this section apply, and E, not Grandmother, 
may claim Child as a dependent.
    Example 6. F and G are the divorced parents of Child. In May of 
2009, Child turns age 18 and is emancipated under the law of the state 
where Child resides. Therefore, in 2009 and later years, F and G do not 
have the right under state law to physical custody of Child for over 
one-half of the calendar year, and Child is not in the custody of F and 
G for over one-half of the calendar year. Section 152(e) and this 
section do not apply, and whether Child is the qualifying child or 
qualifying relative of F or G is determined under section 152(c) or (d).
    Example 7. (i) The facts are the same as in Example 6, except that 
Child turns age 18 and is emancipated under state law on August 1, 2009, 
resides with F from January 1, 2009, through May 31, 2009, and resides 
with G from June 1, 2009, through December 31, 2009. F executes a Form 
8332 releasing F's right to claim Child as a dependent for 2009, which G 
attaches to G's 2009 return.
    (ii) Under paragraph (c) of this section, Child is in the custody of 
F and G for over one-half of the calendar year.
    (iii) Under paragraph (d)(1) of this section, Child is treated as 
not residing with either parent after Child's emancipation. Therefore, 
Child resides with F for 151 nights and with G for 61 nights. Because 
the requirements of paragraphs (b)(2) and (3) of this section are met, 
section 152(e) and this section apply, and G may claim Child as a 
dependent.
    Example 8. H and J are the divorced parents of Child. Child 
generally resides with H during the week and with J every other weekend. 
Child resides with J in H's residence for 10 consecutive nights while H 
is hospitalized. Under paragraph (d)(1)(i) of this section, Child 
resides with H for the 10 nights.
    Example 9. K and L, who are separated under a written separation 
agreement, are the parents of Child. In August 2009, K and

[[Page 181]]

Child spend 10 nights together in a hotel while on vacation. Under 
paragraph (d)(1)(ii) of this section, Child resides with K for the 10 
nights that K and Child are on vacation.
    Example 10. M and N are the divorced parents of Child. On December 
31, 2009, Child attends a party at M's residence. After midnight on 
January 1, 2010, Child travels to N's residence, where Child sleeps. 
Under paragraph (d)(1) of this section, Child resides with N for the 
night of December 31, 2009, to January 1, 2010, because Child sleeps at 
N's residence that night. However, under paragraph (d)(2) of this 
section, the night of December 31, 2009, to January 1, 2010, is 
allocated to taxable year 2009 for purposes of determining whether Child 
resides with M or N for a greater number of nights in 2009.
    Example 11. O and P, who never married, are the parents of Child. In 
2009, Child spends alternate weeks residing with O and P. During a week 
that Child is residing with O, O gives Child permission to spend a night 
at the home of a friend. Under paragraph (d)(3)(i) of this section, the 
night Child spends at the friend's home is treated as a night that Child 
resides with O.
    Example 12. The facts are the same as in Example 11, except that 
Child also resides at summer camp for 6 weeks. Because Child resides 
with each parent for alternate weeks, Child would have resided with O 
for 3 weeks and with P for 3 weeks of the period that Child is at camp. 
Under paragraph (d)(3)(i) of this section, Child is treated as residing 
with O for 3 weeks and with P for 3 weeks.
    Example 13. The facts are the same as in Example 12, except that 
Child does not spend alternate weeks residing with O and P, and it 
cannot be determined whether Child would have resided with O or P for 
the period that Child is at camp. Under paragraph (d)(3)(ii) of this 
section, Child is treated as residing with neither parent for the 6 
weeks.
    Example 14. (i) Q and R are the divorced parents of Child. Q works 
from 11 PM to 7 AM Sunday through Thursday nights. Because of Q's 
nighttime work schedule, Child resides with R Sunday through Thursday 
nights and with Q Friday and Saturday nights. Therefore, in 2009, Child 
resides with R for 261 nights and with Q for 104 nights. Child spends 
all daytime hours when Child is not in school with Q and Q's address is 
registered with Child's school as Child's primary residence. Q executes 
a Form 8332 for 2009 releasing Q's right to claim Child as a dependent 
for that year, which R attaches to R's 2009 return.
    (ii) Under paragraph (d) of this section, Q is the custodial parent 
of Child in 2009. Child resides with R for a greater number of nights 
than with Q due to Q's nighttime work schedule, and Child spends a 
greater number of days with Q. Therefore, paragraph (d)(5) of this 
section applies rather than paragraph (d)(1) of this section. Because 
the requirements of paragraphs (b)(2) and (3) of this section are met, R 
may claim Child as a dependent.
    Example 15. (i) In 2009, S and T, the parents of Child, execute a 
written separation agreement. The agreement provides that Child will 
live with S and that T will make monthly child support payments to S. In 
2009, Child resides with S for 335 nights and with T for 30 nights. S 
executes a letter declaring that S will not claim Child as a dependent 
in 2009 and in subsequent alternate years. The letter contains all the 
information requested on Form 8332, does not require the satisfaction of 
any condition such as T's payment of support, and has no purpose other 
than to serve as a written declaration under section 152(e) and this 
section. T attaches the letter to T's return for 2009 and 2011.
    (ii) In 2010, T fails to provide support for Child, and S executes a 
Form 8332 revoking the release of S's right to claim Child as a 
dependent for 2011. S delivers a copy of the Form 8332 to T, attaches a 
copy of the Form 8332 to S's tax return for 2011, and keeps a copy of 
the Form 8332 and evidence of delivery of the written notice to T.
    (iii) T may claim Child as a dependent for 2009 because S releases 
the right to claim Child as a dependent under paragraph (b)(3) of this 
section by executing the letter, which conforms to the requirements of 
paragraph (e)(1) of this section, and T attaches the letter to T's 
return in accordance with paragraph (e)(2) of this section. In 2010, S 
revokes the release of the claim in accordance with paragraph (e)(3) of 
this section, and the revocation takes effect in 2011, the taxable year 
that begins in the first calendar year after S provides written notice 
of the revocation to T. Therefore, in 2011, section 152(e) and this 
section do not apply, and whether Child is the qualifying child or 
qualifying relative of S or T is determined under section 152(c) or (d).
    Example 16. The facts are the same as Example 15, except that the 
letter expressly states that S releases the right to claim Child as a 
dependent only if T is current in the payment of support for Child at 
the end of the calendar year. The letter does not qualify as a written 
declaration under paragraph (b)(3) of this section because S's agreement 
not to claim Child as a dependent is conditioned on T's payment of 
support and, under paragraph (e)(1)(i) of this section, a written 
declaration must be unconditional. Therefore, section 152(e) and this 
section do not apply, and whether Child is the qualifying child or 
qualifying relative of S or T for 2009 as well as 2011 is determined 
under section 152(c) or (d).
    Example 17. (i) U and V are the divorced parents of Child. Child 
resides with U for more nights than with V in 2009 through 2011. In 
2009, U provides a written statement to V

[[Page 182]]

declaring that U will not claim Child as a dependent, but the statement 
does not specify the year or years it is effective. V attaches the 
statement to V's returns for 2009 through 2011.
    (ii) Because the written statement does not specify a year or years, 
under paragraph (e)(1) of this section, it is not a written declaration 
that conforms to the substance of Form 8332. Under paragraph (e)(4) of 
this section, the statement has no effect. Section 152(e) and this 
section do not apply, and whether Child is the qualifying child or 
qualifying relative of U or V is determined under section 152(c) or (d).
    Example 18. (i) W and X are the divorced parents of Child. In 2009, 
Child resides solely with W. The divorce decree requires X to pay child 
support to W and requires W to execute a Form 8332 releasing W's right 
to claim Child as a dependent. W fails to sign a Form 8332 for 2009, and 
X attaches an unsigned Form 8332 to X's return for 2009.
    (ii) The order in the divorce decree requiring W to execute a Form 
8332 is ineffective to allocate the right to claim Child as a dependent 
to X. Furthermore, under paragraph (e)(1) of this section, the unsigned 
Form 8332 does not conform to the substance of Form 8332, and under 
paragraph (e)(4) of this section, the Form 8332 has no effect. 
Therefore, section 152(e) and this section do not apply, and whether 
Child is the qualifying child or qualifying relative of W or X is 
determined under section 152(c) or (d).
    (iii) If, however, W executes a Form 8332 for 2009, and X attaches 
the Form 8332 to X's return, then X may claim Child as a dependent in 
2009.
    Example 19. (i) Y and Z are the divorced parents of Child. In 2003, 
Y and Z enter into a separation agreement, which is incorporated into a 
divorce decree, under which Y, the custodial parent, releases Y's right 
to claim Child as a dependent for all future years. The separation 
agreement satisfies the requirements for the form of a written 
declaration in effect at the time it is executed. Z attaches a copy of 
the separation agreement to Z's returns for 2003 through 2009.
    (ii) Under paragraph (e)(1)(ii) of this section, a separation 
agreement may not serve as a written declaration. However, under 
paragraph (e)(5) of this section, a written declaration executed in a 
taxable year beginning on or before July 2, 2008, that satisfies the 
requirements for the form of a written declaration in effect at the time 
the written declaration is executed, will be treated as meeting the 
requirements of paragraph (e)(1) of this section. Therefore, the 
separation agreement may serve as the written declaration required by 
paragraph (b)(3)(i) of this section for 2009, and Z may claim Child as a 
dependent in 2009 and later years.
    Example 20. (i) The facts are the same as in Example 19, except that 
in 2009 Y executes a Form 8332 revoking the release of Y's right to 
claim Child as a dependent for 2010. Y complies with all the 
requirements of paragraph (e)(3) of this section.
    (ii) Although Y executes the separation agreement releasing Y's 
right to claim Child as a dependent in a taxable year beginning on or 
before July 2, 2008, under paragraph (e)(5) of this section, Y's 
execution of the Form 8332 in 2009 is effective to revoke the release. 
Therefore, section 152(e) and this section do not apply in 2010, and 
whether Child is the qualifying child or qualifying relative of Y or Z 
is determined under section 152(c) or (d).

    (h) Effective/applicability date. This section applies to taxable 
years beginning after July 2, 2008.

[T.D. 9408, 73 FR 37801, July 2, 2008]



Sec.  1.153-1  Determination of marital status.

    For the purpose of determining the right of an individual to claim 
an exemption for his spouse under section 151(b), the determination of 
whether such individual is married shall be made as of the close of his 
taxable year, unless his spouse dies during such year, in which case the 
determination shall be made as of the time of such death. An individual 
legally separated from his spouse under a decree of divorce or separate 
maintenance shall not be considered as married. The provisions of this 
section may be illustrated by the following examples:

    Example 1. A, who files his returns on the basis of a calendar year, 
married B on December 31, 1956. B, who had never previously married, had 
no gross income for the calendar year 1956 nor was she the dependent of 
another taxpayer for such year. A may claim an exemption for B for 1956.
    Example 2. C and his wife, D, were married in 1940. They remained 
married until July 1956 at which time D was granted a decree of divorce. 
C, who files his income tax returns on a calendar year basis, cannot 
claim an exemption for D on his 1956 return as C and D were not married 
on the last day of C's taxable year. Had D died instead of being 
divorced, C could have claimed an exemption for D for 1956 as their 
marital status would have been determined as of the date of D's death.

[[Page 183]]



Sec.  1.154  Statutory provisions; cross references.

    Sec. 154. Cross references. (1) For definitions of ``husband'' and 
``wife'', as used in section 152(b)(4), see section 7701(a)(17).
    (2) For deductions of estates and trusts, in lieu of the exemptions 
under section 151, see section 642(b).
    (3) For exemptions of nonresident aliens, see section 873(b)(3).
    (4) For exemptions of citizens deriving income mainly from sources 
within possessions of the United States, see section 931(e).

(Sec. 154 as amended by sec. 103(c)(2), Foreign Investors Tax Act 1966 
(80 Stat. 1551))

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960, as 
amended by T.D. 7332, 39 FR 44216, Dec. 23, 1974]

          Itemized Deductions for Individuals and Corporations



Sec.  1.161-1  Allowance of deductions.

    Section 161 provides for the allowance as deductions, in computing 
taxable income under section 63(a), of the items specified in Part VI 
(section 161 and following), Subchapter B, Chapter 1 of the Code, 
subject to the exceptions provided in Part IX (section 261 and 
following), of such Subchapter B, relating to items not deductible. 
Double deductions are not permitted. Amounts deducted under one 
provision of the Internal Revenue Code of 1954 cannot again be deducted 
under any other provision thereof. See also section 7852(c), relating to 
the taking into account, both in computing a tax under Subtitle A of the 
Internal Revenue Code of 1954 and a tax under Chapter 1 or 2 of the 
Internal Revenue Code of 1939, of the same item of deduction.



Sec.  1.162-1  Business expenses.

    (a) In general. Business expenses deductible from gross income 
include the ordinary and necessary expenditures directly connected with 
or pertaining to the taxpayer's trade or business, except items which 
are used as the basis for a deduction or a credit under provisions of 
law other than section 162. The cost of goods purchased for resale, with 
proper adjustment for opening and closing inventories, is deducted from 
gross sales in computing gross income. See paragraph (a) of Sec.  1.161-
3. Among the items included in business expenses are management 
expenses, commissions (but see section 263 and the regulations 
thereunder), labor, supplies, incidental repairs, operating expenses of 
automobiles used in the trade or business, traveling expenses while away 
from home solely in the pursuit of a trade or business (see Sec.  1.162-
2), advertising and other selling expenses, together with insurance 
premiums against fire, storm, theft, accident, or other similar losses 
in the case of a business, and rental for the use of business property. 
No such item shall be included in business expenses, however, to the 
extent that it is used by the taxpayer in computing the cost of property 
included in its inventory or used in determining the gain or loss basis 
of its plant, equipment, or other property. See section 1054 and the 
regulations thereunder. A deduction for an expense paid or incurred 
after December 30, 1969, which would otherwise be allowable under 
section 162 shall not be denied on the grounds that allowance of such 
deduction would frustrate a sharply defined public policy. See section 
162(c), (f), and (g) and the regulations thereunder. The full amount of 
the allowable deduction for ordinary and necessary expenses in carrying 
on a business is deductible, even though such expenses exceed the gross 
income derived during the taxable year from such business. In the case 
of any sports program to which section 114 (relating to sports programs 
conducted for the American National Red Cross) applies, expenses 
described in section 114(a)(2) shall be allowable as deductions under 
section 162(a) only to the extent that such expenses exceed the amount 
excluded from gross income under section 114(a).
    (b) Cross references. (1) For charitable contributions by 
individuals and corporations not deductible under section 162, see Sec.  
1.162-15.
    (2) For items not deductible, see sections 261-276, inclusive, and 
the regulations thereunder.
    (3) For research and experimental expenditures, see section 174 and 
regulations thereunder.
    (4) For soil and water conservation expenditures, see section 175 
and regulations thereunder.

[[Page 184]]

    (5) For expenditures attributable to grant or loan by United States 
for encouragement of exploration for, or development or mining of, 
critical and strategic minerals or metals, see section 621 and 
regulations thereunder.
    (6) For treatment of certain rental payments with respect to public 
utility property, see section 167(1) and Sec.  1.167(1)-3.
    (7) For limitations on the deductibility of miscellaneous itemized 
deductions, see section 67 and Sec. Sec.  1.67-1T through 1.67-4T.
    (8) For the timing of deductions with respect to notional principal 
contracts. see Sec.  1.446-3.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6690, 28 FR 
12253, Nov. 19, 1963; T.D. 6996, 34 FR 835, Jan. 18, 1969; T.D. 7315, 39 
FR 20203, June 7, 1974; T.D. 7345, 40 FR 7437, Feb. 20, 1975; T.D. 8189, 
53 FR 9881, Mar. 28, 1988; T.D. 8491, 58 FR 53128, Oct. 14, 1993]



Sec.  1.162-2  Traveling expenses.

    (a) Traveling expenses include travel fares, meals and lodging, and 
expenses incident to travel such as expenses for sample rooms, telephone 
and telegraph, public stenographers, etc. Only such traveling expenses 
as are reasonable and necessary in the conduct of the taxpayer's 
business and directly attributable to it may be deducted. If the trip is 
undertaken for other than business purposes, the travel fares and 
expenses incident to travel are personal expenses and the meals and 
lodging are living expenses. If the trip is solely on business, the 
reasonable and necessary traveling expenses, including travel fares, 
meals and lodging, and expenses incident to travel, are business 
expenses. For the allowance of traveling expenses as deductions in 
determining adjusted gross income, see section 62(2)(B) and the 
regulations thereunder.
    (b)(1) If a taxpayer travels to a destination and while at such 
destination engages in both business and personal activities, traveling 
expenses to and from such destination are deductible only if the trip is 
related primarily to the taxpayer's trade or business. If the trip is 
primarily personal in nature, the traveling expenses to and from the 
destination are not deductible even though the taxpayer engages in 
business activities while at such destination. However, expenses while 
at the destination which are properly allocable to the taxpayer's trade 
or business are deductible even though the traveling expenses to and 
from the destination are not deductible.
    (2) Whether a trip is related primarily to the taxpayer's trade or 
business or is primarily personal in nature depends on the facts and 
circumstances in each case. The amount of time during the period of the 
trip which is spent on personal activity compared to the amount of time 
spent on activities directly relating to the taxpayer's trade or 
business is an important factor in determining whether the trip is 
primarily personal. If, for example, a taxpayer spends one week while at 
a destination on activities which are directly related to his trade or 
business and subsequently spends an additional five weeks for vacation 
or other personal activities, the trip will be considered primarily 
personal in nature in the absence of a clear showing to the contrary.
    (c) Where a taxpayer's wife accompanies him on a business trip, 
expenses attributable to her travel are not deductible unless it can be 
adequately shown that the wife's presence on the trip has a bona fide 
business purpose. The wife's performance of some incidental service does 
not cause her expenses to qualify as deductible business expenses. The 
same rules apply to any other members of the taxpayer's family who 
accompany him on such a trip.
    (d) Expenses paid or incurred by a taxpayer in attending a 
convention or other meeting may constitute an ordinary and necessary 
business expense under section 162 depending upon the facts and 
circumstances of each case. No distinction will be made between self-
employed persons and employees. The fact that an employee uses vacation 
or leave time or that his attendance at the convention is voluntary will 
not necessarily prohibit the allowance of the deduction. The allowance 
of deductions for such expenses will depend upon whether there is a 
sufficient relationship between the taxpayer's trade of business and his 
attendance at the convention or other meeting so that he is benefiting 
or advancing the

[[Page 185]]

interests of his trade or business by such attendance. If the convention 
is for political, social or other purposes unrelated to the taxpayer's 
trade or business, the expenses are not deductible.
    (e) Commuters' fares are not considered as business expenses and are 
not deductible.
    (f) For rules with respect to the reporting and substantiation of 
traveling and other business expenses of employees for taxable years 
beginning after December 31, 1957, see Sec.  1.162-17.



Sec.  1.162-3  Materials and supplies.

    (a) In general--(1) Non-incidental materials and supplies. Except as 
provided in paragraphs (d), (e), and (f) of this section, amounts paid 
to acquire or produce materials and supplies (as defined in paragraph 
(c) of this section) are deductible in the taxable year in which the 
materials and supplies are first used in the taxpayer's operations or 
are consumed in the taxpayer's operations.
    (2) Incidental materials and supplies. Amounts paid to acquire or 
produce incidental materials and supplies (as defined in paragraph (c) 
of this section) that are carried on hand and for which no record of 
consumption is kept or of which physical inventories at the beginning 
and end of the taxable year are not taken, are deductible in the taxable 
year in which these amounts are paid, provided taxable income is clearly 
reflected.
    (3) Use or consumption of rotable and temporary spare parts. Except 
as provided in paragraphs (d), (e), and (f) of this section, for 
purposes of paragraph (a)(1) of this section, rotable and temporary 
spare parts (defined under paragraph (c)(2) of this section) are first 
used in the taxpayer's operations or are consumed in the taxpayer's 
operations in the taxable year in which the taxpayer disposes of the 
parts.
    (b) Coordination with other provisions of the Internal Revenue Code. 
Nothing in this section changes the treatment of any amount that is 
specifically provided for under any provision of the Internal Revenue 
Code (Code) or regulations other than section 162(a) or section 212 and 
the regulations under those sections. For example, see Sec.  1.263(a)-3, 
which requires taxpayers to capitalize amounts paid to improve tangible 
property and section 263A and the regulations under section 263A, which 
require taxpayers to capitalize the direct and allocable indirect costs, 
including the cost of materials and supplies, of property produced by 
the taxpayer and property acquired for resale. See also Sec.  1.471-1, 
which requires taxpayers to include in inventory certain materials and 
supplies.
    (c) Definitions--(1) Materials and supplies. For purposes of this 
section, materials and supplies means tangible property that is used or 
consumed in the taxpayer's operations that is not inventory and that--
    (i) Is a component acquired to maintain, repair, or improve a unit 
of tangible property (as determined under Sec.  1.263(a)-3(e)) owned, 
leased, or serviced by the taxpayer and that is not acquired as part of 
any single unit of tangible property;
    (ii) Consists of fuel, lubricants, water, and similar items, 
reasonably expected to be consumed in 12 months or less, beginning when 
used in the taxpayer's operations;
    (iii) Is a unit of property as determined under Sec.  1.263(a)-3(e) 
that has an economic useful life of 12 months or less, beginning when 
the property is used or consumed in the taxpayer's operations;
    (iv) Is a unit of property as determined under Sec.  1.263(a)-3(e) 
that has an acquisition cost or production cost (as determined under 
section 263A) of $200 or less (or other amount as identified in 
published guidance in the Federal Register or in the Internal Revenue 
Bulletin (see Sec.  601.601(d)(2)(ii)(b) of this chapter); or
    (v) Is identified in published guidance in the Federal Register or 
in the Internal Revenue Bulletin (see Sec.  601.601(d)(2)(ii)(b) of this 
chapter) as materials and supplies for which treatment is permitted 
under this section.
    (2) Rotable and temporary spare parts. For purposes of this section, 
rotable spare parts are materials and supplies under paragraph (c)(1)(i) 
of this section that are acquired for installation on a unit of 
property, removable from that unit of property, generally repaired or 
improved, and either reinstalled on the

[[Page 186]]

same or other property or stored for later installation. Temporary spare 
parts are materials and supplies under paragraph (c)(1)(i) of this 
section that are used temporarily until a new or repaired part can be 
installed and then are removed and stored for later installation.
    (3) Standby emergency spare parts. Standby emergency spare parts are 
materials and supplies under paragraph (c)(1)(i) of this section that 
are--
    (i) Acquired when particular machinery or equipment is acquired (or 
later acquired and set aside for use in particular machinery or 
equipment);
    (ii) Set aside for use as replacements to avoid substantial 
operational time loss caused by emergencies due to particular machinery 
or equipment failure;
    (iii) Located at or near the site of the installed related machinery 
or equipment so as to be readily available when needed;
    (iv) Directly related to the particular machinery or piece of 
equipment they serve;
    (v) Normally expensive;
    (vi) Only available on special order and not readily available from 
a vendor or manufacturer;
    (vii) Not subject to normal periodic replacement;
    (viii) Not interchangeable in other machines or equipment;
    (ix) [Reserved]
    (x) Not acquired in quantity (generally only one is on hand for each 
piece of machinery or equipment); and
    (xi) Not repaired and reused.
    (4) Economic useful life--(i) General rule. The economic useful life 
of a unit of property is not necessarily the useful life inherent in the 
property but is the period over which the property may reasonably be 
expected to be useful to the taxpayer or, if the taxpayer is engaged in 
a trade or business or an activity for the production of income, the 
period over which the property may reasonably be expected to be useful 
to the taxpayer in its trade or business or for the production of 
income, as applicable. The factors that must be considered in 
determining this period are provided under Sec.  1.167(a)-1(b).
    (ii) Taxpayers with an applicable financial statement. For taxpayers 
with an applicable financial statement (as defined in paragraph 
(c)(4)(iii) of this section), the economic useful life of a unit of 
property, solely for the purposes of applying the provisions of this 
paragraph (c), is the useful life initially used by the taxpayer for 
purposes of determining depreciation in its applicable financial 
statement, regardless of any salvage value of the property. If a 
taxpayer does not have an applicable financial statement for the taxable 
year in which a unit of property was originally acquired or produced, 
the economic useful life of the unit of property must be determined 
under paragraph (c)(4)(i) of this section. Further, if a taxpayer treats 
amounts paid for a unit of property as an expense in its applicable 
financial statement on a basis other than the useful life of the 
property or if a taxpayer does not depreciate the unit of property on 
its applicable financial statement, the economic useful life of the unit 
of property must be determined under paragraph (c)(4)(i) of this 
section. For example, if a taxpayer has a policy of treating as an 
expense on its applicable financial statement amounts paid for a unit of 
property costing less than a certain dollar amount, notwithstanding that 
the unit of property has a useful life of more than one year, the 
economic useful life of the unit of property must be determined under 
paragraph (c)(4)(i) of this section.
    (iii) Definition of applicable financial statement. The taxpayer's 
applicable financial statement is the taxpayer's financial statement 
listed in paragraphs (c)(4)(iii)(A) through (C) of this section that has 
the highest priority (including within paragraph (c)(4)(iii)(B) of this 
section). The financial statements are, in descending priority--
    (A) A financial statement required to be filed with the Securities 
and Exchange Commission (SEC) (the 10-K or the Annual Statement to 
Shareholders);
    (B) A certified audited financial statement that is accompanied by 
the report of an independent certified public accountant (or in the case 
of a foreign entity, by the report of a similarly qualified independent 
professional), that is used for--
    (1) Credit purposes;

[[Page 187]]

    (2) Reporting to shareholders, partners, or similar persons; or
    (3) Any other substantial non-tax purpose; or
    (C) A financial statement (other than a tax return) required to be 
provided to the federal or a state government or any federal or state 
agency (other than the SEC or the Internal Revenue Service).
    (5) Amount paid. For purposes of this section, in the case of a 
taxpayer using an accrual method of accounting, the terms amount paid 
and payment mean a liability incurred (within the meaning of Sec.  
1.446-1(c)(1)(ii)). A liability may not be taken into account under this 
section prior to the taxable year during which the liability is 
incurred.
    (6) Produce. For purposes of this section, produce means construct, 
build, install, manufacture, develop, create, raise, or grow. This 
definition is intended to have the same meaning as the definition used 
for purposes of section 263A(g)(1) and Sec.  1.263A-2(a)(1)(i), except 
that improvements are excluded from the definition in this paragraph 
(c)(6) and are separately defined and addressed in Sec.  1.263(a)-3. 
Amounts paid to produce materials and supplies are subject to section 
263A.
    (d) Election to capitalize and depreciate certain materials and 
supplies--(1) In general. A taxpayer may elect to treat as a capital 
expenditure and to treat as an asset subject to the allowance for 
depreciation the cost of any rotable spare part, temporary spare part, 
or standby emergency spare part as defined in paragraph (c)(2) or (c)(3) 
of this section. Except as specified in paragraph (d)(2) of this 
section, an election made under this paragraph (d) applies to amounts 
paid during the taxable year to acquire or produce any rotable, 
temporary, or standby emergency spare part to which paragraph (a) of 
this section would apply (but for the election under this paragraph 
(d)). Any property for which this election is made shall not be treated 
as a material or a supply.
    (2) Exceptions. A taxpayer may not elect to capitalize and 
depreciate under this paragraph (d) any amount paid to acquire or 
produce a rotable, temporary, or standby emergency spare part defined in 
paragraph (c)(2) or (c)(3) of this section if--
    (i) The rotable, temporary, or standby emergency spare part is 
intended to be used as a component of a unit of property under paragraph 
(c)(1)(iii), (iv), or (v) of this section;
    (ii) The rotable, temporary, or standby emergency spare part is 
intended to be used as a component of a property described in paragraph 
(c)(1)(i) and the taxpayer cannot or has not elected to capitalize and 
depreciate that property under this paragraph (d); or
    (iii) The amount is paid to acquire or produce a rotable or 
temporary spare part and the taxpayer uses the optional method of 
accounting for rotable and temporary spare parts under paragraph (e) to 
of this section.
    (3) Manner of electing. A taxpayer makes the election under this 
paragraph (d) by capitalizing the amounts paid to acquire or produce a 
rotable, temporary, or standby emergency spare part in the taxable year 
the amounts are paid and by beginning to depreciate the costs when the 
asset is placed in service by the taxpayer for purposes of determining 
depreciation under the applicable provisions of the Internal Revenue 
Code and the Treasury Regulations. Section 1.263(a)-2 provides for the 
treatment of amounts paid to acquire or produce real or personal 
tangible property. A taxpayer must make the election under this 
paragraph (d) in its timely filed original Federal tax return (including 
extensions) for the taxable year the asset is placed in service by the 
taxpayer for purposes of determining depreciation. Sections 301.9100-1 
through 301.9100-3 of this chapter provide the rules governing 
extensions of the time to make regulatory elections. In the case of an S 
corporation or a partnership, the election is made by the S corporation 
or partnership, and not by the shareholders or partners. A taxpayer may 
make an election for each rotable, temporary, or standby emergency spare 
part that qualifies for the election under this paragraph (d). This 
election does not apply to an asset or a portion thereof placed in 
service and disposed of in the same taxable year. A taxpayer may revoke 
an election made under this paragraph (d) or made under

[[Page 188]]

Sec.  1.162-3T(d), as contained in 26 CFR part 1, revised as of April 1, 
2013, only by filing a request for a private letter ruling and obtaining 
the Commissioner's consent to revoke the election. The Commissioner may 
grant a request to revoke this election if the taxpayer acted reasonably 
and in good faith and the revocation will not prejudice the interests of 
the Government. See generally Sec.  301.9100-3 of this chapter. The 
manner of electing and revoking the election to capitalize under this 
paragraph (d) or under Sec.  1.162-3T(d), as contained in 26 CFR part 1, 
revised as of April 1, 2013, may be modified through guidance of general 
applicability (see Sec. Sec.  601.601(d)(2) and 601.602 of this 
chapter). An election may not be made or revoked through the filing of 
an application for change in accounting method or, before obtaining the 
Commissioner's consent to make the late election or to revoke the 
election, by filing an amended Federal tax return.
    (e) Optional method of accounting for rotable and temporary spare 
parts--(1) In general. This paragraph (e) provides an optional method of 
accounting for rotable and temporary spare parts (the optional method 
for rotable parts). A taxpayer may use the optional method for rotable 
parts, instead of the general rule under paragraph (a)(3) of this 
section, to account for its rotable and temporary spare parts as defined 
in paragraph (c)(2) of this section. A taxpayer that uses the optional 
method for rotable parts must use this method for all of its pools of 
rotable and temporary spare parts used in the same trade or business and 
for which it uses this method for its books and records. If a taxpayer 
uses the optional method for rotable parts for pools of rotable and 
temporary spare parts for which the taxpayer does not use the optional 
method for its books and records, then the taxpayer must use the 
optional method for all its pools in the same trade or business, whether 
rotable or temporary. The optional method for rotable parts is a method 
of accounting under section 446(a). Under the optional method for 
rotable parts, the taxpayer must apply the rules in this paragraph (e) 
to each rotable or temporary spare part (part) upon the taxpayer's 
initial installation, removal, repair, maintenance or improvement, 
reinstallation, and disposal of each part.
    (2) Description of optional method for rotable parts--(i) Initial 
installation. The taxpayer must deduct the amount paid to acquire or 
produce the part in the taxable year that the part is first installed on 
a unit of property for use in the taxpayer's operations.
    (ii) Removal from unit of property. In each taxable year in which 
the part is removed from a unit of property to which it was initially or 
subsequently installed, the taxpayer must--
    (A) Include in gross income the fair market value of the part; and
    (B) Include in the basis of the part the fair market value of the 
part included in income under paragraph (e)(2)(ii)(A) of this section 
and the amount paid to remove the part from the unit of property.
    (iii) Repair, maintenance, or improvement of part. The taxpayer may 
not currently deduct and must include in the basis of the part any 
amounts paid to maintain, repair, or improve the part in the taxable 
year these amounts are paid.
    (iv) Reinstallation of part. The taxpayer must deduct the amounts 
paid to reinstall the part and those amounts included in the basis of 
the part under paragraphs (e)(2)(ii)(B) and (e)(2)(iii) of this section, 
to the extent that those amounts have not been previously deducted under 
this paragraph (e)(2)(iv), in the taxable year that the part is 
reinstalled on a unit of property.
    (v) Disposal of the part. The taxpayer must deduct the amounts 
included in the basis of the part under paragraphs (e)(2)(ii)(B) and 
(e)(2)(iii) of this section, to the extent that those amounts have not 
been previously deducted under paragraph (e)(2)(iv) of this section, in 
the taxable year in which the part is disposed of by the taxpayer.
    (f) Application of de minimis safe harbor. If a taxpayer elects to 
apply the de minimis safe harbor under Sec.  1.263(a)-1(f) to amounts 
paid for the production or acquisition of tangible property, then the 
taxpayer must apply the de minimis safe harbor to amounts paid for all 
materials and supplies that meet the requirements of Sec.  1.263(a)-
1(f), except for those materials and supplies that

[[Page 189]]

the taxpayer elects to capitalize and depreciate under paragraph (d) of 
this section or for which the taxpayer properly uses the optional method 
of accounting for rotable and temporary spare parts under paragraph (e) 
of this section. If the taxpayer properly applies the de minimis safe 
harbor under Sec.  1.263(a)-1(f) to amounts paid for materials and 
supplies, then these amounts are not treated as amounts paid for 
materials and supplies under this section. See Sec.  1.263(a)-1(f)(5) 
for the time and manner of electing the de minimis safe harbor and Sec.  
1.263(a)-1(f)(3)(iv) for the treatment of safe harbor amounts.
    (g) Sale or disposition of materials and supplies. Upon sale or 
other disposition, materials and supplies as defined in this section are 
not treated as a capital asset under section 1221 or as property used in 
the trade or business under section 1231. Any asset for which the 
taxpayer makes the election to capitalize and depreciate under paragraph 
(d) of this section shall not be treated as a material or supply, and 
the recognition and character of the gain or loss for such depreciable 
asset are determined under other applicable provisions of the Code.
    (h) Examples. The rules of this section are illustrated by the 
following examples, in which it is assumed, unless otherwise stated, 
that the property is not an incidental material or supply, that the 
taxpayer computes its income on a calendar year basis, that the taxpayer 
does not make the election to apply paragraph (d) of this section, or 
use the method of accounting described in paragraph (e) of this section, 
and that the taxpayer has not elected to apply the de minimis safe 
harbor under Sec.  1.263(a)-1(f). The following examples illustrate only 
the application of this section and, unless otherwise stated, do not 
address the treatment under other provisions of the Code (for example, 
section 263A).

    Example 1 Non-rotable components. A owns a fleet of aircraft that it 
operates in its business. In Year 1, A purchases a stock of spare parts, 
which it uses to maintain and repair its aircraft. A keeps a record of 
consumption of these spare parts. In Year 2, A uses the spare parts for 
the repair and maintenance of one of its aircraft. Assume each aircraft 
is a unit of property under Sec.  1.263(a)-3(e) and that spare parts are 
not rotable or temporary spare parts under paragraph (c)(2) of this 
section. Assume these repair and maintenance activities do not improve 
the aircraft under Sec.  1.263(a)-3. These parts are materials and 
supplies under paragraph (c)(1)(i) of this section because they are 
components acquired and used to maintain and repair A's aircraft. Under 
paragraph (a)(1) of this section, the amounts that A paid for the spare 
parts in Year 1 are deductible in Year 2, the taxable year in which the 
spare parts are first used to repair and maintain the aircraft.
    Example 2 Rotable spare parts; disposal method. B operates a fleet 
of specialized vehicles that it uses in its service business. Assume 
that each vehicle is a unit of property under Sec.  1.263(a)-3(e). At 
the time that it acquires a new type of vehicle, B also acquires a 
substantial number of rotable spare parts that it will keep on hand to 
quickly replace similar parts in B's vehicles as those parts break down 
or wear out. These rotable parts are removable from the vehicles and are 
repaired so that they can be reinstalled on the same or similar 
vehicles. In Year 1, B acquires several vehicles and a number of rotable 
spare parts to be used as replacement parts in these vehicles. In Year 
2, B repairs several vehicles by using these rotable spare parts to 
replace worn or damaged parts. In Year 3, B removes these rotable spare 
parts from its vehicles, repairs the parts, and reinstalls them on other 
similar vehicles. In Year 5, B can no longer use the rotable parts it 
acquired in Year 1 and disposes of them as scrap. Assume that B does not 
improve any of the rotable spare parts under Sec.  1.263(a)-3. Under 
paragraph (c)(1)(i) of this section, the rotable spare parts acquired in 
Year 1 are materials and supplies. Under paragraph (a)(3) of this 
section, rotable spare parts are generally used or consumed in the 
taxable year in which the taxpayer disposes of the parts. Therefore, 
under paragraph (a)(1) of this section, the amounts that B paid for the 
rotable spare parts in Year 1 are deductible in Year 5, the taxable year 
in which B disposes of the parts.
    Example 3 Rotable spare parts; application of optional method of 
accounting. C operates a fleet of specialized vehicles that it uses in 
its service business. Assume that each vehicle is a unit of property 
under Sec.  1.263(a)-3(e). At the time that it acquires a new type of 
vehicle, C also acquires a substantial number of rotable spare parts 
that it will keep on hand to replace similar parts in C's vehicles as 
those parts break down or wear out. These rotable parts are removable 
from the vehicles and are repaired so that they can be reinstalled on 
the same or similar vehicles. C uses the optional method of accounting 
for all its rotable and temporary spare parts under paragraph (e) of 
this section. In Year 1, C acquires several vehicles and a number of 
rotable spare parts (the ``Year 1 rotable parts'') to be used as 
replacement parts in

[[Page 190]]

these vehicles. In Year 2, C repairs several vehicles and uses the Year 
1 rotable parts to replace worn or damaged parts. In Year 3, C pays 
amounts to remove these Year 1 rotable parts from its vehicles. In Year 
4, C pays amounts to maintain, repair, or improve the Year 1 rotable 
parts. In Year 5, C pays amounts to reinstall the Year 1 rotable parts 
on other similar vehicles. In Year 8, C removes the Year 1 rotable parts 
from these vehicles and stores these parts for possible later use. In 
Year 9, C disposes of the Year 1 rotable parts. Under paragraph (e) of 
this section, C must deduct the amounts paid to acquire and install the 
Year 1 rotable parts in Year 2, the taxable year in which the rotable 
parts are first installed by C in C's vehicles. In Year 3, when C 
removes the Year 1 rotable parts from its vehicles, C must include in 
its gross income the fair market value of each part. Also, in Year 3, C 
must include in the basis of each Year 1 rotable part the fair market 
value of the rotable part and the amount paid to remove the rotable part 
from the vehicle. In Year 4, C must include in the basis of each Year 1 
rotable part the amounts paid to maintain, repair, or improve each 
rotable part. In Year 5, the year that C reinstalls the Year 1 rotable 
parts (as repaired or improved) in other vehicles, C must deduct the 
reinstallation costs and the amounts previously included in the basis of 
each part. In Year 8, the year that C removes the Year 1 rotable parts 
from the vehicles, C must include in income the fair market value of 
each rotable part removed. In addition, in Year 8, C must include in the 
basis of each part the fair market value of that part and the amount 
paid to remove each rotable part from the vehicle. In Year 9, the year 
that C disposes of the Year 1 rotable parts, C may deduct the amounts 
remaining in the basis of each rotable part.
    Example 4 Rotable part acquired as part of a single unit of 
property; not material or supply. D operates a fleet of aircraft. In 
Year 1, D acquires a new aircraft, which includes two new aircraft 
engines. The aircraft costs $500,000 and has an economic useful life of 
more than 12 months, beginning when it is placed in service. In Year 5, 
after the aircraft is operated for several years in D's business, D 
removes the engines from the aircraft, repairs or improves the engines, 
and either reinstalls the engines on a similar aircraft or stores the 
engines for later reinstallation. Assume the aircraft purchased in Year 
1, including its two engines, is a unit of property under Sec.  
1.263(a)-3(e). Because the engines were acquired as part of the 
aircraft, a single unit of property, the engines are not materials or 
supplies under paragraph (c)(1)(i) of this section nor rotable or 
temporary spare parts under paragraph (c)(2) of this section. 
Accordingly, D may not apply the rules of this section to the aircraft 
engines upon the original acquisition of the aircraft nor after the 
removal of the engines from the aircraft for use in the same or similar 
aircraft. Rather, D must apply the rules under Sec. Sec.  1.263(a)-2 and 
1.263(a)-3 to the aircraft, including its engines, to determine the 
treatment of amounts paid to acquire, produce, or improve the unit of 
property.
    Example 5 Consumable property. E operates a fleet of aircraft that 
carries freight for its customers. E has several storage tanks on its 
premises, which hold jet fuel for its aircraft. Assume that once the jet 
fuel is placed in E's aircraft, the jet fuel is reasonably expected to 
be consumed within 12 months or less. On December 31, Year 1, E 
purchases a two-year supply of jet fuel. In Year 2, E uses a portion of 
the jet fuel purchased on December 31, Year 1, to fuel the aircraft used 
in its business. The jet fuel that E purchased in Year 1 is a material 
or supply under paragraph (c)(1)(ii) of this section because it is 
reasonably expected to be consumed within 12 months or less from the 
time it is placed in E's aircraft. Under paragraph (a)(1) of this 
section, E may deduct in Year 2 the amounts paid for the portion of jet 
fuel used in the operation of E's aircraft in Year 2.
    Example 6 Unit of property that costs $200 or less. F operates a 
business that rents out a variety of small individual items to customers 
(rental items). F maintains a supply of rental items on hand. In Year 1, 
F purchases a large quantity of rental items to use in its rental 
business. Assume that each rental item is a unit of property under Sec.  
1.263(a)-3(e) and costs $200 or less. In Year 2, F begins using all the 
rental items purchased in Year 1 by providing them to customers of its 
rental business. F does not sell or exchange these items on established 
retail markets at any time after the items are used in the rental 
business. The rental items are materials and supplies under paragraph 
(c)(1)(iv) of this section. Under paragraph (a)(1) of this section, the 
amounts that F paid for the rental items in Year 1 are deductible in 
Year 2, the taxable year in which the rental items are first used in F's 
business.
    Example 7 Unit of property that costs $200 or less. G provides 
billing services to its customers. In Year 1, G pays amounts to purchase 
50 scanners to be used by its employees. Assume each scanner is a unit 
of property under Sec.  1.263(a)-3(e) and costs less than $200. In Year 
1, G's employees begin using 35 of the scanners, and F stores the 
remaining 15 scanners for use in a later taxable year. The scanners are 
materials and supplies under paragraph (c)(1)(iv) of this section. Under 
paragraph (a)(1) of this section, the amounts G paid for 35 of the 
scanners are deductible in Year 1, the taxable year in which G first 
uses each of those scanners. The amounts that G paid for each of the 
remaining 15 scanners are deductible in the taxable

[[Page 191]]

year in which each machine is first used in G's business.
    Example 8 Materials and supplies that cost less than $200; de 
minimis safe harbor. Assume the same facts as in Example 7 except that 
G's scanners qualify for the de minimis safe harbor under Sec.  
1.263(a)-1(f), and G properly elects to apply the de minimis safe harbor 
under Sec.  1.263(a)-1(f) to amounts paid in Year 1. G must apply the de 
minimis safe harbor under Sec.  1.263(a)-1(f) to amounts paid for the 
scanners, rather than treat these amounts as costs of materials and 
supplies under this section. In accordance with Sec.  1.263(a)-
1(f)(3)(iv), G may deduct the amounts paid for all 50 scanners under 
Sec.  1.162-1 in the taxable year the amounts are paid.
    Example 9 Unit of property that costs $200 or less; bulk purchase. H 
provides consulting services to its customers. In Year 1, H pays $500 to 
purchase one box of 10 toner cartridges to use as needed for H's 
printers. Assume each toner cartridge is a unit of property under Sec.  
1.263(a)-3(e). In Year 1, H's employees place 8 of the toner cartridges 
in printers in H's office, and store the remaining 2 cartridges for use 
in a later taxable year. The toner cartridges are materials and supplies 
under paragraph (c)(1)(iv) of this section because even though purchased 
in one box costing more than $200, the allocable cost of each unit of 
property equals $50. Therefore, under paragraph (a)(1) of this section, 
the $400 paid by H for 8 of the cartridges is deductible in Year 1, the 
taxable year in which H first uses each of those cartridges. The amounts 
paid by H for each of the remaining 2 cartridges ($50 each) are 
deductible in the taxable year in which each cartridge is first used in 
H's business.
    Example 10 Materials and supplies used in improvements; coordination 
with Sec.  1.263(a)-3. J owns various machines that are used in its 
business. Assume that each machine is a unit of property under Sec.  
1.263(a)-3(e). In Year 1, J purchases a supply of spare parts for its 
machines. J acquired the parts to use in the repair or maintenance of 
the machines under Sec.  1.162-4 or in the improvement of the machines 
under Sec.  1.263(a)-3. The spare parts are not rotable or temporary 
spare parts under paragraph (c)(2) of this section. In Year 2, J uses 
all of these spare parts in an activity that improves a machine under 
Sec.  1.263(a)-3. Under paragraph (c)(1)(i) of this section, the spare 
parts purchased by J in Year 1 are materials and supplies. Under 
paragraph (a)(1) of this section, the amounts paid for the spare parts 
are otherwise deductible as materials and supplies in Year 2, the 
taxable year in which J uses those parts. However, because these 
materials and supplies are used to improve J's machine, J is required to 
capitalize the amounts paid for those spare parts under Sec.  1.263(a)-
3.
    Example 11 Cost of producing materials and supplies; coordination 
with section 263A. K is a manufacturer that produces liquid waste as 
part of its operations. K determines that its current liquid waste 
disposal process is inadequate. To remedy the problem, in Year 1, K 
constructs a leaching pit to provide a draining area for the liquid 
waste. Assume the leaching pit is a unit of property under Sec.  
1.263(a)-3(e) and has an economic useful life of 12 months or less, 
starting on the date that K begins to use the leaching pit as a draining 
area. At the end of this period, K's factory will be connected to the 
local sewer system. In Year 2, K starts using the leaching pit in its 
operations. The amounts paid to construct the leaching pit (including 
the direct and allocable indirect costs of property produced under 
section 263A) are amounts paid for a material or supply under paragraph 
(c)(1)(iii) of this section. However, the amounts paid to construct the 
leaching pit may be subject to capitalization under section 263A if 
these amounts comprise the direct or allocable indirect costs of 
property produced by K.
    Example 12 Costs of acquiring materials and supplies for production 
of property; coordination with section 263A. In Year 1, L purchases 
jigs, dies, molds, and patterns for use in the manufacture of L's 
products. Assume each jig, die, mold, and pattern is a unit of property 
under Sec.  1.263(a)-3(e). The economic useful life of each jig, die, 
mold, and pattern is 12 months or less, beginning when each item is used 
in the manufacturing process. The jigs, dies, molds, and patterns are 
not components acquired to maintain, repair, or improve any of L's 
equipment under paragraph (c)(1)(i) of this section. L begins using the 
jigs, dies, molds and patterns in Year 2 to manufacture its products. 
These items are materials and supplies under paragraph (c)(1)(iii) of 
this section. Under paragraph (a)(1) of this section, the amounts paid 
for the items are otherwise deductible in Year 2, the taxable year in 
which L first uses those items. However, the amounts paid for these 
materials and supplies may be subject to capitalization under section 
263A if these amounts comprise the direct or allocable indirect costs of 
property produced by L.
    Example 13 Election to capitalize and depreciate. M is in the mining 
business. M acquires certain temporary spare parts, which it keeps on 
hand to avoid operational time loss in the event it must make temporary 
repairs to a unit of property that is subject to depreciation. These 
parts are not used to improve property under Sec.  1.263(a)-3(d). These 
temporary spare parts are used until a new or repaired part can be 
installed and then are removed and stored for later temporary 
installation. M does not use the optional method of accounting for 
rotable and temporary spare parts in paragraph (e) of this section for 
any of its rotable or temporary spare parts. The temporary spare parts 
are materials and supplies under paragraph (c)(1)(i) of

[[Page 192]]

this section. Under paragraphs (a)(1) and (a)(3) of this section, the 
amounts paid for the temporary spare parts are deductible in the taxable 
year in which they are disposed of by M. However, because it is unlikely 
that the temporary spare parts will be disposed of in the near future, M 
would prefer to treat the amounts paid for the spare parts as capital 
expenditures subject to depreciation. M may elect under paragraph (d) of 
this section to treat the cost of each temporary spare part as a capital 
expenditure and as an asset subject to an allowance for depreciation. M 
makes this election by capitalizing the amounts paid for each spare part 
in the taxable year that M acquires the spare parts and by beginning to 
recover the costs of each part on its timely filed Federal tax return 
for the taxable year in which the part is placed in service for purposes 
of determining depreciation under the applicable provisions of the 
Internal Revenue Code and the Treasury Regulations. See Sec.  1.263(a)-
2(g) for the treatment of capital expenditures.
    Example 14 Election to apply de minimis safe harbor. (i) N provides 
consulting services to its customers. In Year 1, N pays amounts to 
purchase 50 laptop computers. Each laptop computer is a unit of property 
under Sec.  1.263(a)-3(e), costs $400, and has an economic useful life 
of more than 12 months. Also in Year 1, N purchases 50 office chairs to 
be used by its employees. Each office chair is a unit of property that 
costs $100. N has an applicable financial statement (as defined in Sec.  
1.263(a)-1(f)(4)) and N has a written accounting policy at the beginning 
Year 1 to expense amounts paid for units of property costing $500 or 
less. N treats amounts paid for property costing $500 or less as an 
expense on its applicable financial statement in Year 1.
    (ii) The laptop computers are not materials or supplies under 
paragraph (c) of this section. Therefore, the amounts N pays for the 
computers must generally be capitalized under Sec.  1.263(a)-2(d) as 
amounts paid for the acquisition of tangible property. The office chairs 
are materials and supplies under paragraph (c)(1)(iv) of this section. 
Thus, under paragraph (a)(1) of this section, the amounts paid for the 
office chairs are deductible in the taxable year in which they are first 
used in N's business. However, under paragraph (f) of this section, if N 
properly elects to apply the de minimis safe harbor under Sec.  
1.263(a)-1(f) to amounts paid in Year 1, then N must apply the de 
minimis safe harbor under Sec.  1.263(a)-1(f) to amounts paid for the 
computers and the office chairs, rather than treat the office chairs as 
the costs of materials and supplies under Sec.  1.162-3. Under the de 
minimis safe harbor, N may not capitalize the amounts paid for the 
computers under Sec.  1.263(a)-2 nor treat the office chairs as 
materials and supplies under Sec.  1.162-3. Instead, in accordance with 
Sec.  1.263(a)-1(f)(3)(iv), under Sec.  1.162-1, N may deduct the 
amounts paid for the computers and the office chairs in the taxable year 
paid.

    (i) Accounting method changes. Except as otherwise provided in this 
section, a change to comply with this section is a change in method of 
accounting to which the provisions of sections 446 and 481 and the 
accompanying regulations apply. A taxpayer seeking to change to a method 
of accounting permitted in this section must secure the consent of the 
Commissioner in accordance with Sec.  1.446-1(e) and follow the 
administrative procedures issued under Sec.  1.446-1(e)(3)(ii) for 
obtaining the Commissioner's consent to change its accounting method.
    (j) Effective/applicability date--(1) In general. This section 
generally applies to amounts paid or incurred in taxable years beginning 
on or after January 1, 2014. However, a taxpayer may apply paragraph (e) 
of this section (the optional method of accounting for rotable and 
temporary spare parts) to taxable years beginning on or after January 1, 
2014. Except as provided in paragraphs (j)(2) and (j)(3) of this 
section, Sec.  1.162-3 as contained in 26 CFR part 1 edition revised as 
of April 1, 2011, applies to taxable years beginning before January 1, 
2014.
    (2) Early application of this section--(i) In general. Except for 
paragraph (e) of this section, a taxpayer may choose to apply this 
section to amounts paid or incurred in taxable years beginning on or 
after January 1, 2012. A taxpayer may choose to apply paragraph (e) of 
this section (the optional method of accounting for rotable and 
temporary spare parts) to taxable years beginning on or after January 1, 
2012.
    (ii) Transition rule for election to capitalize materials and 
supplies on 2012 and 2013 returns. If under paragraph (j)(2)(i) of this 
section, a taxpayer chooses to make the election to capitalize and 
depreciate certain materials and supplies under paragraph (d) of this 
section for its taxable year beginning on or after January 1, 2012, and 
ending on or before September 19, 2013 (applicable taxable year), and 
the taxpayer did not make the election specified in paragraph (d)(3) of 
this section on its timely filed original Federal tax return for the 
applicable taxable year, the taxpayer must make the election specified 
in

[[Page 193]]

paragraph (d)(3) of this section for the applicable taxable year by 
filing an amended Federal tax return for the applicable taxable year on 
or before 180 days from the due date including extensions of the 
taxpayer's Federal tax return for the applicable taxable year, 
notwithstanding that the taxpayer may not have extended the due date.
    (3) Optional application of TD 9564. Except for Sec.  1.162-3T(e), a 
taxpayer may choose to apply Sec.  1.162-3T as contained in TD 9564 (76 
FR 81060) December 27, 2011, to amounts paid or incurred (to acquire or 
produce property) in taxable years beginning on or after January 1, 
2012, and before January 1, 2014. In applying Sec.  1.162-3T(d)(3), as 
contained in 26 CFR part 1, revised as of April 1, 2013, a taxpayer 
makes the election under Sec.  1.162-3T(d) by capitalizing the amounts 
paid to acquire or produce a material or supply in the taxable year the 
amounts are paid and by beginning to depreciate the costs when the asset 
is placed in service by the taxpayer for purposes of determining 
depreciation under the applicable provisions of the Internal Revenue 
Code and the Treasury Regulations. The election under Sec.  1.162-3T(d), 
as contained in 26 CFR part 1, revised as of April 1, 2013, does not 
apply to an asset or a portion thereof placed in service and disposed of 
in the same taxable year. A taxpayer may choose to apply Sec.  1.162-
3T(e) (the optional method of accounting for rotable and temporary spare 
parts) as contained in TD 9564 (76 FR 81060) December 27, 2011, to 
taxable years beginning on or after January 1, 2012, and before January 
1, 2014.

[T.D. 9636, 78 FR 57701, Sept. 19, 2013, as amended at 79 FR 42190, July 
21, 2014]



Sec.  1.162-4  Repairs.

    (a) In general. A taxpayer may deduct amounts paid for repairs and 
maintenance to tangible property if the amounts paid are not otherwise 
required to be capitalized. Optionally, Sec.  1.263(a)-3(n) provides an 
election to capitalize amounts paid for repair and maintenance 
consistent with the taxpayer's books and records.
    (b) Accounting method changes. A change to comply with this section 
is a change in method of accounting to which the provisions of sections 
446 and 481 and the accompanying regulations apply. A taxpayer seeking 
to change to a method of accounting permitted in this section must 
secure the consent of the Commissioner in accordance with Sec.  1.446-
1(e) and follow the administrative procedures issued under Sec.  1.446-
1(e)(3)(ii) for obtaining the Commissioner's consent to change its 
accounting method.
    (c) Effective/applicability date--(1) In general. This section 
applies to taxable years beginning on or after January 1, 2014. Except 
as provided in paragraphs (c)(2) and (c)(3) of this section, Sec.  
1.162-4 as contained in 26 CFR part 1 edition revised as of April 1, 
2011, applies to taxable years beginning before January 1, 2014.
    (2) Early application of this section. A taxpayer may choose to 
apply this section to taxable years beginning on or after January 1, 
2012.
    (3) Optional application of TD 9564. A taxpayer may choose to apply 
Sec.  1.162-4T as contained in TD 9564 (76 FR 81060), December 27, 2011, 
to taxable years beginning on or after January 1, 2012, and before 
January 1, 2014.

[T.D. 9636, 78 FR 57705, Sept. 19, 2013, as amended at 79 FR 42191, July 
21, 2014]



Sec.  1.162-5  Expenses for education.

    (a) General rule. Expenditures made by an individual for education 
(including research undertaken as part of his educational program) which 
are not expenditures of a type described in paragraph (b) (2) or (3) of 
this section are deductible as ordinary and necessary business expenses 
(even though the education may lead to a degree) if the education--
    (1) Maintains or improves skills required by the individual in his 
employment or other trade or business, or
    (2) Meets the express requirements of the individual's employer, or 
the requirements of applicable law or regulations, imposed as a 
condition to the retention by the individual of an established 
employment relationship, status, or rate of compensation.
    (b) Nondeductible educational expenditures--(1) In general. 
Educational expenditures described in subparagraphs (2) and (3) of this 
paragraph are personal expenditures or constitute an inseparable 
aggregate of personal and

[[Page 194]]

capital expenditures and, therefore, are not deductible as ordinary and 
necessary business expenses even though the education may maintain or 
improve skills required by the individual in his employment or other 
trade or business or may meet the express requirements of the 
individual's employer or of applicable law or regulations.
    (2) Minimum educational requirements. (i) The first category of 
nondeductible educational expenses within the scope of subparagraph (1) 
of this paragraph are expenditures made by an individual for education 
which is required of him in order to meet the minimum educational 
requirements for qualification in his employment or other trade or 
business. The minimum education necessary to qualify for a position or 
other trade or business must be determined from a consideration of such 
factors as the requirements of the employer, the applicable law and 
regulations, and the standards of the profession, trade, or business 
involved. The fact that an individual is already performing service in 
an employment status does not establish that he has met the minimum 
educational requirements for qualification in that employment. Once an 
individual has met the minimum educational requirements for 
qualification in his employment or other trade or business (as in effect 
when he enters the employment or trade or business), he shall be treated 
as continuing to meet those requirements even though they are changed.
    (ii) The minimum educational requirements for qualification of a 
particular individual in a position in an educational institution is the 
minimum level of education (in terms of aggregate college hours or 
degree) which under the applicable laws or regulations, in effect at the 
time this individual is first employed in such position, is normally 
required of an individual initially being employed in such a position. 
If there are no normal requirements as to the minimum level of education 
required for a position in an educational institution, then an 
individual in such a position shall be considered to have met the 
minimum educational requirements for qualification in that position when 
he becomes a member of the faculty of the educational institution. The 
determination of whether an individual is a member of the faculty of an 
educational institution must be made on the basis of the particular 
practices of the institution. However, an individual will ordinarily be 
considered to be a member of the faculty of an institution if (a) he has 
tenure or his years of service are being counted toward obtaining 
tenure; (b) the institution is making contributions to a retirement plan 
(other than Social Security or a similar program) in respect of his 
employment; or (c) he has a vote in faculty affairs.
    (iii) The application of this subparagraph may be illustrated by the 
following examples:

    Example 1. General facts:State X requires a bachelor's degree for 
beginning secondary school teachers which must include 30 credit hours 
of professional educational courses. In addition, in order to retain his 
position, a secondary school teacher must complete a fifth year of 
preparation within 10 years after beginning his employment. If an 
employing school official certifies to the State Department of Education 
that applicants having a bachelor's degree and the required courses in 
professional education cannot be found, he may hire individuals as 
secondary school teachers if they have completed a minimum of 90 
semester hours of college work. However, to be retained in his position, 
such an individual must obtain his bachelor's degree and complete the 
required professional educational courses within 3 years after his 
employment commences. Under these facts, a bachelor's degree, without 
regard to whether it includes 30 credit hours of professional 
educational courses, is considered to be the minimum educational 
requirement for qualification as a secondary school teacher in State X. 
This is the case notwithstanding the number of teachers who are actually 
hired without such a degree. The following are examples of the 
application of these facts in particular situations:
    Situation 1. A, at the time he is employed as a secondary school 
teacher in State X, has a bachelor's degree including 30 credit hours of 
professional educational courses. After his employment, A completes a 
fifth college year of education and, as a result, is issued a standard 
certificate. The fifth college year of education undertaken by A is not 
education required to meet the minimum educational requirements for 
qualification as a secondary school teacher. Accordingly, the 
expenditures for such education are deductible unless the expenditures 
are for education which is part of a program of study

[[Page 195]]

being pursued by A which will lead to qualifying him in a new trade or 
business.
    Situation 2. Because of a shortage of applicants meeting the stated 
requirements, B, who has a bachelor's degree, is employed as a secondary 
school teacher in State X even though he has only 20 credit hours of 
professional educational courses. After his employment, B takes an 
additional 10 credit hours of professional educational courses. Since 
these courses do not constitute education required to meet the minimum 
educational requirements for qualification as a secondary school teacher 
which is a bachelor's degree and will not lead to qualifying B in a new 
trade or business, the expenditures for such courses are deductible.
    Situation 3. Because of a shortage of applicants meeting the stated 
requirements, C is employed as a secondary school teacher in State X 
although he has only 90 semester hours of college work toward his 
bachelor's degree. After his employment, C undertakes courses leading to 
a bachelor's degree. These courses (including any courses in 
professional education) constitute education required to meet the 
minimum educational requirements for qualification as a secondary school 
teacher. Accordingly, the expenditures for such education are not 
deductible.
    Situation 4. Subsequent to the employment of A, B, and C, but before 
they have completed a fifth college year of education, State X changes 
its requirements affecting secondary school teachers to provide that 
beginning teachers must have completed 5 college years of preparation. 
In the cases of A, B, and C, a fifth college year of education is not 
considered to be education undertaken to meet the minimum educational 
requirements for qualifications as a secondary school teacher. 
Accordingly, expenditures for a fifth year of college will be deductible 
unless the expenditures are for education which is part of a program 
being pursued by A, B, or C which will lead to qualifying him in a new 
trade or business.
    Example 2. D, who holds a bachelor's degree, obtains temporary 
employment as an instructor at University Y and undertakes graduate 
courses as a candidate for a graduate degree. D may become a faculty 
member only if he obtains a graduate degree and may continue to hold a 
position as instructor only so long as he shows satisfactory progress 
towards obtaining this graduate degree. The graduate courses taken by D 
constitute education required to meet the minimum educational 
requirements for qualification in D's trade or business and, thus, the 
expenditures for such courses are not deductible.
    Example 3. E, who has completed 2 years of a normal 3-year law 
school course leading to a bachelor of laws degree (LL.B.), is hired by 
a law firm to do legal research and perform other functions on a full-
time basis. As a condition to continued employment, E is required to 
obtain an LL.B. and pass the State bar examination. E completes his law 
school education by attending night law school, and he takes a bar 
review course in order to prepare for the State bar examination. The law 
courses and bar review course constitute education required to meet the 
minimum educational requirements for qualification in E's trade or 
business and, thus, the expenditures for such courses are not 
deductible.

    (3) Qualification for new trade or business. (i) The second category 
of nondeductible educational expenses within the scope of subparagraph 
(1) of this paragraph are expenditures made by an individual for 
education which is part of a program of study being pursued by him which 
will lead to qualifying him in a new trade or business. In the case of 
an employee, a change of duties does not constitute a new trade or 
business if the new duties involve the same general type of work as is 
involved in the individual's present employment. For this purpose, all 
teaching and related duties shall be considered to involve the same 
general type of work. The following are examples of changes in duties 
which do not constitute new trades or businesses:
    (a) Elementary to secondary school classroom teacher.
    (b) Classroom teacher in one subject (such as mathematics) to 
classroom teacher in another subject (such as science).
    (c) Classroom teacher to guidance counselor.
    (d) Classroom teacher to principal.
    (ii) The application of this subparagraph to individuals other than 
teachers may be illustrated by the following examples:

    Example 1. A, a self-employed individual practicing a profession 
other than law, for example, engineering, accounting, etc., attends law 
school at night and after completing his law school studies receives a 
bachelor of laws degree. The expenditures made by A in attending law 
school are nondeductible because this course of study qualifies him for 
a new trade or business.
    Example 2. Assume the same facts as in example (1) except that A has 
the status of an employee rather than a self-employed individual, and 
that his employer requires him to obtain a bachelor of laws degree. A 
intends to continue practicing his nonlegal profession as an employee of 
such employer. Nevertheless, the expenditures made by A in

[[Page 196]]

attending law school are not deductible since this course of study 
qualifies him for a new trade or business.
    Example 3. B, a general practitioner of medicine, takes a 2-week 
course reviewing new developments in several specialized fields of 
medicine. B's expenses for the course are deductible because the course 
maintains or improves skills required by him in his trade or business 
and does not qualify him for a new trade or business.
    Example 4. C, while engaged in the private practice of psychiatry, 
undertakes a program of study and training at an accredited 
psychoanalytic institute which will lead to qualifying him to practice 
psychoanalysis. C's expenditures for such study and training are 
deductible because the study and training maintains or improves skills 
required by him in his trade or business and does not qualify him for a 
new trade or business.

    (c) Deductible educational expenditures--(1) Maintaining or 
improving skills. The deduction under the category of expenditures for 
education which maintains or improves skills required by the individual 
in his employment or other trade or business includes refresher courses 
or courses dealing with current developments as well as academic or 
vocational courses provided the expenditures for the courses are not 
within either category of nondeductible expenditures described in 
paragraph (b) (2) or (3) of this section.
    (2) Meeting requirements of employer. An individual is considered to 
have undertaken education in order to meet the express requirements of 
his employer, or the requirements of applicable law or regulations, 
imposed as a condition to the retention by the taxpayer of his 
established employment relationship, status, or rate of compensation 
only if such requirements are imposed for a bona fide business purpose 
of the individual's employer. Only the minimum education necessary to 
the retention by the individual of his established employment 
relationship, status, or rate of compensation may be considered as 
undertaken to meet the express requirements of the taxpayer's employer. 
However, education in excess of such minimum education may qualify as 
education undertaken in order to maintain or improve the skills required 
by the taxpayer in his employment or other trade or business (see 
subparagraph (1) of this paragraph). In no event, however, is a 
deduction allowable for expenditures for education which, even though 
for education required by the employer or applicable law or regulations, 
are within one of the categories of nondeductible expenditures described 
in paragraph (b) (2) and (3) of this section.
    (d) Travel as a form of education. Subject to the provisions of 
paragraph (b) and (e) of this section, expenditures for travel 
(including travel while on sabbatical leave) as a form of education are 
deductible only to the extent such expenditures are attributable to a 
period of travel that is directly related to the duties of the 
individual in his employment or other trade or business. For this 
purpose, a period of travel shall be considered directly related to the 
duties of an individual in his employment or other trade or business 
only if the major portion of the activities during such period is of a 
nature which directly maintains or improves skills required by the 
individual in such employment or other trade or business. The approval 
of a travel program by an employer or the fact that travel is accepted 
by an employer in the fulfillment of its requirements for retention of 
rate of compensation, status or employment, is not determinative that 
the required relationship exists between the travel involved and the 
duties of the individual in his particular position.
    (e) Travel away from home. (1) If an individual travels away from 
home primarily to obtain education the expenses of which are deductible 
under this section, his expenditures for travel, meals, and lodging 
while away from home are deductible. However, if as an incident of such 
trip the individual engages in some personal activity such as 
sightseeing, social visiting, or entertaining, or other recreation, the 
portion of the expenses attributable to such personal activity 
constitutes nondeductible personal or living expenses and is not 
allowable as a deduction. If the individual's travel away from home is 
primarily personal, the individual's expenditures for travel, meals and 
lodging (other than meals and lodging during the time spent in 
participating in deductible education pursuits) are

[[Page 197]]

not deductible. Whether a particular trip is primarily person or 
primarily to obtain education the expenses of which are deductible under 
this section depends upon all the facts and circumstances of each case. 
An important factor to be taken into consideration in making the 
determination is the relative amount of time devoted to personal 
activity as compared with the time devoted to educational pursuits. The 
rules set forth in this paragraph are subject to the provisions of 
section 162(a)(2), relating to deductibility of certain traveling 
expenses, and section 274 (c) and (d), relating to allocation of certain 
foreign travel expenses and substantiation required, respectively, and 
the regulations thereunder.
    (2) Examples. The application of this subsection may be illustrated 
by the following examples:

    Example 1. A, a self-employed tax practitioner, decides to take a 1-
week course in new developments in taxation, which is offered in City X, 
500 miles away from his home. His primary purpose in going to X is to 
take the course, but he also takes a side trip to City Y (50 miles from 
X) for 1 day, takes a sightseeing trip while in X, and entertains some 
personal friends. A's transportation expenses to City X and return to 
his home are deductible but his transportation expenses to City Y are 
not deductible. A's expenses for meals and lodging while away from home 
will be allocated between his educational pursuits and his personal 
activities. Those expenses which are entirely personal, such as 
sightseeing and entertaining friends, are not deductible to any extent.
    Example 2. The facts are the same as in example (1) except that A's 
primary purpose in going to City X is to take a vacation. This purpose 
is indicated by several factors, one of which is the fact that he spends 
only 1 week attending the tax course and devotes 5 weeks entirely to 
personal activities. None of A's transportation expenses are deductible 
and his expenses for meals and lodging while away from home are not 
deductible to the extent attributable to personal activities. His 
expenses for meals and lodging allocable to the week attending the tax 
course are, however, deductible.
    Example 3. B, a high school mathematics teacher in New York City, in 
the summertime travels to a university in California in order to take a 
mathematics course the expense of which is deductible under this 
section. B pursues only one-fourth of a full course of study and the 
remainder of her time is devoted to personal activities the expense of 
which is not deductible. Absent a showing by B of a substantial 
nonpersonal reason for taking the course in the university in 
California, the trip is considered taken primarily for personal reasons 
and the cost of traveling from New York City to California and return 
would not be deductible. However, one-fourth of the cost of B's meals 
and lodging while attending the university in California may be 
considered properly allocable to deductible educational pursuits and, 
therefore, is deductible.

[T.D. 6918, 32 FR 6679, May 2, 1967]



Sec.  1.162-7  Compensation for personal services.

    (a) There may be included among the ordinary and necessary expenses 
paid or incurred in carrying on any trade or business a reasonable 
allowance for salaries or other compensation for personal services 
actually rendered. The test of deductibility in the case of compensation 
payments is whether they are reasonable and are in fact payments purely 
for services.
    (b) The test set forth in paragraph (a) of this section and its 
practical application may be further stated and illustrated as follows:
    (1) Any amount paid in the form of compensation, but not in fact as 
the purchase price of services, is not deductible. An ostensible salary 
paid by a corporation may be a distribution of a dividend on stock. This 
is likely to occur in the case of a corporation having few shareholders, 
practically all of whom draw salaries. If in such a case the salaries 
are in excess of those ordinarily paid for similar services and the 
excessive payments correspond or bear a close relationship to the 
stockholdings of the officers or employees, it would seem likely that 
the salaries are not paid wholly for services rendered, but that the 
excessive payments are a distribution of earnings upon the stock. An 
ostensible salary may be in part payment for property. This may occur, 
for example, where a partnership sells out to a corporation, the former 
partners agreeing to continue in the service of the corporation. In such 
a case it may be found that the salaries of the former partners are not 
merely for services, but in part constitute payment for the transfer of 
their business.
    (2) The form or method of fixing compensation is not decisive as to 
deductibility. While any form of contingent

[[Page 198]]

compensation invites scrutiny as a possible distribution of earnings of 
the enterprise, it does not follow that payments on a contingent basis 
are to be treated fundamentally on any basis different from that 
applying to compensation at a flat rate. Generally speaking, if 
contingent compensation is paid pursuant to a free bargain between the 
employer and the individual made before the services are rendered, not 
influenced by any consideration on the part of the employer other than 
that of securing on fair and advantageous terms the services of the 
individual, it should be allowed as a deduction even though in the 
actual working out of the contract it may prove to be greater than the 
amount which would ordinarily be paid.
    (3) In any event the allowance for the compensation paid may not 
exceed what is reasonable under all the circumstances. It is, in 
general, just to assume that reasonable and true compensation is only 
such amount as would ordinarily be paid for like services by like 
enterprises under like circumstances. The circumstances to be taken into 
consideration are those existing at the date when the contract for 
services was made, not those existing at the date when the contract is 
questioned.
    (4) For disallowance of deduction in the case of certain transfers 
of stock pursuant to employees stock options, see section 421 and the 
regulations thereunder.



Sec.  1.162-8  Treatment of excessive compensation.

    The income tax liability of the recipient in respect of an amount 
ostensibly paid to him as compensation, but not allowed to be deducted 
as such by the payor, will depend upon the circumstances of each case. 
Thus, in the case of excessive payments by corporations, if such 
payments correspond or bear a close relationship to stockholdings, and 
are found to be a distribution of earnings or profits, the excessive 
payments will be treated as a dividend. If such payments constitute 
payment for property, they should be treated by the payor as a capital 
expenditure and by the recipient as part of the purchase price. In the 
absence of evidence to justify other treatment, excessive payments for 
salaries or other compensation for personal services will be included in 
gross income of the recipient.



Sec.  1.162-9  Bonuses to employees.

    Bonuses to employees will constitute allowable deductions from gross 
income when such payments are made in good faith and as additional 
compensation for the services actually rendered by the employees, 
provided such payments, when added to the stipulated salaries, do not 
exceed a reasonable compensation for the services rendered. It is 
immaterial whether such bonuses are paid in cash or in kind or partly in 
cash and partly in kind. Donations made to employees and others, which 
do not have in them the element of compensation or which are in excess 
of reasonable compensation for services, are not deductible from gross 
income.



Sec.  1.162-10  Certain employee benefits.

    (a) In general. Amounts paid or accrued by a taxpayer on account of 
injuries received by employees and lump sum amounts paid or accrued as 
compensation for injuries, are proper deductions as ordinary and 
necessary expenses. Such deductions are limited to the amount not 
compensated for by insurance or otherwise. Amounts paid or accrued 
within the taxable year for dismissal wages, unemployment benefits, 
guaranteed annual wages, vacations, or a sickness, accident, 
hospitalization, medical expense, recreational, welfare, or similar 
benefit plan, are deductible under section 162(a) if they are ordinary 
and necessary expenses of the trade or business. However, except as 
provided in paragraph (b) of this section, such amounts shall not be 
deductible under section 162(a) if, under any circumstances, they may be 
used to provide benefits under a stock bonus, pension, annuity, profit-
sharing, or other deferred compensation plan of the type referred to in 
section 404(a). In such an event, the extent to which these amounts are 
deductible from gross income shall be governed by the provisions of 
section 404 and the regulations issued thereunder.

[[Page 199]]

    (b) Certain negotiated plans. (1) Subject to the limitations set 
forth in subparagraphs (2) and (3) of this paragraph, contributions paid 
by an employer under a plan under which such contributions are held in a 
welfare trust for the purpose of paying (either from principal or income 
or both) for the benefit of employees, their families, and dependents, 
at least medical or hospital care, and pensions on retirement or death 
of employees, are deductible when paid as business expenses under 
section 162(a).
    (2) For the purpose of subparagraph (1) of this paragraph, the word 
``plan'' means any plan established prior to January 1, 1954, as a 
result of an agreement between employee representatives and the 
Government of the United States, during a period of Government 
operation, under seizure powers, of a major part of the productive 
facilities of the industry in which the employer claiming the deduction 
is engaged. The phrase ``plan established prior to January 1, 1954, as a 
result of an agreement'' is intended primarily to cover a trust 
established under the terms of such an agreement. It also includes a 
trust established under a plan of an employer, or group of employers, 
who, by reason of producing the same commodity, are in competition with 
the employers whose facilities were seized and who would therefore be 
expected to establish such a trust as a reasonable measure to maintain a 
sound position in the labor market producing the commodity. For example, 
if a trust was established under such an agreement in the bituminous 
coal industry, a similar trust established in the anthracite coal 
industry within a reasonable time, but before January 1, 1954, would 
qualify under subparagraph (1) of this paragraph.
    (3) If any trust described in subparagraph (2) of this paragraph 
becomes qualified for exemption from tax under the provisions of section 
501(a), the deductibility of contributions by an employer to such trust 
on or after any date of such qualification shall no longer be governed 
by the provisions of section 162, even though the trust may later lose 
its exemption from tax under section 501(a).
    (c) Other plans providing deferred compensation. For rules relating 
to the deduction of amounts paid to or under a stock bonus, pension, 
annuity, or profit-sharing plan or amounts paid or accrued under any 
other plan deferring the receipt of compensation, see section 404 and 
the regulations thereunder.



Sec.  1.162-10T  Questions and answers relating to the deduction 
of employee benefits under the Tax Reform Act of 1984; certain limits 
on amounts deductible (temporary).

    Q-1: How does the amendment of section 404(b) by the Tax Reform Act 
of 1984 affect the deduction of employee benefits under section 162 of 
the Internal Revenue Code?
    A-1: As amended by the Tax Reform Act of 1984, section 404(b) 
clarifies that section 404(a) and (d) (in the case of employees and 
nonemployees, respectively) shall govern the deduction of contributions 
paid or compensation paid or incurred under a plan, or method or 
arrangement, deferring the receipt of compensation or providing for 
deferred benefits. Section 404(a) and (d) requires that such a 
contribution or compensation be paid or incurred for purposes of section 
162 or 212 and satisfy the requirements for deductibility under either 
of these sections. However, notwithstanding the above, section 404 does 
not apply to contributions paid or accrued with respect to a ``welfare 
benefit fund'' (as defined in section 419(e)) after July 18, 1984, in 
taxable years of employers (and payors) ending after that date.
    Also, section 463 shall govern the deduction of vacation pay by a 
taxpayer that has elected the application of such section. Section 
404(b), as amended, generally applies to contributions paid and 
compensation paid or incurred after July 18, 1984, in taxable years of 
employers (and payors) ending after that date. See Q&A-3 of Sec.  
1.404(b)-1T. For rules relating to the deduction of contributions 
attributable to the provision of deferred benefits, see section 404 (a), 
(b) and (d) and Sec.  1.404(a)-1T, Sec.  1.404(b)-1T and Sec.  1.404(d)-
1T. For rules relating to the deduction of contributions paid or accrued 
with respect to a welfare benefit fund, see section 419,

[[Page 200]]

Sec.  1.419-1T and Sec.  1.419A-2T. For rules relating to the deduction 
of vacation pay for which an election is made under section 463, see 
Sec.  301.9100-16T of this chapter and Sec.  1.463-1T.
    Q-2: How does the enactment of section 419 by the Tax Reform Act of 
1984 affect the deduction of employee benefits under section 162?
    A-2: As enacted by the Tax Reform Act of 1984, section 419 shall 
govern the deduction of contributions paid or accrued by an employer (or 
a person receiving services under section 419(g)) with respect to a 
``welfare benefit fund'' (within the meaning of section 419(e)) after 
December 31, 1985, in taxable years of the employer (or person receiving 
the services) ending after that date. Section 419(a) requires that such 
a contribution be paid or accrued for purposes of section 162 or 212 and 
satisfy the requirements for deductibility under either of those 
sections. Generally, subject to a binding contract exception (as 
described in section 511(e)(5) of the Tax Reform Act of 1984), section 
419 shall also govern the deduction of the contribution of a facility 
(or other contribution used to acquire or improve a facility) to a 
welfare benefit fund after June 22, 1984. See Q&A-11 of Sec.  1.419-1T. 
In the case of a welfare benefit fund maintained pursuant to a 
collective bargaining agreement, section 419 applies to the extent 
provided under the special effective date rule described in Q&A-2 of 
Sec.  1.419-1T and the special rules of Sec.  1.419A-2T. For rules 
relating to the deduction of contributions paid or accrued with respect 
to a welfare benefit fund, see section 419 and Sec.  1.419-1T.

[T.D. 8073, 51 FR 4319, Feb. 4, 1986, as amended by T.D. 8435, 57 FR 
43896, Sept. 23, 1992]



Sec.  1.162-11  Rentals.

    (a) Acquisition of a leasehold. If a leasehold is acquired for 
business purposes for a specified sum, the purchaser may take as a 
deduction in his return an aliquot part of such sum each year, based on 
the number of years the lease has to run. Taxes paid by a tenant to or 
for a landlord for business property are additional rent and constitute 
a deductible item to the tenant and taxable income to the landlord, the 
amount of the tax being deductible by the latter. For disallowance of 
deduction for income taxes paid by a lessee corporation pursuant to a 
lease arrangement with the lessor corporation, see section 110 and the 
regulations thereunder. See section 178 and the regulations thereunder 
for rules governing the effect to be given renewal options in amortizing 
the costs incurred after July 28, 1958 of acquiring a lease. See Sec.  
1.197-2 for rules governing the amortization of costs to acquire limited 
interests in section 197 intangibles.
    (b) Improvements by lessee on lessor's property--(1) In general. The 
cost to a taxpayer of erecting buildings or making permanent 
improvements on property of which the taxpayer is a lessee is a capital 
expenditure. For the rules regarding improvements to leased property 
when the improvements are tangible property, see Sec.  1.263(a)-3(f). 
For the rules regarding depreciation or amortization deductions for 
leasehold improvements, see Sec.  1.167(a)-4.
    (2) Effective/applicability date--(i) In general. This paragraph (b) 
applies to taxable years beginning on or after January 1, 2014. Except 
as provided in paragraphs (b)(2)(ii) and (b)(2)(iii) of this section, 
Sec.  1.162-11(b) as contained in 26 CFR part 1 edition revised as of 
April 1, 2011, applies to taxable years beginning before January 1, 
2014.
    (ii) Early application of this paragraph. A taxpayer may choose to 
apply this paragraph (b) to taxable years beginning on or after January 
1, 2012.
    (iii) Optional application of TD 9564. A taxpayer may choose to 
apply Sec.  1.162-11T(b) as contained in TD 9564 (76 FR 81060) December 
27, 2011, to taxable years beginning on or after January 1, 2012, and 
before January 1, 2014.

[T.D. 6520, 25 FR 13692, Dec. 24, 1960, as amended by T.D. 8865, 65 FR 
3825, Jan. 25, 2000; T.D. 9564, 76 FR 81084, Dec. 27, 2011; T.D. 9636, 
78 FR 57706, Sept. 19, 2013 ]



Sec.  1.162-12  Expenses of farmers.

    (a) Farms engaged in for profit. A farmer who operates a farm for 
profit is entitled to deduct from gross income as necessary expenses all 
amounts actually expended in the carrying on of the business of farming. 
The cost of ordinary tools of short life or small cost, such as hand 
tools, including shovels,

[[Page 201]]

rakes, etc., may be deducted. The purchase of feed and other costs 
connected with raising livestock may be treated as expense deductions 
insofar as such costs represent actual outlay, but not including the 
value of farm produce grown upon the farm or the labor of the taxpayer. 
For rules regarding the capitalization of expenses of producing property 
in the trade or business of farming, see section 263A and the 
regulations thereunder. For taxable years beginning after July 12, 1972, 
where a farmer is engaged in producing crops and the process of 
gathering and disposal of such crops is not completed within the taxable 
year in which such crops were planted, expenses deducted may, with the 
consent of the Commissioner (see section 446 and the regulations 
thereunder), be determined upon the crop method, and such deductions 
must be taken in the taxable year in which the gross income from the 
crop has been realized. For taxable years beginning on or before July 
12, 1972, where a farmer is engaged in producing crops which take more 
than a year from the time of planting to the process of gathering and 
disposal, expenses deducted may, with the consent of the Commissioner 
(see section 446 and the regulations thereunder), be determined upon the 
crop method, and such deductions must be taken in the taxable year in 
which the gross income from the crop has been realized. If a farmer does 
not compute income upon the crop method, the cost of seeds and young 
plants which are purchased for further development and cultivation prior 
to sale in later years may be deducted as an expense for the year of 
purchase, provided the farmer follows a consistent practice of deducting 
such costs as an expense from year to year. The preceding sentence does 
not apply to the cost of seeds and young plants connected with the 
planting of timber (see section 611 and the regulations thereunder). For 
rules regarding the capitalization of expenses of producing property in 
the trade or business of farming, see section 263A of the Internal 
Revenue Code and Sec.  1.263A-4. The cost of farm machinery, equipment, 
and farm buildings represents a capital investment and is not an 
allowable deduction as an item of expense. Amounts expended in the 
development of farms, orchards, and ranches prior to the time when the 
productive state is reached may, at the election of the taxpayer, be 
regarded as investments of capital. For the treatment of soil and water 
conservation expenditures as expenses which are not chargeable to 
capital account, see section 175 and the regulations thereunder. For 
taxable years beginning after December 31, 1959, in the case of 
expenditures paid or incurred by farmers for fertilizer, lime, etc., see 
section 180 and the regulations thereunder. Amounts expended in 
purchasing work, breeding, dairy, or sporting animals are regarded as 
investments of capital, and shall be depreciated unless such animals are 
included in an inventory in accordance with Sec.  1.61-4. The purchase 
price of an automobile, even when wholly used in carrying on farming 
operations, is not deductible, but is regarded as an investment of 
capital. The cost of gasoline, repairs, and upkeep of an automobile if 
used wholly in the business of farming is deductible as an expense; if 
used partly for business purposes and partly for the pleasure or 
convenience of the taxpayer or his family, such cost may be apportioned 
according to the extent of the use for purposes of business and pleasure 
or convenience, and only the proportion of such cost justly attributable 
to business purposes is deductible as a necessary expense.
    (b) Farms not engaged in for profit; taxable years beginning before 
January 1, 1970--(1) In general. If a farm is operated for recreation or 
pleasure and not on a commercial basis, and if the expenses incurred in 
connection with the farm are in excess of the receipts therefrom, the 
entire receipts from the sale of farm products may be ignored in 
rendering a return of income, and the expenses incurred, being regarded 
as personal expenses, will not constitute allowable deductions.
    (2) Effective date. The provisions of this paragraph shall apply 
with respect to taxable years beginning before January 1, 1970.
    (3) Cross reference. For provisions relating to activities not 
engaged in for profit, applicable to taxable years beginning after 
December 31, 1969, see

[[Page 202]]

section 183 and the regulations thereunder.

[T.D. 7198, 37 FR 13679, July 13, 1972, as amended by T.D. 8729, 62 FR 
44546, Aug. 22, 1997; T.D. 8897, 65 FR 50643, Aug. 21, 2000]



Sec.  1.162-13  Depositors' guaranty fund.

    Banking corporations which pursuant to the laws of the State in 
which they are doing business are required to set apart, keep, and 
maintain in their banks the amount levied and assessed against them by 
the State authorities as a ``Depositors' guaranty fund,'' may deduct 
from their gross income the amount so set apart each year to this fund 
provided that such fund, when set aside and carried to the credit of the 
State banking board or duly authorized State officer, ceases to be an 
asset of the bank and may be withdrawn in whole or in part upon demand 
by such board or State officer to meet the needs of these officers in 
reimbursing depositors in insolvent banks, and provided further that no 
portion of the amount thus set aside and credited is returnable under 
the laws of the State to the assets of the banking corporation. If, 
however, such amount is simply set up on the books of the bank as a 
reserve to meet a contingent liability and remains an asset of the bank, 
it will not be deductible except as it is actually paid out as required 
by law and upon demand of the proper State officers.



Sec.  1.162-14  Expenditures for advertising or promotion of good will.

    A corporation which has, for the purpose of computing its excess 
profits tax credit under Subchapter E, Chapter 2, or Subchapter D, 
Chapter 1 of the Internal Revenue Code of 1939, elected under section 
733 or section 451 (applicable to the excess profits tax imposed by 
Subchapter E of Chapter 2, and Subchapter D of Chapter 1, respectively) 
to charge to capital account for taxable years in its base period 
expenditures for advertising or the promotion of good will which may be 
regarded as capital investments, may not deduct similar expenditures for 
the taxable year. See section 263(b). Such a taxpayer has the burden of 
proving that expenditures for advertising or the promotion of good will 
which it seeks to deduct in the taxable year may not be regarded as 
capital investments under the provisions of the regulations prescribed 
under section 733 or section 451 of the Internal Revenue Code of 1939. 
See 26 CFR, 1938 ed., 35.733-2 (Regulations 112) and 26 CFR (1939) 
40.451-2 (Regulations 130). For the disallowance of deductions for the 
cost of advertising in programs of certain conventions of political 
parties, or in publications part of the proceeds of which directly or 
indirectly inures (or is intended to inure) to or for the use of a 
political party or political candidate, see Sec.  1.276-1.

[T.D. 6996, 34 FR 835, Jan. 18, 1969]



Sec.  1.162-15  Contributions, dues, etc.

    (a) Contributions to organizations described in section 170--(1) In 
general. No deduction is allowable under section 162(a) for a 
contribution or gift by an individual or a corporation if any part 
thereof is deductible under section 170. For example, if a taxpayer 
makes a contribution of $5,000 and only $4,000 of this amount is 
deductible under section 170(a) (whether because of the percentage 
limitation under either section 170(b) (1) or (2), the requirement as to 
time of payment, or both) no deduction is allowable under section 162(a) 
for the remaining $1,000.
    (2) Scope of limitations. The limitations provided in section 162(b) 
and this paragraph apply only to payments which are in fact 
contributions or gifts to organizations described in section 170. For 
example, payments by a transit company to a local hospital (which is a 
charitable organization within the meaning of section 170) in 
consideration of a binding obligation on the part of the hospital to 
provide hospital services and facilities for the company's employees are 
not contributions or gifts within the meaning of section 170 and may be 
deductible under section 162(a) if the requirements of section 162(a) 
are otherwise satisfied.
    (b) Other contributions. Donations to organizations other than those 
described in section 170 which bear a direct relationship to the 
taxpayer's business and are made with a reasonable expectation of a 
financial return commensurate with the amount of the

[[Page 203]]

donation may constitute allowable deductions as business expenses, 
provided the donation is not made for a purpose for which a deduction is 
not allowable by reason of the provisions of paragraph (b)(1)(i) or (c) 
of Sec.  1.162-20. For example, a transit company may donate a sum of 
money to an organization (of a class not referred to in section 170) 
intending to hold a convention in the city in which it operates, with a 
reasonable expectation that the holding of such convention will augment 
its income through a greater number of people using its transportation 
facilities.
    (c) Dues. Dues and other payments to an organization, such as a 
labor union or a trade association, which otherwise meet the 
requirements of the regulations under section 162, are deductible in 
full. For limitations on the deductibility of dues and other payments, 
see paragraph (b) and (c) of Sec.  1.162-20.
    (d) Cross reference. For provisions dealing with expenditures for 
institutional or ``good will'' advertising, see Sec.  1.162-20.

[T.D. 6819, 30 FR 5580, Apr. 20, 1965]



Sec.  1.162-16  Cross reference.

    For special rules relating to expenses in connection with 
subdividing real property for sale, see section 1237 and the regulations 
thereunder.



Sec.  1.162-17  Reporting and substantiation of certain 
business expenses of employees.

    (a) Introductory. The purpose of the regulations in this section is 
to provide rules for the reporting of information on income tax returns 
by taxpayers who pay or incur ordinary and necessary business expenses 
in connection with the performance of services as an employee and to 
furnish guidance as to the type of records which will be useful in 
compiling such information and in its substantiation, if required. The 
rules prescribed in this section do not apply to expenses paid or 
incurred for incidentals, such as office supplies for the employer or 
local transportation in connection with an errand. Employees incurring 
such incidental expenses are not required to provide substantiation for 
such amounts. The term ``ordinary and necessary business expenses'' 
means only those expenses which are ordinary and necessary in the 
conduct of the taxpayer's business and are directly attributable to such 
business. The term does not include nondeductible personal, living or 
family expenses.
    (b) Expenses for which the employee is required to account to his 
employer--(1) Reimbursements equal to expenses. The employee need not 
report on his tax return (either itemized or in total amount) expenses 
for travel, transportation, entertainment, and similar purposes paid or 
incurred by him solely for the benefit of his employer for which he is 
required to account and does account to his employer and which are 
charged directly or indirectly to the employer (for example, through 
credit cards) or for which the employee is paid through advances, 
reimbursements, or otherwise, provided the total amount of such 
advances, reimbursements, and charges is equal to such expenses. In such 
a case the taxpayer need only state in his return that the total of 
amounts charged directly or indirectly to his employer through credit 
cards or otherwise and received from the employer as advances or 
reimbursements did not exceed the ordinary and necessary business 
expenses paid or incurred by the employee.
    (2) Reimbursements in excess of expenses. In case the total of 
amounts charged directly or indirectly to the employer and received from 
the employer as advances, reimbursements, or otherwise, exceeds the 
ordinary and necessary business expenses paid or incurred by the 
employee and the employee is required to and does account to his 
employer for such expenses, the taxpayer must include such excess in 
income and state on his return that he has done so.
    (3) Expenses in excess of reimbursements. If the employee's ordinary 
and necessary business expenses exceed the total of the amounts charged 
directly or indirectly to the employer and received from the employer as 
advances, reimbursements, or otherwise, and the employee is required to 
and does account to his employer for such expenses, the taxpayer may 
make the statement in his return required by subparagraph (1) of this 
paragraph unless he wishes to claim a deduction for

[[Page 204]]

such excess. If, however, he wishes to secure a deduction for such 
excess, he must submit a statement showing the following information as 
part of his tax return:
    (i) The total of any charges paid or borne by the employer and of 
any other amounts received from the employer for payment of expenses 
whether by means of advances, reimbursements or otherwise; and
    (ii) The nature of his occupation, the number of days away from home 
on business, and the total amount of ordinary and necessary business 
expenses paid or incurred by him (including those charged directly or 
indirectly to the employer through credit cards or otherwise) broken 
down into such broad categories as transportation, meals and lodging 
while away from home overnight, entertainment expenses, and other 
business expenses.
    (4) To ``account'' to his employer as used in this section means to 
submit an expense account or other required written statement to the 
employer showing the business nature and the amount of all the 
employee's expenses (including those charged directly or indirectly to 
the employer through credit cards or otherwise) broken down into such 
broad categories as transportation, meals and lodging while away from 
home overnight, entertainment expenses, and other business expenses. For 
this purpose, the Commissioner in his discretion may approve reasonable 
business practices under which mileage, per diem in lieu of subsistence, 
and similar allowances providing for ordinary and necessary business 
expenses in accordance with a fixed scale may be regarded as equivalent 
to an accounting to the employer.
    (c) Expenses for which the employee is not required to account to 
his employer. If the employee is not required to account to his employer 
for his ordinary and necessary business expenses, e.g., travel, 
transportation, entertainment, and similar items, or, though required, 
fails to account for such expenses, he must submit, as a part of his tax 
return, a statement showing the following information:
    (1) The total of all amounts received as advances or reimbursements 
from his employer in connection with the ordinary and necessary business 
expenses of the employee, including amounts charged directly or 
indirectly to the employer through credit cards or otherwise; and
    (2) The nature of his occupation, the number of days away from home 
on business, and the total amount of ordinary and necessary business 
expenses paid or incurred by him (including those charged directly or 
indirectly to the employer through credit cards or otherwise) broken 
down into such broad categories as transportation, meals and lodging 
while away from home overnight, entertainment expenses, and other 
business expenses.
    (d) Substantiation of items of expense. (1) Although the 
Commissioner may require any taxpayer to substantiate such information 
concerning expense accounts as may appear to be pertinent in determining 
tax liability, taxpayers ordinarily will not be called upon to 
substantiate expense account information except those in the following 
categories:
    (i) A taxpayer who is not required to account to his employer, or 
who does not account;
    (ii) A taxpayer whose expenses exceed the total of amounts charged 
to his employer and amounts received through advances, reimbursements or 
otherwise and who claims a deduction on his return for such excess;
    (iii) A taxpayer who is related to his employer within the meaning 
of section 267(b); and
    (iv) Other taxpayers in cases where it is determined that the 
accounting procedures used by the employer for the reporting and 
substantiation of expenses by employees are not adequate.
    (2) The Code contemplates that taxpayers keep such records as will 
be sufficient to enable the Commissioner to correctly determine income 
tax liability. Accordingly, it is to the advantage of taxpayers who may 
be called upon to substantiate expense account information to maintain 
as adequate and detailed records of travel, transportation, 
entertainment, and similar business expenses as practical since the 
burden of proof is upon the taxpayer to show that such expenses were not 
only paid or incurred but also that they constitute ordinary and 
necessary business

[[Page 205]]

expenses. One method for substantiating expenses incurred by an employee 
in connection with his employment is through the preparation of a daily 
diary or record of expenditures, maintained in sufficient detail to 
enable him to readily identify the amount and nature of any expenditure, 
and the preservation of supporting documents, especially in connection 
with large or exceptional expenditures. Nevertheless, it is recognized 
that by reason of the nature of certain expenses or the circumstances 
under which they are incurred, it is often difficult for an employee to 
maintain detailed records or to preserve supporting documents for all 
his expenses. Detailed records of small expenditures incurred in 
traveling or for transportation, as for example, tips, will not be 
required.
    (3) Where records are incomplete or documentary proof is 
unavailable, it may be possible to establish the amount of the 
expenditures by approximations based upon reliable secondary sources of 
information and collateral evidence. For example, in connection with an 
item of traveling expense a taxpayer might establish that he was in a 
travel status a certain number of days but that it was impracticable for 
him to establish the details of all his various items of travel expense. 
In such a case rail fares or plane fares can usually be ascertained with 
exactness and automobile costs approximated on the basis of mileage 
covered. A reasonable approximation of meals and lodging might be based 
upon receipted hotel bills or upon average daily rates for such 
accommodations and meals prevailing in the particular community for 
comparable accommodations. Since detailed records of incidental items 
are not required, deductions for these items may be based upon a 
reasonable approximation. In cases where a taxpayer is called upon to 
substantiate expense account information, the burden is on the taxpayer 
to establish that the amounts claimed as a deduction are reasonably 
accurate and constitute ordinary and necessary business expenses paid or 
incurred by him in connection with his trade or business. In connection 
with the determination of factual matters of this type, due 
consideration will be given to the reasonableness of the stated 
expenditures for the claimed purposes in relation to the taxpayer's 
circumstances (such as his income and the nature of his occupation), to 
the reliability and accuracy of records in connection with other items 
more readily lending themselves to detailed recordkeeping, and to all of 
the facts and circumstances in the particular case.
    (e) Applicability. (1) Except as provided in subparagraph (2) of 
this paragraph, the provisions of the regulations in this section are 
supplemental to existing regulations relating to information required to 
be submitted with income tax returns, and shall be applicable with 
respect to taxable years beginning after December 31, 1957, 
notwithstanding any existing regulation to the contrary.
    (2) With respect to taxable years ending after December 31, 1962, 
but only in respect of periods after such date, the provisions of the 
regulations in this section are superseded by the regulations under 
section 274(d) to the extent inconsistent therewith. See Sec.  1.274-5.
    (3) For taxable years beginning on or after January 1, 1989, the 
provisions of this section are superseded by the regulations under 
section 62(c) to the extent this section is inconsistent with those 
regulations. See Sec.  1.62-2.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6630, 27 FR 
12935, Dec. 29, 1962; T.D. 8276, 54 FR 51026, Dec. 12, 1989; T.D. 8324, 
55 FR 51695, Dec. 17, 1990]



Sec.  1.162-18  Illegal bribes and kickbacks.

    (a) Illegal payments to government officials or employees--(1) In 
general. No deduction shall be allowed under section 162(a) for any 
amount paid or incurred, directly or indirectly, to an official or 
employee of any government, or of any agency or other instrumentality of 
any government, if--
    (i) In the case of a payment made to an official or employee of a 
government other than a foreign government described in subparagraph (3) 
(ii) or (iii) of this paragraph, the payment constitutes an illegal 
bribe or kickback, or
    (ii) In the case of a payment made to an official or employee of a 
foreign government described in subparagraph (3) (ii) or (iii) of this 
paragraph, the

[[Page 206]]

making of the payment would be unlawful under the laws of the United 
States (if such laws were applicable to the payment and to the official 
or employee at the time the expenses were paid or incurred).

No deduction shall be allowed for an accrued expense if the eventual 
payment thereof would fall within the prohibition of this section. The 
place where the expenses are paid or incurred is immaterial. For 
purposes of subdivision (ii) of this subparagraph, lawfulness, or 
unlawfulness of the payment under the laws of the foreign country is 
immaterial.
    (2) Indirect payment. For purposes of this paragraph, an indirect 
payment to an individual shall include any payment which inures to his 
benefit or promotes his interests, regardless of the medium in which the 
payment is made and regardless of the identity of the immediate 
recipient or payor. Thus, for example, payment made to an agent, 
relative, or independent contractor of an official or employee, or even 
directly into the general treasury of a foreign country of which the 
beneficiary is an official or employee, may be treated as an indirect 
payment to the official or employee, if in fact such payment inures or 
will inure to his benefit or promotes or will promote his financial or 
other interests. A payment made by an agent or independent contractor of 
the taxpayer which benefits the taxpayer shall be treated as an indirect 
payment by the taxpayer to the official or employee.
    (3) Official or employee of a government. Any individual officially 
connected with--
    (i) The Government of the United States, a State, a territory or 
possession of the United States, the District of Columbia, or the 
Commonwealth of Puerto Rico,
    (ii) The government of a foreign country, or
    (iii) A political subdivision of, or a corporation or other entity 
serving as an agency or instrumentality of, any of the above,

in whatever capacity, whether on a permanent or temporary basis, and 
whether or not serving for compensation, shall be included within the 
term ``official or employee of a government'', regardless of the place 
of residence or post of duty of such individual. An independent 
contractor would not ordinarily be considered to be an official or 
employee. For purposes of section 162(c) and this paragraph, the term 
``foreign country'' shall include any foreign nation, whether or not 
such nation has been accorded diplomatic recognition by the United 
States. Individuals who purport to act on behalf of or as the government 
of a foreign nation, or an agency or instrumentality thereof, shall be 
treated under this section as officials or employees of a foreign 
government, whether or not such individuals in fact control such foreign 
nation, agency, or instrumentality, and whether or not such individuals 
are accorded diplomatic recognition. Accordingly, a group in rebellion 
against an established government shall be treated as officials or 
employees of a foreign government, as shall officials or employees of 
the government against which the group is in rebellion.
    (4) Laws of the United States. The term ``laws of the United 
States'', to which reference is made in paragraph (a)(1)(ii) of this 
section, shall be deemed to include only Federal statutes, including 
State laws which are assimilated into Federal law by Federal statute, 
and legislative and interpretative regulations thereunder. The term 
shall also be limited to statutes which prohibit some act or acts, for 
the violation of which there is a civil or criminal penalty.
    (5) Burden of proof. In any proceeding involving the issue of 
whether, for purposes of section 162(c)(1), a payment made to a 
government official or employee constitutes an illegal bribe or kickback 
(or would be unlawful under the laws of the United States) the burden of 
proof in respect of such issue shall be upon the Commissioner to the 
same extent as he bears the burden of proof in civil fraud cases under 
section 7454 (i.e., he must prove the illegality of the payment by clear 
and convincing evidence).
    (6) Example. The application of this paragraph may be illustrated by 
the following example:

    Example. X Corp. is in the business of selling hospital equipment in 
State Y. During

[[Page 207]]

1970, X Corp. employed A who at the time was employed full time by State 
Y as Superintendent of Hospitals. The purpose of A's employment by X 
Corp. was to procure for it an improper advantage over other concerns in 
the making of sales to hospitals in respect of which A, as 
Superintendent, had authority. X Corp. paid A $5,000 during 1970. The 
making of this payment was illegal under the laws of State Y. Under 
section 162(c)(1), X Corp. is precluded from deducting as a trade or 
business expense the $5,000 paid to A.

    (b) Other illegal payments--(1) In general. No deduction shall be 
allowed under section 162(a) for any payment (other than a payment 
described in paragraph (a) of this section) made, directly or 
indirectly, to any person, if the payment constitutes an illegal bribe, 
illegal kickback, or other illegal payment under the laws of the United 
States (as defined in paragraph (a)(4) of this section), or under any 
State law (but only if such State law is generally enforced), which 
subjects the payor to a criminal penalty or the loss (including a 
suspension) of license or privilege to engage in a trade or business 
(whether or not such penalty or loss is actually imposed upon the 
taxpayer). For purposes of this paragraph, a kickback includes a payment 
in consideration of the referral of a client, patient, or customer. This 
paragraph applies only to payments made after December 30, 1969.
    (2) State law. For purposes of this paragraph, State law means a 
statute of a State or the District of Columbia.
    (3) Generally enforced. For purposes of this paragraph, a State law 
shall be considered to be generally enforced unless it is never enforced 
or the only persons normally charged with violations thereof in the 
State (or the District of Columbia) enacting the law are infamous or 
those whose violations are extraordinarily flagrant. For example, a 
criminal statute of a State shall be considered to be generally enforced 
unless violations of the statute which are brought to the attention of 
appropriate enforcement authorities do not result in any enforcement 
action in the absence of unusual circumstances.
    (4) Burden of proof. In any proceeding involving the issue of 
whether, for purposes of section 162(c)(2), a payment constitutes an 
illegal bribe, illegal kickback, or other illegal payment the burden of 
proof in respect of such issue shall be upon the Commissioner to the 
same extent as he bears the burden of proof in civil fraud cases under 
section 7454 (i.e., he must prove the illegality of the payment by clear 
and convincing evidence).
    (5) Example. The application of this paragraph may be illustrated by 
the following example:

    Example. X Corp., a calendar-year taxpayer, is engaged in the ship 
repair business in State Y. During 1970, repairs on foreign ships 
accounted for a substantial part of its total business. It was X Corp.'s 
practice to kick back approximately 10 percent of the repair bill to the 
captain and chief engineer of all foreign-owned vessels, which kickbacks 
are illegal under a law of State Y (which is generally enforced) and 
potentially subject X Corp. to fines. During 1970, X Corp. paid $50,000 
in such kickbacks. On X Corp.'s return for 1970, a deduction under 
section 162 was taken for the $50,000. The deduction of the $50,000 of 
illegal kickbacks during 1970 is disallowed under section 162(c)(2), 
whether or not X Corp. is prosecuted with respect to the kickbacks.

    (c) Kickbacks, rebates, and bribes under medicare and medicaid. No 
deduction shall be allowed under section 162(a) for any kickback, 
rebate, or bribe (whether or not illegal) made on or after December 10, 
1971, by any provider of services, supplier, physician, or other person 
who furnishes items or services for which payment is or may be made 
under the Social Security Act, as amended, or in whole or in part out of 
Federal funds under a State plan approved under such Act, if such 
kickback, rebate, or bribe is made in connection with the furnishing of 
such items or services or the making or receipt of such payments. For 
purposes of this paragraph, a kickback includes a payment in 
consideration of the referral of a client, patient, or customer.

[T.D. 7345, 40 FR 7437, Feb. 20, 1975; 40 FR 8948, Mar. 4, 1975]



Sec.  1.162-19  Capital contributions to Federal National Mortgage Association.

    (a) In general. The initial holder of stock of the Federal National 
Mortgage Association (FNMA) which is issued pursuant to section 303(c) 
of the Federal National Mortgage Association

[[Page 208]]

Charter Act (12 U.S.C., section 1718) in a taxable year beginning after 
December 31, 1959, shall treat the excess, if any, of the issuance price 
(the amount of capital contributions evidenced by a share of stock) over 
the fair market value of the stock as of the issue date of such stock as 
an ordinary and necessary business expense paid or incurred during the 
year in which occurs the date of issuance of the stock. To the extent 
that a sale to FNMA of mortgage paper gives rise to the issuance of a 
share of FNMA stock during a taxable year beginning after December 31, 
1959, such sale is to be treated in a manner consistent with the purpose 
for, and the legislative intent underlying the enactment of, the 
provisions of section 8, Act of September 14, 1960 (Pub. L. 86-779, 74 
Stat. 1003). Thus, for the purpose of determining an initial holder's 
gain or loss from the sale to FNMA of mortgage paper, with respect to 
which a share of FNMA stock is issued in a taxable year beginning after 
December 31, 1959 (irrespective of when the sale is made), the amount 
realized by the initial holder from the sale of the mortgage paper is 
the amount of the ``FNMA purchase price''. The ``FNMA purchase price'' 
is the gross amount of the consideration agreed upon between FNMA and 
the initial holder for the purchase of the mortgage paper, without 
regard to any deduction therefrom as, for example, a deduction 
representing a capital contribution or a purchase or marketing fee. The 
date of issuance of the stock is the date which appears on the stock 
certificates of the initial holder as the date of issue. The initial 
holder is the original purchaser who is issued stock of the Federal 
National Mortgage Association pursuant to section 303(c) of the Act, and 
who appears on the books of FNMA as the initial holder. In determining 
the period for which the initial holder has held such stock, such period 
shall begin with the date of issuance.
    (b) Examples. The provisions of paragraph (a) of this section may be 
illustrated by the following examples:

    Example 1. A, a banking institution which reports its income on a 
calendar year basis, sold mortgage paper with an outstanding principal 
balance of $12,500 to FNMA on October 17, 1960. The FNMA purchase price 
was $11,500. A's basis for the mortgage paper was $10,500. In accordance 
with the terms of the contract, FNMA deducted $375 ($250 representing 
capital contribution and $125 representing purchase and marketing fee) 
from the amount of the purchase price. FNMA credited A's account with 
the amount of the capital contribution. A stock certificate evidencing 
two shares of FNMA common stock of $100 par value was mailed to A and 
FNMA deducted $200 from A's account, leaving a net balance of $50 in 
such account. The stock certificate, bearing an issue date of November 
1, 1960, was received by A on November 7, 1960. The fair market value of 
a share of FNMA stock on October 17, 1960, was $65, on November 1, 1960, 
was $67, and on November 7, 1960, was $68. A may deduct $66 the 
difference between the issuance price ($200) and the fair market value 
($134) of the two shares of stock on the date of issuance (November 1, 
1960), as a business expense for the taxable year 1960. The basis of 
each share of stock issued as of November 1, 1960 will be $67. See 
section 1054 and Sec.  1.1054-1. A's gain from the sale of the mortgage 
paper is $875 computed as follows:

Amount realized in FNMA purchase price........................   $11,500
A's basis in mortgage paper.........................   $10,500
Purchase and marketing fee..........................       125
                                                     ----------
                                                      ........    10,625
                                                               ---------
Gain on sale..................................................       875
 

    Example 2. Assume the same facts as in Example (1), and, in 
addition, that A sold to FNMA on December 15, 1960, additional mortgage 
paper having an outstanding principal balance of $12,500. FNMA deducted 
from the FNMA purchase price $250 representing capital contribution and 
credited A's account with this amount. A then had a total credit of $300 
to his account consisting of the $50 balance from the transaction 
described in Example (1) and $250 from the December 15th transaction. A 
stock certificate evidencing three shares of FNMA common stock of $100 
par value was mailed to A and FNMA deducted $300 from A's account. The 
stock certificate, bearing an issue date of January 1, 1961, was 
received by A on January 9, 1961. The fair market value of a share of 
FNMA stock on January 1, 1961, was $69. A may deduct $93, the difference 
between the issuance price ($300) and the fair market value ($207) of 
the three shares of stock on the date of issuance (January 1, 1961), as 
a business expense for the taxable year 1961. The gain or loss on the 
sale of mortgage paper on December 15, 1960, is reportable for the 
taxable year 1960.

[T.D. 6690, 28 FR 12253, Nov. 19, 1963]

[[Page 209]]



Sec.  1.162-20  Expenditures attributable to lobbying, political campaigns, 
attempts to influence legislation, etc., and certain advertising.

    (a) In general--(1) Scope of section. This section contains rules 
governing the deductibility or nondeductibility of expenditures for 
lobbying purposes, for the promotion or defeat of legislation, for 
political campaign purposes (including the support of or opposition to 
any candidate for public office) or for carrying on propaganda 
(including advertising) related to any of the foregoing purposes. For 
rules applicable to such expenditures in respect of taxable years 
beginning before January 1, 1963, and for taxable years beginning after 
December 31, 1962, see paragraphs (b) and (c), respectively, of this 
section. This section also deals with expenditures for institutional or 
``good will'' advertising.
    (2) Institutional or ``good will'' advertising. Expenditures for 
institutional or ``good will'' advertising which keeps the taxpayer's 
name before the public are generally deductible as ordinary and 
necessary business expenses provided the expenditures are related to the 
patronage the taxpayer might reasonably expect in the future. For 
example, a deduction will ordinarily be allowed for the cost of 
advertising which keeps the taxpayer's name before the public in 
connection with encouraging contributions to such organizations as the 
Red Cross, the purchase of United States Savings Bonds, or participation 
in similar causes. In like fashion, expenditures for advertising which 
presents views on economic, financial, social, or other subjects of a 
general nature, but which does not involve any of the activities 
specified in paragraph (b) or (c) of this section for which a deduction 
is not allowable, are deductible if they otherwise meet the requirements 
of the regulations under section 162.
    (b) Taxable years beginning before January 1, 1963--(1) In general. 
(i) For taxable years beginning before January 1, 1963, expenditures for 
lobbying purposes, for the promotion or defeat of legislation, for 
political campaign purposes (including the support of or opposition to 
any candidate for public office), or for carrying on propaganda 
(including advertising) related to any of the foregoing purposes are not 
deductible from gross income. For example, the cost of advertising to 
promote or defeat legislation or to influence the public with respect to 
the desirability or undesirability of proposed legislation is not 
deductible as a business expense, even though the legislation may 
directly affect the taxpayer's business.
    (ii) If a substantial part of the activities of an organization, 
such as a labor union or a trade association, consists of one or more of 
the activities specified in the first sentence of this subparagraph, 
deduction will be allowed only for such portion of the dues or other 
payments to the organization as the taxpayer can clearly establish is 
attributable to activities other than those so specified. The 
determination of whether such specified activities constitute a 
substantial part of an organization's activities shall be based on all 
the facts and circumstances. In no event shall special assessments or 
similar payments (including an increase in dues) made to any 
organization for any of such specified purposes be deductible. For other 
provisions relating to the deductibility of dues and other payments to 
an organization, such as a labor union or a trade association, see 
paragraph (c) of Sec.  1.162-15.
    (2) Expenditures for promotion or defeat of legislation. For 
purposes of this paragraph, expenditures for the promotion or the defeat 
of legislation include, but shall not be limited to, expenditures for 
the purpose of attempting to--
    (i) Influence members of a legislative body directly, or indirectly 
by urging or encouraging the public to contact such members for the 
purpose of proposing, supporting, or opposing legislation, or
    (ii) Influence the public to approve or reject a measure in a 
referendum, initiative, vote on a constitutional amendment, or similar 
procedure.
    (c) Taxable years beginning after December 31, 1962--(1) In general. 
For taxable years beginning after December 31, 1962, certain types of 
expenses incurred with respect to legislative matters are deductible 
under section 162(a) if they otherwise meet the requirements of the 
regulations under section 162. These deductible expenses are described 
in subparagraph (2) of this paragraph. All

[[Page 210]]

other expenditures for lobbying purposes, for the promotion or defeat of 
legislation (see paragraph (b)(2) of this section), for political 
campaign purposes (including the support of or opposition to any 
candidate for public office), or for carrying on propaganda (including 
advertising) relating to any of the foregoing purposes are not 
deductible from gross income for such taxable years. For the 
disallowance of deductions for bad debts and worthless securities of a 
political party, see Sec.  1.271-1. For the disallowance of deductions 
for certain indirect political contributions, such as the cost of 
certain advertising and the cost of admission to certain dinners, 
programs, and inaugural events, see Sec.  1.276-1.
    (2) Appearances, etc., with respect to legislation--(i) General 
rule. Pursuant to the provisions of section 162(e), expenses incurred 
with respect to legislative matters which may be deductible are those 
ordinary and necessary expenses (including, but not limited to, 
traveling expenses described in section 162(a)(2) and the cost of 
preparing testimony) paid or incurred by the taxpayer during a taxable 
year beginning after December 31, 1962, in carrying on any trade or 
business which are in direct connection with--
    (a) Appearances before, submission of statements to, or sending 
communications to, the committees, or individual members of Congress or 
of any legislative body of a State, a possession of the United States, 
or a political subdivision of any of the foregoing with respect to 
legislation or proposed legislation of direct interest to the taxpayer, 
or
    (b) Communication of information between the taxpayer and an 
organization of which he is a member with respect to legislation or 
proposed legislation of direct interest to the taxpayer and to such 
organization.

For provisions relating to dues paid or incurred with respect to an 
organization of which the taxpayer is a member, see subparagraph (3) of 
this paragraph.
    (ii) Legislation or proposed legislation of direct interest to the 
taxpayer--(a) Legislation or proposed legislation. The term 
``legislation or proposed legislation'' includes bills and resolutions 
introduced by a member of Congress or other legislative body referred to 
in subdivision (i)(a) of this subparagraph for consideration by such 
body as well as oral or written proposals for legislative action 
submitted to the legislative body or to a committee or member of such 
body.
    (b) Direct interest--(1) In general. (i) Legislation or proposed 
legislation is of direct interest to a taxpayer if the legislation or 
proposed legislation is of such a nature that it will, or may reasonably 
be expected to, affect the trade or business of the taxpayer. It is 
immaterial whether the effect, or expected effect, on the trade or 
business will be beneficial or detrimental to the trade or business or 
whether it will be immediate. If legislation or proposed legislation has 
such a relationship to a trade or business that the expenses of any 
appearance or communication in connection with the legislation meets the 
ordinary and necessary test of section 162(a), then such legislation 
ordinarily meets the direct interest test of section 162(e). However, if 
the nature of the legislation or proposed legislation is such that the 
likelihood of its having an effect on the trade or business of the 
taxpayer is remote or speculative, the legislation or proposed 
legislation is not of direct interest to the taxpayer. Legislation or 
proposed legislation which will not affect the trade or business of the 
taxpayer is not of direct interest to the taxpayer even though such 
legislation will affect the personal, living, or family activities or 
expenses of the taxpayer. Legislation or proposed legislation is not of 
direct interest to a taxpayer merely because it may affect business in 
general; however, if the legislation or proposed legislation will, or 
may reasonably be expected to, affect the taxpayer's trade or business 
it will be of direct interest to the taxpayer even though it also will 
affect the trade or business of other taxpayers or business in general. 
To meet the direct interest test, it is not necessary that all 
provisions of the legislation or proposed legislation have an effect, or 
expected effect, on the taxpayer's trade or business. The test will be 
met if one of the provisions of the legislation has the specified 
effect. Legislation or proposed legislation will

[[Page 211]]

be considered to be of direct interest to a membership organization if 
it is of direct interest to the organization, as such, or if it is of 
direct interest to one or more of its members.
    (ii) Legislation which would increase or decrease the taxes 
applicable to the trade or business, increase or decrease the operating 
costs or earnings of the trade or business, or increase or decrease the 
administrative burdens connected with the trade or business meets the 
direct interest test. Legislation which would increase the social 
security benefits or liberalize the right to such benefits meets the 
direct interest test because such changes in the social security 
benefits may reasonably be expected to affect the retirement benefits 
which the employer will be asked to provide his employees or to increase 
his taxes. Legislation which would impose a retailer's sales tax is of 
direct interest to a retailer because, although the tax may be passed on 
to his customers, collection of the tax will impose additional burdens 
on the retailer, and because the increased cost of his products to the 
consumer may reduce the demand for them. Legislation which would provide 
an income tax credit or exclusion for shareholders is of direct interest 
to a corporation, because those tax benefits may increase the sources of 
capital available to the corporation. Legislation which would favorably 
or adversely affect the business of a competitor so as to affect the 
taxpayer's competitive position is of direct interest to the taxpayer. 
Legislation which would improve the school system of a community is of 
direct interest to a membership organization comprised of employers in 
the community because the improved school system is likely to make the 
community more attractive to prospective employees of such employers. On 
the other hand, proposed legislation relating to Presidential succession 
in the event of the death of the President has only a remote and 
speculative effect on any trade or business and therefore does not meet 
the direct interest test. Similarly, if a corporation is represented 
before a congressional committee to oppose an appropriation bill merely 
because of a desire to bring increased Government economy with the hope 
that such economy will eventually cause a reduction in the Federal 
income tax, the legislation does not meet the direct interest test 
because any effect it may have upon the corporation's trade or business 
is highly speculative.
    (2) Appearances, etc., by expert witnesses. (i) An appearance or 
communication (of a type described in paragraph (c)(2)(i)(a) of this 
section) by an individual in connection with legislation or proposed 
legislation shall be considered to be with respect to legislation of 
direct interest to such individual if the legislation is in a field in 
which he specializes as an employee, if the appearance or communication 
is not on behalf of his employer, and if it is customary for individuals 
in his type of employment to publicly express their views in respect of 
matters in their field of competence. Expenses incurred by such an 
individual in connection with such an appearance of communication, 
including traveling expenses properly allocable thereto, represent 
ordinary and necessary business expenses and are, therefore, deductible 
under section 162. For example, if a university professor who teaches in 
the field of money and banking appears, on his own behalf, before a 
legislative committee to testify on proposed legislation regarding the 
banking system, his expenses incurred in connection with such appearance 
are deductible under section 162 since university professors customarily 
take an active part in the development of the law in their field of 
competence and publicly communicate the results of their work.
    (ii) An appearance or communication (of a type described in 
paragraph (c)(2)(i)(a) of this section) by an employee or self-employed 
individual in connection with legislation or proposed legislation shall 
be considered to be with respect to legislation of direct interest to 
such person if the legislation is in the field in which he specializes 
in his business (or as an employee) and if the appearance or 
communication is made pursuant to an invitation extended to him 
individually for the purpose of receiving his expert testimony. Expenses 
incurred by an employee or self-employed individual in connection

[[Page 212]]

with such an appearance or communication, including traveling expenses 
properly allocable thereto, represent ordinary and necessary business 
expenses and are, therefore, deductible under section 162. For example, 
if a self-employed individual is personally invited by a congressional 
committee to testify on proposed legislation in the field in which he 
specializes in his business, his expenses incurred in connection with 
such appearance are deductible under section 162. If a self-employed 
individual makes an appearance, on his own behalf, before a legislative 
committee without having been extended an invitation his expenses will 
be deductible to the extent otherwise provided in this paragraph.
    (3) Nominations, etc. A taxpayer does not have a direct interest in 
matters such as nominations, appointments, or the operation of the 
legislative body.
    (iii) Allowable expenses. To be deductible under section 162(a), 
expenditures which meet the tests of deductibility under the provisions 
of this paragraph must also qualify as ordinary and necessary business 
expenses under section 162(a) and, in addition, be in direct connection 
with the carrying on of the activities specified in subdivision (i)(a) 
or (i)(b) of this subparagraph. For example, a taxpayer appearing before 
a committee of the Congress to present testimony concerning legislation 
or proposed legislation in which he has a direct interest may deduct the 
ordinary and necessary expenses directly connected with his appearance, 
such as traveling expenses described in section 162(a)(2), and the cost 
of preparing testimony.
    (3) Deductibility of dues and other payments to an organization. If 
a substantial part of the activities of an organization, such as a labor 
union or a trade association, consists of one or more of the activities 
to which this paragraph relates (legislative matters, political 
campaigns, etc.), exclusive of any activity constituting an appearance 
or communication with respect to legislation or proposed legislation of 
direct interest to the organization (see subparagraph (c)(2)(ii)(b)(1)), 
a deduction will be allowed only for such portion of the dues or other 
payments to the organization as the taxpayer can clearly establish is 
attributable to activities to which this paragraph does not relate and 
to any activity constituting an appearance or communication with respect 
to legislation or proposed legislation of direct interest to the 
organization. The determination of whether a substantial part of an 
organization's activities consists of one or more of the activities to 
which this paragraph relates (exclusive of appearances or communications 
with respect to legislation or proposed legislation of direct interest 
to the organization) shall be based on all the facts and circumstances. 
In no event shall a deduction be allowed for that portion of a special 
assessment or similar payment (including an increase in dues) made to 
any organization for any activity to which this paragraph relates if the 
activity does not constitute an appearance or communication with respect 
to legislation or proposed legislation of direct interest to the 
organization. If an organization pays or incurs expenses allocable to 
legislative activities which meet the tests of subdivisions (i) and (ii) 
of subparagraph (2) of this paragraph (appearances or communications 
with respect to legislation or proposed legislation of direct interest 
to the organization), on behalf of its members, the dues paid by a 
taxpayer are deductible to the extent used for such activities. Dues 
paid by a taxpayer will be considered to be used for such an activity, 
and thus deductible, although the legislation or proposed legislation 
involved is not of direct interest to the taxpayer, if, pursuant to the 
provisions of subparagraph (2)(ii)(b)(1) of this paragraph, the 
legislation or proposed legislation is of direct interest to the 
organization, as such, or is of direct interest to one or more members 
of the organization. For other provisions relating to the deductibility 
of dues and other payments to an organization, such as a labor union or 
a trade association, see paragraph (c) of Sec.  1.162-15.
    (4) Limitations. No deduction shall be allowed under section 162(a) 
for any amount paid or incurred (whether by way of contribution, gift, 
or otherwise) in connection with any attempt to influence the general 
public, or segments thereof, with respect to legislative matters, 
elections, or referendums. For

[[Page 213]]

example, no deduction shall be allowed for any expenses incurred in 
connection with ``grassroot'' campaigns or any other attempts to urge or 
encourage the public to contact members of a legislative body for the 
purpose of proposing, supporting, or opposing legislation.
    (5) Expenses paid or incurred after December 31, 1993, in connection 
with influencing legislation other than certain local legislation. The 
provisions of paragraphs (c)(1) through (3) of this section are 
superseded for expenses paid or incurred after December 31, 1993, in 
connection with influencing legislation (other than certain local 
legislation) to the extent inconsistent with section 162(e)(1)(A) (as 
limited by section 162(e)(2)) and Sec. Sec.  1.162-20(d) and 1.162-29.
    (d) Dues allocable to expenditures after 1993. No deduction is 
allowed under section 162(a) for the portion of dues or other similar 
amounts paid by the taxpayer to an organization exempt from tax (other 
than an organization described in section 501(c)(3)) which the 
organization notifies the taxpayer under section 6033(e)(1)(A)(ii) is 
allocable to expenditures to which section 162(e)(1) applies. The first 
sentence of this paragraph (d) applies to dues or other similar amounts 
whether or not paid on or before December 31, 1993. Section 1.162-
20(c)(3) is superseded to the extent inconsistent with this paragraph 
(d).

[T.D. 6819, 30 FR 5581, Apr. 20, 1965, as amended by T.D. 6996, 34 FR 
835, Jan. 18, 1969; T.D. 8602, 60 FR 37573, July 21, 1995]



Sec.  1.162-21  Fines and penalties.

    (a) In general. No deduction shall be allowed under section 162(a) 
for any fine or similar penalty paid to--
    (1) The government of the United States, a State, a territory or 
possession of the United States, the District of Columbia, or the 
Commonwealth of Puerto Rico;
    (2) The government of a foreign country; or
    (3) A political subdivision of, or corporation or other entity 
serving as an agency or instrumentality of, any of the above.
    (b) Definition. (1) For purposes of this section a fine or similar 
penalty includes an amount--
    (i) Paid pursuant to conviction or a plea of guilty or nolo 
contendere for a crime (felony or misdemeanor) in a criminal proceeding;
    (ii) Paid as a civil penalty imposed by Federal, State, or local 
law, including additions to tax and additional amounts and assessable 
penalties imposed by chapter 68 of the Internal Revenue Code of 1954;
    (iii) Paid in settlement of the taxpayer's actual or potential 
liability for a fine or penalty (civil or criminal); or
    (iv) Forfeited as collateral posted in connection with a proceeding 
which could result in imposition of such a fine or penalty.
    (2) The amount of a fine or penalty does not include legal fees and 
related expenses paid or incurred in the defense of a prosecution or 
civil action arising from a violation of the law imposing the fine or 
civil penalty, nor court costs assessed against the taxpayer, or 
stenographic and printing charges. Compensatory damages (including 
damages under section 4A of the Clayton Act (15 U.S.C. 15a), as amended) 
paid to a government do not constitute a fine or penalty.
    (c) Examples. The application of this section may be illustrated by 
the following examples:

    Example 1. M Corp. was indicted under section 1 of the Sherman Anti-
Trust Act (15 U.S.C. 1) for fixing and maintaining prices of certain 
electrical products. M Corp. was convicted and was fined $50,000. The 
United States sued M Corp. under section 4A of the Clayton Act (15 
U.S.C. 15a) for $100,000, the amount of the actual damages resulting 
from the price fixing of which M Corp. was convicted. Pursuant to a 
final judgment entered in the civil action. M Corp. paid the United 
States $100,000 in damages. Section 162(f) precludes M Corp. from 
deducting the fine of $50,000 as a trade or business expense. Section 
162(f) does not preclude it from deducting the $100,000 paid to the 
United States as actual damages.
    Example 2. N Corp. was found to have violated 33 U.S.C. 1321(b)(3) 
when a vessel it operated discharged oil in harmful quantities into the 
navigable waters of the United States. A civil penalty under 33 U.S.C. 
1321(b)(6) of $5,000 was assessed against N Corp. with respect to the 
discharge. N Corp. paid $5,000 to the Coast Guard in payment of the 
civil penalty. Section 162(f) precludes N Corp. from deducting the 
$5,000 penalty.
    Example 3. O Corp., a manufacturer of motor vehicles, was found to 
have violated 42

[[Page 214]]

U.S.C. 1857f-2(a)(1) by selling a new motor vehicle which was not 
covered by the required certificate of conformity. Pursuant to 42 U.S.C. 
1857f-4, O Corp. was required to pay, and did pay, a civil penalty of 
$10,000. In addition, pursuant to 42 U.S.C. 1857f-5a(c)(1), O Corp. was 
required to expend, and did expend, $500 in order to remedy the 
nonconformity of that motor vehicle. Section 162(f) precludes O Corp. 
from deducting the $10,000 penalty as a trade or business expense, but 
does not preclude it from deducting the $500 which it expended to remedy 
the nonconformity.
    Example 4. P Corp. was the operator of a coal mine in which occurred 
a violation of a mandatory safety standard prescribed by the Federal 
Coal Mine Health and Safety Act of 1969 (30 U.S.C. 801 et seq.). 
Pursuant to 30 U.S.C. 819(a), a civil penalty of $10,000 was assessed 
against P Corp., and P Corp. paid the penalty. Section 162(f) precludes 
P Corp. from deducting the $10,000 penalty.
    Example 5. Q Corp., a common carrier engaged in interstate commerce 
by railroad, hauled a railroad car which was not equipped with efficient 
hand brakes, in violation of 45 U.S.C. 11. Q Corp. was found to be 
liable for a penalty of $250 pursuant to 45 U.S.C. 13. Q Corp. paid that 
penalty. Section 162(f) precludes Q Corp. from deducting the $250 
penalty.
    Example 6. R Corp. owned and operated on the highways of State X a 
truck weighing in excess of the amount permitted under the law of State 
X. R Corp. was found to have violated the law and was assessed a fine of 
$85 which it paid to State X. Section 162(f) precludes R Corp. from 
deducting the amount so paid.
    Example 7. S Corp. was found to have violated a law of State Y which 
prohibited the emission into the air of particulate matter in excess of 
a limit set forth in a regulation promulgated under that law. The 
Environmental Quality Hearing Board of State Y assessed a fine of $500 
against S Corp. The fine was payable to State Y, and S Corp. paid it. 
Section 162(f) precludes S Corp. from deducting the $500 fine.
    Example 8. T Corp. was found by a magistrate of City Z to be 
operating in such city an apartment building which did not conform to a 
provision of the city housing code requiring operable fire escapes on 
apartment buildings of that type. Upon the basis of the magistrate's 
finding, T Corp. was required to pay, and did pay, a fine of $200 to 
City Z. Section 162(f) precludes T Corp. from deducting the $200 fine.

[T.D. 7345, 40 FR 7437, Feb. 20, 1975; 40 FR 8948, Mar. 4, 1975, as 
amended by T.D. 7366, 40 FR 29290, July 11, 1975]



Sec.  1.162-22  Treble damage payments under the antitrust laws.

    (a) In general. In the case of a taxpayer who after December 31, 
1969, either is convicted in a criminal action of a violation of the 
Federal antitrust laws or enters a plea of guilty or nolo contendere to 
an indictment or information charging such a violation, and whose 
conviction or plea does not occur in a new trial following an appeal of 
a conviction on or before such date, no deduction shall be allowed under 
section 162(a) for two-thirds of any amount paid or incurred after 
December 31, 1969, with respect to--
    (1) Any judgment for damages entered against the taxpayer under 
section 4 of the Clayton Act (15 U.S.C. 15), as amended, on account of 
such violation or any related violation of the Federal antitrust laws, 
provided such related violation occurred prior to the date of the final 
judgment of such conviction, or
    (2) Settlement of any action brought under such section 4 on account 
of such violation or related violation.

For the purposes of this section, where a civil judgment has been 
entered or a settlement made with respect to a violation of the 
antitrust laws and a criminal proceeding is based upon the same 
violation, the criminal proceeding need not have been brought prior to 
the civil judgment or settlement. If, in his return for any taxable 
year, a taxpayer claims a deduction for an amount paid or incurred with 
respect to a judgment or settlement described in the first sentence of 
this paragraph and is subsequently convicted of a violation of the 
antitrust laws which makes a portion of such amount unallowable, then 
the taxpayer shall file an amended return for such taxable year on which 
the amount of the deduction is appropriately reduced. Attorney's fees, 
court costs, and other amounts paid or incurred in connection with a 
controversy under such section 4 which meet the requirements of section 
162 are deductible under that section. For purposes of subparagraph (2) 
of this paragraph, the amount paid or incurred in settlement shall not 
include amounts attributable to the plaintiff's costs of suit and 
attorney's

[[Page 215]]

fees, to the extent that such costs or fees have actually been paid.
    (b) Conviction. For purposes of paragraph (a) of this section, a 
taxpayer is convicted of a violation of the antitrust laws if a judgment 
of conviction (whether or not a final judgment) with respect to such 
violation has been entered against him, provided a subsequent final 
judgment of acquittal has not been entered or criminal prosecution with 
respect to such violation terminated without a final judgment of 
conviction. During the pendency of an appeal or other action directly 
contesting a judgment of conviction, the taxpayer should file a 
protective claim for credit or refund to avoid being barred by the 
period of limitations on credit or refund under section 6511.
    (c) Related violation. For purposes of this section, a violation of 
the Federal antitrust laws is related to a subsequent violation if (1) 
with respect to the subsequent violation the United States obtains both 
a judgment in a criminal proceeding and an injunction against the 
taxpayer, and (2) the taxpayer's actions which constituted the prior 
violation would have contravened such injunction if such injunction were 
applicable at the time of the prior violation.
    (d) Settlement following a dismissal of an action or amendment of 
the complaint. For purposes of paragraph (a)(2) of this section, an 
amount may be considered as paid in settlement of an action even though 
the action is dismissed or otherwise disposed of prior to such 
settlement or the complaint is amended to eliminate the claim with 
respect to the violation or related violation.
    (e) Antitrust laws. The term ``antitrust laws'' as used in section 
162(g) and this section shall include the Federal acts enumerated in 
paragraph (1) of section 1 of the Clayton Act (15 U.S.C. 12), as 
amended.
    (f) Examples. The application of this section may be illustrated by 
the following examples:

    Example 1. In 1970, the United States instituted a criminal 
prosecution against X Co., Y Co., A, the president of X Co., and B, the 
president of Y Co., under section 1 of the Sherman Anti-Trust Act, 15 
U.S.C. 1. In the indictment, the defendants were charged with conspiring 
to fix and maintain prices of electrical transformers from 1965 to 1970. 
All defendants entered pleas of nolo contendere to these charges. These 
pleas were accepted and judgments of conviction entered. In a companion 
civil suit, the United States obtained an injunction prohibiting the 
defendants from conspiring to fix and maintain prices in the electrical 
transformer market. Thereafter, Z Co. sued X Co. and Y Co. for $300,000 
in treble damages under section 4 of the Clayton Act. Z Co.'s complaint 
alleged that the criminal conspiracy between X Co. and Y Co. forced Z 
Co. to pay excessive prices for electrical transformers. X Co. and Y Co. 
each paid Z Co. $85,000 in full settlement of Z Co.'s action. Of each 
$85,000 paid, $10,000 was attributable to court costs and attorney's 
fees actually paid by Z Co. Under section 162(g), X Co. and Y Co. are 
each precluded from deducting as a trade or business expense more than 
$35,000 of the $85,000 paid to Z Co. in settlement--

$10,000 + [($85,000-$10,000) / 3]

    Example 2. Assume the same facts as in example (1) except that Z 
Co.'s claim for treble damages was based on a conspiracy to fix and 
maintain prices in the sale of electrical transformers during 1963. 
Although the criminal prosecution of the defendants did not involve 1963 
(a year barred by the applicable criminal statute of limitations when 
the prosecution was instituted), Z Co.'s pleadings alleged that the 
civil statute of limitations had been tolled by the defendants' 
fraudulent concealment of their conspiracy. Since the United States has 
obtained both a judgment in a criminal proceeding and an injunction 
against the defendants in connection with their activities from 1965 to 
1970, and the alleged actions of the defendants in 1963 would have 
contravened such injunction if it were applicable in 1963, the alleged 
violation in 1963 is related to the violation from 1965 to 1970. 
Accordingly, the tax consequences to X Co. and Y Co. of the payments of 
$85,000 in settlement of Z Co.'s claim against X Co. and Y Co. are the 
same as in example (1).
    Example 3. Assume the same facts as in example (1) except that Z 
Co.'s claim for treble damages was based on a conspiracy to fix and 
maintain prices with respect to electrical insulators for high-tension 
power poles. Since the civil action was not based on the same violation 
of the Federal antitrust laws as the criminal action, or on a related 
violation (a violation which would have contravened the injunction if it 
were applicable), X Co. and Y Co. are not precluded by section 162(g) 
from deducting as a trade or business expense the entire $85,000 paid by 
each in settlement of the civil action.

[T.D. 7217, 37 FR 23916, Nov. 10, 1972]

[[Page 216]]



Sec.  1.162-24  Travel expenses of state legislators.

    (a) In general. For purposes of section 162(a), in the case of any 
taxpayer who is a state legislator at any time during the taxable year 
and who makes an election under section 162(h) for the taxable year--
    (1) The taxpayer's place of residence within the legislative 
district represented by the taxpayer is the taxpayer's home for that 
taxable year;
    (2) The taxpayer is deemed to have expended for living expenses (in 
connection with the taxpayer's trade or business as a legislator) an 
amount determined by multiplying the number of legislative days of the 
taxpayer during the taxable year by the greater of--
    (i) The amount generally allowable with respect to those days to 
employees of the state of which the taxpayer is a legislator for per 
diem while away from home, to the extent the amount does not exceed 110 
percent of the amount described in paragraph (a)(2)(ii) of this section; 
or
    (ii) The Federal per diem with respect to those days for the 
taxpayer's state capital; and
    (3) The taxpayer is deemed to be away from home in the pursuit of a 
trade or business on each legislative day.
    (b) Legislative day. For purposes of section 162(h)(1) and this 
section, for any taxpayer who makes an election under section 162(h), a 
legislative day is any day on which the taxpayer is a state legislator 
and--
    (1) The legislature is in session;
    (2) The legislature is not in session for a period that is not 
longer than 4 consecutive days, without extension for Saturdays, 
Sundays, or holidays;
    (3) The taxpayer's attendance at a meeting of a committee of the 
legislature is formally recorded; or
    (4) The taxpayer's attendance at any session of the legislature that 
only a limited number of members are expected to attend (such as a pro 
forma session), on any day not described in paragraph (b)(1) or (b)(2) 
of this section, is formally recorded.
    (c) Fifty mile rule. Section 162(h) and this section do not apply to 
any taxpayer who is a state legislator and whose place of residence 
within the legislative district represented by the taxpayer is 50 or 
fewer miles from the capitol building of the state. For purposes of this 
paragraph (c), the distance between the taxpayer's place of residence 
within the legislative district represented by the taxpayer and the 
capitol building of the state is the shortest of the more commonly 
traveled routes between the two points.
    (d) Definitions and special rules. The following definitions apply 
for purposes of section 162(h) and this section.
    (1) State legislator. A taxpayer becomes a state legislator on the 
day the taxpayer is sworn into office and ceases to be a state 
legislator on the day following the day on which the taxpayer's term in 
office ends.
    (2) Living expenses. Living expenses include lodging, meals, and 
incidental expenses. Incidental expenses has the same meaning as in 41 
CFR 300-3.1.
    (3) In session--(i) In general. For purposes of this section, the 
legislature of which a taxpayer is a member is in session on any day if, 
at any time during that day, the members of the legislature are expected 
to attend and participate as an assembled body of the legislature.
    (ii) Examples. The following examples illustrate the rules of this 
paragraph (d)(3):

    Example 1. B is a member of the legislature of State X. On Day 1, 
the State X legislature is convened and the members of the legislature 
are expected to attend and participate. On Day 1, the State X 
legislature is in session within the meaning of paragraph (d)(3)(i) of 
this section. B does not attend the session of the State X legislature 
on Day 1. However, Day 1 is a legislative day for B for purposes of 
section 162(h)(2)(A) and paragraph (b)(1) of this section.
    Example 2. C, D, and E are members of the legislature of State X. On 
Day 2, the State X legislature is convened for a limited session in 
which not all members of the legislature are expected to attend and 
participate. Thus, on Day 2 the legislature is not in session within the 
meaning of paragraph (d)(3)(i) of this section, and Day 2 is not a 
legislative day under paragraph (b)(1) of this section. In addition, Day 
2 is not a day described in paragraph (b)(2) of this section. C and D 
are the only members who are called to, and do, attend the limited 
session on Day 2, and their attendance at the session is formally 
recorded. E is not called and does not attend. Therefore, Day 2 is a 
legislative day as to C

[[Page 217]]

and D under section 162(h)(2)(B) and paragraph (b)(4) of this section. 
Day 2 is not a legislative day as to E.

    (4) Committee of the legislature. A committee of the legislature is 
any group that includes one or more legislators and that is charged with 
conducting business of the legislature. Committees of the legislature 
include, but are not limited to, committees to which the legislature 
refers bills for consideration, committees that the legislature has 
authorized to conduct inquiries into matters of public concern, and 
committees charged with the internal administration of the legislature. 
For purposes of this section, groups that are not considered committees 
of the legislature include, but are not limited to, groups that promote 
particular issues, raise campaign funds, or are caucuses of members of a 
political party.
    (5) Federal per diem. The Federal per diem for any city and day is 
the maximum amount allowable to employees of the executive branch of the 
Federal government for living expenses while away from home in pursuit 
of a trade or business in that city on that day. See 5 U.S.C. 5702 and 
the regulations under that section.
    (e) Election--(1) Time for making election. A taxpayer's election 
under section 162(h) must be made for each taxable year for which the 
election is to be in effect and must be made no later than the due date 
(including extensions) of the taxpayer's Federal income tax return for 
the taxable year.
    (2) Manner of making election. A taxpayer makes an election under 
section 162(h) by attaching a statement to the taxpayer's income tax 
return for the taxable year for which the election is made. The 
statement must include--
    (i) The taxpayer's name, address, and taxpayer identification 
number;
    (ii) A statement that the taxpayer is making an election under 
section 162(h); and
    (iii) Information establishing that the taxpayer is a state 
legislator entitled to make the election, for example, a statement 
identifying the taxpayer's state and legislative district and 
representing that the taxpayer's place of residence in the legislative 
district is not 50 or fewer miles from the state capitol building.
    (3) Revocation of election. An election under section 162(h) may be 
revoked only with the consent of the Commissioner. An application for 
consent to revoke an election must be signed by the taxpayer and filed 
with the submission processing center with which the election was filed, 
and must include--
    (i) The taxpayer's name, address, and taxpayer identification 
number;
    (ii) A statement that the taxpayer is revoking an election under 
section 162(h) for a specified year; and
    (iii) A statement explaining why the taxpayer seeks to revoke the 
election.
    (f) Effect of election on otherwise deductible expenses for travel 
away from home--(1) Legislative days--(i) Living expenses. For any 
legislative day for which an election under section 162(h) and this 
section is in effect, the amount of an electing taxpayer's living 
expenses while away from home is the greater of the amount of the living 
expenses--
    (A) Specified in paragraph (a)(2) of this section in connection with 
the trade or business of being a legislator; or
    (B) Otherwise allowable under section 162(a)(2) in the pursuit of 
any trade or business of the taxpayer.
    (ii) Other expenses. For any legislative day for which an election 
under section 162(h) and this section is in effect, the amount of an 
electing taxpayer's expenses (other than living expenses) for travel 
away from home is the sum of the substantiated expenses, such as 
expenses for travel fares, telephone calls, and local transportation, 
that are otherwise deductible under section 162(a)(2) in the pursuit of 
any trade or business of the taxpayer.
    (2) Non-legislative days. For any day that is not a legislative day, 
the amount of an electing taxpayer's expenses (including amounts for 
living expenses) for travel away from home is the sum of the 
substantiated expenses that are otherwise deductible under section 
162(a)(2) in the pursuit of any trade or business of the taxpayer.
    (g) Cross references. See Sec.  1.62-1T(e)(4) for rules regarding 
allocation of unreimbursed expenses of state legislators and section 
274(n) for limitations on

[[Page 218]]

the amount allowable as a deduction for expenses for or allocable to 
meals.
    (h) Effective/applicability date. This section applies to expenses 
paid or incurred, or deemed expended under section 162(h), in taxable 
years beginning after April 8, 2010.

[T.D. 9481, 75 FR 17856, Apr. 8, 2010]



Sec.  1.162-25  Deductions with respect to noncash fringe benefits.

    (a) [Reserved]
    (b) Employee. If an employer provides the use of a vehicle (as 
defined in Sec.  1.61-21(e)(2)) to an employee as a noncash fringe 
benefit and includes the entire value of the benefit in the employee's 
gross income without taking into account any exclusion for a working 
condition fringe allowable under section 132 and the regulations 
thereunder, the employee may deduct that value multiplied by the 
percentage of the total use of the vehicle that is in connection with 
the employer's trade or business (business value). For taxable years 
beginning before January 1, 1990, the employee may deduct the business 
value from gross income in determining adjusted gross income. For 
taxable years beginning on or after January 1, 1990, the employee may 
deduct the business value only as a miscellaneous itemized deduction in 
determining taxable income, subject to the 2-percent floor provided in 
section 67. If the employer determines the value of the noncash fringe 
benefit under a special accounting rule that allows the employer to 
treat the value of benefits provided during the last two months of the 
calendar year or any shorter period as paid during the subsequent 
calendar year, then the employee must determine the deduction allowable 
under this paragraph (b) without regard to any use of the benefit during 
those last two months or any shorter period. The employee may not use a 
cents-per-mile valuation method to determine the deduction allowable 
under this paragraph (b).

[T.D. 8451, 57 FR 57669, Dec. 7, 1992; 57 FR 60568, Dec. 21, 1992]



Sec.  1.162-25T  Deductions with respect to noncash fringe benefits 
(temporary).

    (a) Employer. If an employer includes the value of a noncash fringe 
benefit in an employee's gross income, the employer may not deduct this 
amount as compensation for services, but rather may deduct only the 
costs incurred by the employer in providing the benefit to the employee. 
The employer may be allowed a cost recovery deduction under section 168 
or a deduction under section 179 for an expense not chargeable to 
capital account, or, if the noncash fringe benefit is property leased by 
the employer, a deduction for the ordinary and necessary business 
expense of leasing the property.
    (b) [Reserved]
    (c) Examples. The following examples illustrate the provisions of 
this section.
    (1) On January 1, 1986, X Company owns and provides the use of an 
automobile with a fair market value of $20,000 to E, an employee, for 
the entire calendar year. Both X and E compute taxable income on the 
basis of the calendar year. Seventy percent of the use of the automobile 
by E is in connection with X's trade or business. If X uses the special 
rule provided in Sec.  1.61-21(d) for valuing the availability of the 
automobile and takes into account the amount excludable as a working 
condition fringe, X would include $1,680 ($5,600, the Annual Lease 
Value, less 70 percent of $5,600) in E's gross income for 1986. X may 
not deduct the amount included in E's income as compensation for 
services. X may, however, determine a cost recovery deduction under 
section 168, subject to the limitations under section 280F, for taxable 
year 1986.
    (2) The facts are the same as in Example (1) of paragraph (c)(1) of 
this section, except that X includes $5,600 in E's gross income, the 
value of the noncash fringe benefit without taking into account the 
amount excludable as a working condition fringe. X may not deduct that 
amount as compensation for services, but may determine a cost recovery 
deduction under section 168, subject to the limitations under section 
280F. For purposes of determining adjusted gross income, E may deduct

[[Page 219]]

$3,920 ($5,600 multiplied by the percent of business use).

[T.D. 8061, 50 FR 46013, Nov. 6, 1985, as amended by T.D. 8063, 50 FR 
52312, Dec. 23, 1985; T.D. 8276, 54 FR 51026, Dec. 12, 1989; T.D. 8451, 
57 FR 57669, Dec. 7, 1992; T.D. 9849, 84 FR 9233, Mar. 14, 2019]



Sec.  1.162-27  Certain employee remuneration in excess of $1,000,000.

    (a) Scope. This section provides rules for the application of the $1 
million deduction limit under section 162(m) of the Internal Revenue 
Code. Paragraph (b) of this section provides the general rule limiting 
deductions under section 162(m). Paragraph (c) of this section provides 
definitions of generally applicable terms. Paragraph (d) of this section 
provides an exception from the deduction limit for compensation payable 
on a commission basis. Paragraph (e) of this section provides an 
exception for qualified performance-based compensation. Paragraphs (f) 
and (g) of this section provide special rules for corporations that 
become publicly held corporations and payments that are subject to 
section 280G, respectively. Paragraph (h) of this section provides 
transition rules, including the rules for contracts that are 
grandfathered and not subject to section 162(m). Paragraph (j) of this 
section contains the effective date provisions. For rules concerning the 
deductibility of compensation for services that are not covered by 
section 162(m) and this section, see section 162(a)(1) and Sec.  1.162-
7. This section is not determinative as to whether compensation meets 
the requirements of section 162(a)(1).
    (b) Limitation on deduction. Section 162(m) precludes a deduction 
under chapter 1 of the Internal Revenue Code by any publicly held 
corporation for compensation paid to any covered employee to the extent 
that the compensation for the taxable year exceeds $1,000,000.
    (c) Definitions--(1) Publicly held corporation--(i) General rule. A 
publicly held corporation means any corporation issuing any class of 
common equity securities required to be registered under section 12 of 
the Exchange Act. A corporation is not considered publicly held if the 
registration of its equity securities is voluntary. For purposes of this 
section, whether a corporation is publicly held is determined based 
solely on whether, as of the last day of its taxable year, the 
corporation is subject to the reporting obligations of section 12 of the 
Exchange Act.
    (ii) Affiliated groups. A publicly held corporation includes an 
affiliated group of corporations, as defined in section 1504 (determined 
without regard to section 1504(b)). For purposes of this section, 
however, an affiliated group of corporations does not include any 
subsidiary that is itself a publicly held corporation. Such a publicly 
held subsidiary, and its subsidiaries (if any), are separately subject 
to this section. If a covered employee is paid compensation in a taxable 
year by more than one member of an affiliated group, compensation paid 
by each member of the affiliated group is aggregated with compensation 
paid to the covered employee by all other members of the group. Any 
amount disallowed as a deduction by this section must be prorated among 
the payor corporations in proportion to the amount of compensation paid 
to the covered employee by each such corporation in the taxable year.
    (2) Covered employee--(i) General rule. A covered employee means any 
individual who, on the last day of the taxable year, is--
    (A) The chief executive officer of the corporation or is acting in 
such capacity; or
    (B) Among the four highest compensated officers (other than the 
chief executive officer).
    (ii) Application of rules of the Securities and Exchange Commission. 
Whether an individual is the chief executive officer described in 
paragraph (c)(2)(i)(A) of this section or an officer described in 
paragraph (c)(2)(i)(B) of this section is determined pursuant to the 
executive compensation disclosure rules under the Exchange Act.
    (3) Compensation--(i) In general. For purposes of the deduction 
limitation described in paragraph (b) of this section, compensation 
means the aggregate amount allowable as a deduction under chapter 1 of 
the Internal Revenue Code for the taxable year (determined without 
regard to section 162(m)) for remuneration for services performed by a

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covered employee, whether or not the services were performed during the 
taxable year.
    (ii) Exceptions. Compensation does not include--
    (A) Remuneration covered in section 3121(a)(5)(A) through section 
3121(a)(5)(D) (concerning remuneration that is not treated as wages for 
purposes of the Federal Insurance Contributions Act); and
    (B) Remuneration consisting of any benefit provided to or on behalf 
of an employee if, at the time the benefit is provided, it is reasonable 
to believe that the employee will be able to exclude it from gross 
income. In addition, compensation does not include salary reduction 
contributions described in section 3121(v)(1).
    (4) Compensation Committee. The compensation committee means the 
committee of directors (including any subcommittee of directors) of the 
publicly held corporation that has the authority to establish and 
administer performance goals described in paragraph (e)(2) of this 
section, and to certify that performance goals are attained, as 
described in paragraph (e)(5) of this section. A committee of directors 
is not treated as failing to have the authority to establish performance 
goals merely because the goals are ratified by the board of directors of 
the publicly held corporation or, if applicable, any other committee of 
the board of directors. See paragraph (e)(3) of this section for rules 
concerning the composition of the compensation committee.
    (5) Exchange Act. The Exchange Act means the Securities Exchange Act 
of 1934.
    (6) Examples. This paragraph (c) may be illustrated by the following 
examples:

    Example 1. Corporation X is a publicly held corporation with a July 
1 to June 30 fiscal year. For Corporation X's taxable year ending on 
June 30, 1995, Corporation X pays compensation of $2,000,000 to A, an 
employee. However, A's compensation is not required to be reported to 
shareholders under the executive compensation disclosure rules of the 
Exchange Act because A is neither the chief executive officer nor one of 
the four highest compensated officers employed on the last day of the 
taxable year. A's compensation is not subject to the deduction 
limitation of paragraph (b) of this section.
    Example 2. C, a covered employee, performs services and receives 
compensation from Corporations X, Y, and Z, members of an affiliated 
group of corporations. Corporation X, the parent corporation, is a 
publicly held corporation. The total compensation paid to C from all 
affiliated group members is $3,000,000 for the taxable year, of which 
Corporation X pays $1,500,000; Corporation Y pays $900,000; and 
Corporation Z pays $600,000. Because the compensation paid by all 
affiliated group members is aggregated for purposes of section 162(m), 
$2,000,000 of the aggregate compensation paid is nondeductible. 
Corporations X, Y, and Z each are treated as paying a ratable portion of 
the nondeductible compensation. Thus, two thirds of each corporation's 
payment will be nondeductible. Corporation X has a nondeductible 
compensation expense of $1,000,000 ($1,500,000 x $2,000,000/$3,000,000). 
Corporation Y has a nondeductible compensation expense of $600,000 
($900,000 x $2,000,000/$3,000,000). Corporation Z has a nondeductible 
compensation expense of $400,000 ($600,000 x $2,000,000/$3,000,000).
    Example 3. Corporation W, a calendar year taxpayer, has total assets 
equal to or exceeding $5 million and a class of equity security held of 
record by 500 or more persons on December 31, 1994. However, under the 
Exchange Act, Corporation W is not required to file a registration 
statement with respect to that security until April 30, 1995. Thus, 
Corporation W is not a publicly held corporation on December 31, 1994, 
but is a publicly held corporation on December 31, 1995.
    Example 4. The facts are the same as in Example 3, except that on 
December 15, 1996, Corporation W files with the Securities and Exchange 
Commission to disclose that Corporation W is no longer required to be 
registered under section 12 of the Exchange Act and to terminate its 
registration of securities under that provision. Because Corporation W 
is no longer subject to Exchange Act reporting obligations as of 
December 31, 1996, Corporation W is not a publicly held corporation for 
taxable year 1996, even though the registration of Corporation W's 
securities does not terminate until 90 days after Corporation W files 
with the Securities and Exchange Commission.

    (d) Exception for compensation paid on a commission basis. The 
deduction limit in paragraph (b) of this section shall not apply to any 
compensation paid on a commission basis. For this purpose, compensation 
is paid on a commission basis if the facts and circumstances show that 
it is paid solely on account of income generated directly by the 
individual performance of the individual to whom the compensation is 
paid.

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Compensation does not fail to be attributable directly to the individual 
merely because support services, such as secretarial or research 
services, are utilized in generating the income. However, if 
compensation is paid on account of broader performance standards, such 
as income produced by a business unit of the corporation, the 
compensation does not qualify for the exception provided under this 
paragraph (d).
    (e) Exception for qualified performance-based compensation--
    (1) In general. The deduction limit in paragraph (b) of this section 
does not apply to qualified performance-based compensation. Qualified 
performance-based compensation is compensation that meets all of the 
requirements of paragraphs (e)(2) through (e)(5) of this section.
    (2) Performance goal requirement--(i) Preestablished goal. Qualified 
performance-based compensation must be paid solely on account of the 
attainment of one or more preestablished, objective performance goals. A 
performance goal is considered preestablished if it is established in 
writing by the compensation committee not later than 90 days after the 
commencement of the period of service to which the performance goal 
relates, provided that the outcome is substantially uncertain at the 
time the compensation committee actually establishes the goal. However, 
in no event will a performance goal be considered to be preestablished 
if it is established after 25 percent of the period of service (as 
scheduled in good faith at the time the goal is established) has 
elapsed. A performance goal is objective if a third party having 
knowledge of the relevant facts could determine whether the goal is met. 
Performance goals can be based on one or more business criteria that 
apply to the individual, a business unit, or the corporation as a whole. 
Such business criteria could include, for example, stock price, market 
share, sales, earnings per share, return on equity, or costs. A 
performance goal need not, however, be based upon an increase or 
positive result under a business criterion and could include, for 
example, maintaining the status quo or limiting economic losses 
(measured, in each case, by reference to a specific business criterion). 
A performance goal does not include the mere continued employment of the 
covered employee. Thus, a vesting provision based solely on continued 
employment would not constitute a performance goal. See paragraph 
(e)(2)(vi) of this section for rules on compensation that is based on an 
increase in the price of stock.
    (ii) Objective compensation formula. A preestablished performance 
goal must state, in terms of an objective formula or standard, the 
method for computing the amount of compensation payable to the employee 
if the goal is attained. A formula or standard is objective if a third 
party having knowledge of the relevant performance results could 
calculate the amount to be paid to the employee. In addition, a formula 
or standard must specify the individual employees or class of employees 
to which it applies.
    (iii) Discretion. (A) The terms of an objective formula or standard 
must preclude discretion to increase the amount of compensation payable 
that would otherwise be due upon attainment of the goal. A performance 
goal is not discretionary for purposes of this paragraph (e)(2)(iii) 
merely because the compensation committee reduces or eliminates the 
compensation or other economic benefit that was due upon attainment of 
the goal. However, the exercise of negative discretion with respect to 
one employee is not permitted to result in an increase in the amount 
payable to another employee. Thus, for example, in the case of a bonus 
pool, if the amount payable to each employee is stated in terms of a 
percentage of the pool, the sum of these individual percentages of the 
pool is not permitted to exceed 100 percent. If the terms of an 
objective formula or standard fail to preclude discretion to increase 
the amount of compensation merely because the amount of compensation to 
be paid upon attainment of the performance goal is based, in whole or in 
part, on a percentage of salary or base pay and the dollar amount of the 
salary or base pay is not fixed at the time the performance goal is 
established, then the objective formula or standard will not be 
considered

[[Page 222]]

discretionary for purposes of this paragraph (e)(2)(iii) if the maximum 
dollar amount to be paid is fixed at that time.
    (B) If compensation is payable upon or after the attainment of a 
performance goal, and a change is made to accelerate the payment of 
compensation to an earlier date after the attainment of the goal, the 
change will be treated as an increase in the amount of compensation, 
unless the amount of compensation paid is discounted to reasonably 
reflect the time value of money. If compensation is payable upon or 
after the attainment of a performance goal, and a change is made to 
defer the payment of compensation to a later date, any amount paid in 
excess of the amount that was originally owed to the employee will not 
be treated as an increase in the amount of compensation if the 
additional amount is based either on a reasonable rate of interest or on 
one or more predetermined actual investments (whether or not assets 
associated with the amount originally owed are actually invested 
therein) such that the amount payable by the employer at the later date 
will be based on the actual rate of return of a specific investment 
(including any decrease as well as any increase in the value of an 
investment). If compensation is payable in the form of property, a 
change in the timing of the transfer of that property after the 
attainment of the goal will not be treated as an increase in the amount 
of compensation for purposes of this paragraph (e)(2)(iii). Thus, for 
example, if the terms of a stock grant provide for stock to be 
transferred after the attainment of a performance goal and the transfer 
of the stock also is subject to a vesting schedule, a change in the 
vesting schedule that either accelerates or defers the transfer of stock 
will not be treated as an increase in the amount of compensation payable 
under the performance goal.
    (C) Compensation attributable to a stock option, stock appreciation 
right, or other stock-based compensation does not fail to satisfy the 
requirements of this paragraph (e)(2) to the extent that a change in the 
grant or award is made to reflect a change in corporate capitalization, 
such as a stock split or dividend, or a corporate transaction, such as 
any merger of a corporation into another corporation, any consolidation 
of two or more corporations into another corporation, any separation of 
a corporation (including a spinoff or other distribution of stock or 
property by a corporation), any reorganization of a corporation (whether 
or not such reorganization comes within the definition of such term in 
section 368), or any partial or complete liquidation by a corporation.
    (iv) Grant-by-grant determination. The determination of whether 
compensation satisfies the requirements of this paragraph (e)(2) 
generally shall be made on a grant-by-grant basis. Thus, for example, 
whether compensation attributable to a stock option grant satisfies the 
requirements of this paragraph (e)(2) generally is determined on the 
basis of the particular grant made and without regard to the terms of 
any other option grant, or other grant of compensation, to the same or 
another employee. As a further example, except as provided in paragraph 
(e)(2)(vi), whether a grant of restricted stock or other stock-based 
compensation satisfies the requirements of this paragraph (e)(2) is 
determined without regard to whether dividends, dividend equivalents, or 
other similar distributions with respect to stock, on such stock-based 
compensation are payable prior to the attainment of the performance 
goal. Dividends, dividend equivalents, or other similar distributions 
with respect to stock that are treated as separate grants under this 
paragraph (e)(2)(iv) are not performance-based compensation unless they 
separately satisfy the requirements of this paragraph (e)(2).
    (v) Compensation contingent upon attainment of performance goal. 
Compensation does not satisfy the requirements of this paragraph (e)(2) 
if the facts and circumstances indicate that the employee would receive 
all or part of the compensation regardless of whether the performance 
goal is attained. Thus, if the payment of compensation under a grant or 
award is only nominally or partially contingent on attaining a 
performance goal, none of the compensation payable under the grant or 
award will be considered performance-based. For example, if an employee 
is

[[Page 223]]

entitled to a bonus under either of two arrangements, where payment 
under a nonperformance-based arrangement is contingent upon the failure 
to attain the performance goals under an otherwise performance-based 
arrangement, then neither arrangement provides for compensation that 
satisfies the requirements of this paragraph (e)(2). Compensation does 
not fail to be qualified performance-based compensation merely because 
the plan allows the compensation to be payable upon death, disability, 
or change of ownership or control, although compensation actually paid 
on account of those events prior to the attainment of the performance 
goal would not satisfy the requirements of this paragraph (e)(2). As an 
exception to the general rule set forth in the first sentence of 
paragraph (e)(2)(iv) of this section, the facts-and-circumstances 
determination referred to in the first sentence of this paragraph 
(e)(2)(v) is made taking into account all plans, arrangements, and 
agreements that provide for compensation to the employee.
    (vi) Application of requirements to stock options and stock 
appreciation rights--(A) In general. Compensation attributable to a 
stock option or a stock appreciation right is deemed to satisfy the 
requirements of this paragraph (e)(2) if the grant or award is made by 
the compensation committee; the plan under which the option or right is 
granted states the maximum number of shares with respect to which 
options or rights may be granted during a specified period to any 
individual employee; and, under the terms of the option or right, the 
amount of compensation the employee may receive is based solely on an 
increase in the value of the stock after the date of the grant or award. 
A plan may satisfy the requirement to provide a maximum number of shares 
with respect to which stock options and stock appreciation rights may be 
granted to any individual employee during a specified period if the plan 
specifies an aggregate maximum number of shares with respect to which 
stock options, stock appreciation rights, restricted stock, restricted 
stock units and other equity-based awards that may be granted to any 
individual employee during a specified period under a plan approved by 
shareholders in accordance with Sec.  1.162-27(e)(4). If the amount of 
compensation the employee may receive under the grant or award is not 
based solely on an increase in the value of the stock after the date of 
grant or award (for example, in the case of restricted stock, or an 
option that is granted with an exercise price that is less than the fair 
market value of the stock as of the date of grant), none of the 
compensation attributable to the grant or award is qualified 
performance-based compensation under this paragraph (e)(2)(vi)(A). 
Whether a stock option grant is based solely on an increase in the value 
of the stock after the date of grant is determined without regard to any 
dividend equivalent that may be payable, provided that payment of the 
dividend equivalent is not made contingent on the exercise of the 
option. The rule that the compensation attributable to a stock option or 
stock appreciation right must be based solely on an increase in the 
value of the stock after the date of grant or award does not apply if 
the grant or award is made on account of, or if the vesting or 
exercisability of the grant or award is contingent on, the attainment of 
a performance goal that satisfies the requirements of this paragraph 
(e)(2).
    (B) Cancellation and repricing. Compensation attributable to a stock 
option or stock appreciation right does not satisfy the requirements of 
this paragraph (e)(2) to the extent that the number of options granted 
exceeds the maximum number of shares for which options may be granted to 
the employee as specified in the plan. If an option is canceled, the 
canceled option continues to be counted against the maximum number of 
shares for which options may be granted to the employee under the plan. 
If, after grant, the exercise price of an option is reduced, the 
transaction is treated as a cancellation of the option and a grant of a 
new option. In such case, both the option that is deemed to be canceled 
and the option that is deemed to be granted reduce the maximum number of 
shares for which options may be granted to the employee under the plan. 
This paragraph (e)(2)(vi)(B) also

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applies in the case of a stock appreciation right where, after the award 
is made, the base amount on which stock appreciation is calculated is 
reduced to reflect a reduction in the fair market value of stock.
    (vii) Examples. This paragraph (e)(2) may be illustrated by the 
following examples:

    Example 1. No later than 90 days after the start of a fiscal year, 
but while the outcome is substantially uncertain, Corporation S 
establishes a bonus plan under which A, the chief executive officer, 
will receive a cash bonus of $500,000, if year-end corporate sales are 
increased by at least 5 percent. The compensation committee retains the 
right, if the performance goal is met, to reduce the bonus payment to A 
if, in its judgment, other subjective factors warrant a reduction. The 
bonus will meet the requirements of this paragraph (e)(2).
    Example 2. The facts are the same as in Example 1, except that the 
bonus is based on a percentage of Corporation S's total sales for the 
fiscal year. Because Corporation S is virtually certain to have some 
sales for the fiscal year, the outcome of the performance goal is not 
substantially uncertain, and therefore the bonus does not meet the 
requirements of this paragraph (e)(2).
    Example 3. The facts are the same as in Example 1, except that the 
bonus is based on a percentage of Corporation S's total profits for the 
fiscal year. Although some sales are virtually certain for virtually all 
public companies, it is substantially uncertain whether a company will 
have profits for a specified future period even if the company has a 
history of profitability. Therefore, the bonus will meet the 
requirements of this paragraph (e)(2).
    Example 4. B is the general counsel of Corporation R, which is 
engaged in patent litigation with Corporation S. Representatives of 
Corporation S have informally indicated to Corporation R a willingness 
to settle the litigation for $50,000,000. Subsequently, the compensation 
committee of Corporation R agrees to pay B a bonus if B obtains a formal 
settlement for at least $50,000,000. The bonus to B does not meet the 
requirement of this paragraph (e)(2) because the performance goal was 
not established at a time when the outcome was substantially uncertain.
    Example 5. Corporation S, a public utility, adopts a bonus plan for 
selected salaried employees that will pay a bonus at the end of a 3-year 
period of $750,000 each if, at the end of the 3 years, the price of S 
stock has increased by 10 percent. The plan also provides that the 10-
percent goal will automatically adjust upward or downward by the 
percentage change in a published utilities index. Thus, for example, if 
the published utilities index shows a net increase of 5 percent over a 
3-year period, then the salaried employees would receive a bonus only if 
Corporation S stock has increased by 15 percent. Conversely, if the 
published utilities index shows a net decrease of 5 percent over a 3-
year period, then the salaried employees would receive a bonus if 
Corporation S stock has increased by 5 percent. Because these automatic 
adjustments in the performance goal are preestablished, the bonus meets 
the requirement of this paragraph (e)(2), notwithstanding the potential 
changes in the performance goal.
    Example 6. The facts are the same as in Example 5, except that the 
bonus plan provides that, at the end of the 3-year period, a bonus of 
$750,000 will be paid to each salaried employee if either the price of 
Corporation S stock has increased by 10 percent or the earnings per 
share on Corporation S stock have increased by 5 percent. If both the 
earnings-per-share goal and the stock-price goal are preestablished, the 
compensation committee's discretion to choose to pay a bonus under 
either of the two goals does not cause any bonus paid under the plan to 
fail to meet the requirement of this paragraph (e)(2) because each goal 
independently meets the requirements of this paragraph (e)(2). The 
choice to pay under either of the two goals is tantamount to the 
discretion to choose not to pay under one of the goals, as provided in 
paragraph (e)(2)(iii) of this section.
    Example 7. Corporation U establishes a bonus plan under which a 
specified class of employees will participate in a bonus pool if certain 
preestablished performance goals are attained. The amount of the bonus 
pool is determined under an objective formula. Under the terms of the 
bonus plan, the compensation committee retains the discretion to 
determine the fraction of the bonus pool that each employee may receive. 
The bonus plan does not satisfy the requirements of this paragraph 
(e)(2). Although the aggregate amount of the bonus plan is determined 
under an objective formula, a third party could not determine the amount 
that any individual could receive under the plan.
    Example 8. The facts are the same as in Example 7, except that the 
bonus plan provides that a specified share of the bonus pool is payable 
to each employee, and the total of these shares does not exceed 100% of 
the pool. The bonus plan satisfies the requirements of this paragraph 
(e)(2). In addition, the bonus plan will satisfy the requirements of 
this paragraph (e)(2) even if the compensation committee retains the 
discretion to reduce the compensation payable to any individual 
employee, provided that a reduction in the amount of one employee's 
bonus does not result in an increase in the amount of any other 
employee's bonus.
    Example 9. Corporation V establishes a stock option plan for 
salaried employees.

[[Page 225]]

The terms of the stock option plan specify that no individual salaried 
employee shall receive options for more than 100,000 shares over any 3-
year period. The compensation committee grants options for 50,000 shares 
to each of several salaried employees. The exercise price of each option 
is equal to or greater than the fair market value of a share of V stock 
at the time of each grant. Compensation attributable to the exercise of 
the options satisfies the requirements of paragraph (e)(2)(vi) of this 
section. If, however, the terms of the options provide that the exercise 
price is less than fair market value of a share of V stock at the date 
of grant, no compensation attributable to the exercise of those options 
satisfies the requirements of this paragraph (e)(2) unless issuance or 
exercise of the options was contingent upon the attainment of a 
preestablished performance goal that satisfies this paragraph (e)(2). 
If, however, the terms of the plan also provide that Corporation V could 
grant options to purchase no more than 900,000 shares over any 3-year 
period, but did not provide a limitation on the number of shares that 
any individual employee could purchase, then no compensation 
attributable to the exercise of those options satisfies the requirements 
of paragraph (e)(2)(vi) of this section.
    Example 10. The facts are the same as in Example 9, except that, 
within the same 3-year grant period, the fair market value of 
Corporation V stock is significantly less than the exercise price of the 
options. The compensation committee reprices those options to that lower 
current fair market value of Corporation V stock. The repricing of the 
options for 50,000 shares held by each salaried employee is treated as 
the grant of new options for an additional 50,000 shares to each 
employee. Thus, each of the salaried employees is treated as having 
received grants for 100,000 shares. Consequently, if any additional 
options are granted to those employees during the 3-year period, 
compensation attributable to the exercise of those additional options 
would not satisfy the requirements of this paragraph (e)(2). The results 
would be the same if the compensation committee canceled the outstanding 
options and issued new options to the same employees that were 
exercisable at the fair market value of Corporation V stock on the date 
of reissue.
    Example 11. Corporation W maintains a plan under which each 
participating employee may receive incentive stock options, nonqualified 
stock options, stock appreciation rights, or grants of restricted 
Corporation W stock. The plan specifies that each participating employee 
may receive options, stock appreciation rights, restricted stock, or any 
combination of each, for no more than 20,000 shares over the life of the 
plan. The plan provides that stock options may be granted with an 
exercise price of less than, equal to, or greater than fair market value 
on the date of grant. Options granted with an exercise price equal to, 
or greater than, fair market value on the date of grant do not fail to 
meet the requirements of this paragraph (e)(2) merely because the 
compensation committee has the discretion to determine the types of 
awards (i.e., options, rights, or restricted stock) to be granted to 
each employee or the discretion to issue options or make other 
compensation awards under the plan that would not meet the requirements 
of this paragraph (e)(2). Whether an option granted under the plan 
satisfies the requirements of this paragraph (e)(2) is determined on the 
basis of the specific terms of the option and without regard to other 
options or awards under the plan.
    Example 12. Corporation X maintains a plan under which stock 
appreciation rights may be awarded to key employees. The plan permits 
the compensation committee to make awards under which the amount of 
compensation payable to the employee is equal to the increase in the 
stock price plus a percentage ``gross up'' intended to offset the tax 
liability of the employee. In addition, the plan permits the 
compensation committee to make awards under which the amount of 
compensation payable to the employee is equal to the increase in the 
stock price, based on the highest price, which is defined as the highest 
price paid for Corporation X stock (or offered in a tender offer or 
other arms-length offer) during the 90 days preceding exercise. 
Compensation attributable to awards under the plan satisfies the 
requirements of paragraph (e)(2)(vi) of this section, provided that the 
terms of the plan specify the maximum number of shares for which awards 
may be made.
    Example 13. Corporation W adopts a plan under which a bonus will be 
paid to the CEO only if there is a 10% increase in earnings per share 
during the performance period. The plan provides that earnings per share 
will be calculated without regard to any change in accounting standards 
that may be required by the Financial Accounting Standards Board after 
the goal is established. After the goal is established, such a change in 
accounting standards occurs. Corporation W's reported earnings, for 
purposes of determining earnings per share under the plan, are adjusted 
pursuant to this plan provision to factor out this change in standards. 
This adjustment will not be considered an exercise of impermissible 
discretion because it is made pursuant to the plan provision.
    Example 14. Corporation X adopts a performance-based incentive pay 
plan with a four-year performance period. Bonuses under the plan are 
scheduled to be paid in the first year after the end of the performance 
period (year 5). However, in the second year of the performance period, 
the compensation committee determines that any bonuses payable

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in year 5 will instead, for bona fide business reasons, be paid in year 
10. The compensation committee also determines that any compensation 
that would have been payable in year 5 will be adjusted to reflect the 
delay in payment. The adjustment will be based on the greater of the 
future rate of return of a specified mutual fund that invests in blue 
chip stocks or of a specified venture capital investment over the five-
year deferral period. Each of these investments, considered by itself, 
is a predetermined actual investment because it is based on the future 
rate of return of an actual investment. However, the adjustment in this 
case is not based on predetermined actual investments within the meaning 
of paragraph (e)(2)(iii)(B) of this section because the amount payable 
by Corporation X in year 10 will be based on the greater of the two 
investment returns and, thus, will not be based on the actual rate of 
return on either specific investment.
    Example 15. The facts are the same as in Example 14, except that the 
increase will be based on Moody's Average Corporate Bond Yield over the 
five-year deferral period. Because this index reflects a reasonable rate 
of interest, the increase in the compensation payable that is based on 
the index's rate of return is not considered an impermissible increase 
in the amount of compensation payable under the formula.
    Example 16. The facts are the same as in Example 14, except that the 
increase will be based on the rate of return for the Standard & Poor's 
500 Index. This index does not measure interest rates and thus does not 
represent a reasonable rate of interest. In addition, this index does 
not represent an actual investment. Therefore, any additional 
compensation payable based on the rate of return of this index will 
result in an impermissible increase in the amount payable under the 
formula. If, in contrast, the increase were based on the rate of return 
of an existing mutual fund that is invested in a manner that seeks to 
approximate the Standard & Poor's 500 Index, the increase would be based 
on a predetermined actual investment within the meaning of paragraph 
(e)(2)(iii)(B) of this section and thus would not result in an 
impermissible increase in the amount payable under the formula.

    (3) Outside directors--(i) General rule. The performance goal under 
which compensation is paid must be established by a compensation 
committee comprised solely of two or more outside directors. A director 
is an outside director if the director--
    (A) Is not a current employee of the publicly held corporation;
    (B) Is not a former employee of the publicly held corporation who 
receives compensation for prior services (other than benefits under a 
tax-qualified retirement plan) during the taxable year;
    (C) Has not been an officer of the publicly held corporation; and
    (D) Does not receive remuneration from the publicly held 
corporation, either directly or indirectly, in any capacity other than 
as a director. For this purpose, remuneration includes any payment in 
exchange for goods or services.
    (ii) Remuneration received. For purposes of this paragraph (e)(3), 
remuneration is received, directly or indirectly, by a director in each 
of the following circumstances:
    (A) If remuneration is paid, directly or indirectly, to the director 
personally or to an entity in which the director has a beneficial 
ownership interest of greater than 50 percent. For this purpose, 
remuneration is considered paid when actually paid (and throughout the 
remainder of that taxable year of the corporation) and, if earlier, 
throughout the period when a contract or agreement to pay remuneration 
is outstanding.
    (B) If remuneration, other than de minimis remuneration, was paid by 
the publicly held corporation in its preceding taxable year to an entity 
in which the director has a beneficial ownership interest of at least 5 
percent but not more than 50 percent. For this purpose, remuneration is 
considered paid when actually paid or, if earlier, when the publicly 
held corporation becomes liable to pay it.
    (C) If remuneration, other than de minimis remuneration, was paid by 
the publicly held corporation in its preceding taxable year to an entity 
by which the director is employed or self-employed other than as a 
director. For this purpose, remuneration is considered paid when 
actually paid or, if earlier, when the publicly held corporation becomes 
liable to pay it.
    (iii) De minimis remuneration--(A) In general. For purposes of 
paragraphs (e)(3)(ii)(B) and (C) of this section, remuneration that was 
paid by the publicly held corporation in its preceding taxable year to 
an entity is de minimis if payments to the entity did not exceed 5 
percent of the gross revenue of the entity for its taxable year ending

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with or within that preceding taxable year of the publicly held 
corporation.
    (B) Remuneration for personal services and substantial owners. 
Notwithstanding paragraph (e)(3)(iii)(A) of this section, remuneration 
in excess of $60,000 is not de minimis if the remuneration is paid to an 
entity described in paragraph (e)(3)(ii)(B) of this section, or is paid 
for personal services to an entity described in paragraph (e)(3)(ii)(C) 
of this section.
    (iv) Remuneration for personal services. For purposes of paragraph 
(e)(3)(iii)(B) of this section, remuneration from a publicly held 
corporation is for personal services if--
    (A) The remuneration is paid to an entity for personal or 
professional services, consisting of legal, accounting, investment 
banking, and management consulting services (and other similar services 
that may be specified by the Commissioner in revenue rulings, notices, 
or other guidance published in the Internal Revenue Bulletin), performed 
for the publicly held corporation, and the remuneration is not for 
services that are incidental to the purchase of goods or to the purchase 
of services that are not personal services; and
    (B) The director performs significant services (whether or not as an 
employee) for the corporation, division, or similar organization (within 
the entity) that actually provides the services described in paragraph 
(e)(3)(iv)(A) of this section to the publicly held corporation, or more 
than 50 percent of the entity's gross revenues (for the entity's 
preceding taxable year) are derived from that corporation, subsidiary, 
or similar organization.
    (v) Entity defined. For purposes of this paragraph (e)(3), entity 
means an organization that is a sole proprietorship, trust, estate, 
partnership, or corporation. The term also includes an affiliated group 
of corporations as defined in section 1504 (determined without regard to 
section 1504(b)) and a group of organizations that would be an 
affiliated group but for the fact that one or more of the organizations 
are not incorporated. However, the aggregation rules referred to in the 
preceding sentence do not apply for purposes of determining whether a 
director has a beneficial ownership interest of at least 5 percent or 
greater than 50 percent.
    (vi) Employees and former officers. Whether a director is an 
employee or a former officer is determined on the basis of the facts at 
the time that the individual is serving as a director on the 
compensation committee. Thus, a director is not precluded from being an 
outside director solely because the director is a former officer of a 
corporation that previously was an affiliated corporation of the 
publicly held corporation. For example, a director of a parent 
corporation of an affiliated group is not precluded from being an 
outside director solely because that director is a former officer of an 
affiliated subsidiary that was spun off or liquidated. However, an 
outside director would no longer be an outside director if a corporation 
in which the director was previously an officer became an affiliated 
corporation of the publicly held corporation.
    (vii) Officer. Solely for purposes of this paragraph (e)(3), officer 
means an administrative executive who is or was in regular and continued 
service. The term implies continuity of service and excludes those 
employed for a special and single transaction. An individual who merely 
has (or had) the title of officer but not the authority of an officer is 
not considered an officer. The determination of whether an individual is 
or was an officer is based on all of the facts and circumstances in the 
particular case, including without limitation the source of the 
individual's authority, the term for which the individual is elected or 
appointed, and the nature and extent of the individual's duties.
    (viii) Members of affiliated groups. For purposes of this paragraph 
(e)(3), the outside directors of the publicly held member of an 
affiliated group are treated as the outside directors of all members of 
the affiliated group.
    (ix) Examples. This paragraph (e)(3) may be illustrated by the 
following examples:

    Example 1. Corporations X and Y are members of an affiliated group 
of corporations as defined in section 1504, until July 1, 1994, when Y 
is sold to another group. Prior to the sale, A served as an officer of 
Corporation Y.

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After July 1, 1994, A is not treated as a former officer of Corporation 
X by reason of having been an officer of Y.
    Example 2. Corporation Z, a calendar-year taxpayer, uses the 
services of a law firm by which B is employed, but in which B has a 
less-than-5-percent ownership interest. The law firm reports income on a 
July 1 to June 30 basis. Corporation Z appoints B to serve on its 
compensation committee for calendar year 1998 after determining that, in 
calendar year 1997, it did not become liable to the law firm for 
remuneration exceeding the lesser of $60,000 or five percent of the law 
firm's gross revenue (calculated for the year ending June 30, 1997). On 
October 1, 1998, Corporation Z becomes liable to pay remuneration of 
$50,000 to the law firm on June 30, 1999. For the year ending June 30, 
1998, the law firm's gross revenue was less than $1 million. Thus, in 
calendar year 1999, B is not an outside director. However, B may satisfy 
the requirements for an outside director in calendar year 2000, if, in 
calendar year 1999, Corporation Z does not become liable to the law firm 
for additional remuneration. This is because the remuneration actually 
paid on June 30, 1999 was considered paid on October 1, 1998 under 
paragraph (e)(3)(ii)(C) of this section.
    Example 3. Corporation Z, a publicly held corporation, purchases 
goods from Corporation A. D, an executive and less- than-5-percent owner 
of Corporation A, sits on the board of directors of Corporation Z and on 
its compensation committee. For 1997, Corporation Z obtains 
representations to the effect that D is not eligible for any commission 
for D's sales to Corporation Z and that, for purposes of determining D's 
compensation for 1997, Corporation A's sales to Corporation Z are not 
otherwise treated differently than sales to other customers of 
Corporation A (including its affiliates, if any) or are irrelevant. In 
addition, Corporation Z has no reason to believe that these 
representations are inaccurate or that it is otherwise paying 
remuneration indirectly to D personally. Thus, in 1997, no remuneration 
is considered paid by Corporation Z indirectly to D personally under 
paragraph (e)(3)(ii)(A) of this section.
    Example 4. (i) Corporation W, a publicly held corporation, purchases 
goods from Corporation T. C, an executive and less- than-5-percent owner 
of Corporation T, sits on the board of directors of Corporation W and on 
its compensation committee. Corporation T develops a new product and 
agrees on January 1, 1998 to pay C a bonus of $500,000 if Corporation W 
contracts to purchase the product. Even if Corporation W purchases the 
new product, sales to Corporation W will represent less than 5 percent 
of Corporation T's gross revenues. In 1999, Corporation W contracts to 
purchase the new product and, in 2000, C receives the $500,000 bonus 
from Corporation T. In 1998, 1999, and 2000, Corporation W does not 
obtain any representations relating to indirect remuneration to C 
personally (such as the representations described in Example 3).
    (ii) Thus, in 1998, 1999, and 2000, remuneration is considered paid 
by Corporation W indirectly to C personally under paragraph 
(e)(3)(ii)(A) of this section. Accordingly, in 1998, 1999, and 2000, C 
is not an outside director of Corporation W. The result would have been 
the same if Corporation W had obtained appropriate representations but 
nevertheless had reason to believe that it was paying remuneration 
indirectly to C personally.
    Example 5. Corporation R, a publicly held corporation, purchases 
utility service from Corporation Q, a public utility. The chief 
executive officer, and less-than-5-percent owner, of Corporation Q is a 
director of Corporation R. Corporation R pays Corporation Q more than 
$60,000 per year for the utility service, but less than 5 percent of 
Corporation Q's gross revenues. Because utility services are not 
personal services, the fees paid are not subject to the $60,000 de 
minimis rule for remuneration for personal services within the meaning 
of paragraph (e)(3)(iii)(B) of this section. Thus, the chief executive 
officer qualifies as an outside director of Corporation R, unless 
disqualified on some other basis.
    Example 6. Corporation A, a publicly held corporation, purchases 
management consulting services from Division S of Conglomerate P. The 
chief financial officer of Division S is a director of Corporation A. 
Corporation A pays more than $60,000 per year for the management 
consulting services, but less than 5 percent of Conglomerate P's gross 
revenues. Because management consulting services are personal services 
within the meaning of paragraph (e)(3)(iv)(A) of this section, and the 
chief financial officer performs significant services for Division S, 
the fees paid are subject to the $60,000 de minimis rule as remuneration 
for personal services. Thus, the chief financial officer does not 
qualify as an outside director of Corporation A.
    Example 7. The facts are the same as in Example 6, except that the 
chief executive officer, and less-than-5-percent owner, of the parent 
company of Conglomerate P is a director of Corporation A and does not 
perform significant services for Division S. If the gross revenues of 
Division S do not constitute more than 50 percent of the gross revenues 
of Conglomerate P for P's preceding taxable year, the chief executive 
officer will qualify as an outside director of Corporation A, unless 
disqualified on some other basis.

    (4) Shareholder approval requirement--(i) General rule. The material 
terms of the performance goal under which the compensation is to be paid 
must be disclosed to and subsequently approved by

[[Page 229]]

the shareholders of the publicly held corporation before the 
compensation is paid. The requirements of this paragraph (e)(4) are not 
satisfied if the compensation would be paid regardless of whether the 
material terms are approved by shareholders. The material terms include 
the employees eligible to receive compensation; a description of the 
business criteria on which the performance goal is based; and either the 
maximum amount of compensation that could be paid to any employee or the 
formula used to calculate the amount of compensation to be paid to the 
employee if the performance goal is attained (except that, in the case 
of a formula based, in whole or in part, on a percentage of salary or 
base pay, the maximum dollar amount of compensation that could be paid 
to the employee must be disclosed).
    (ii) Eligible employees. Disclosure of the employees eligible to 
receive compensation need not be so specific as to identify the 
particular individuals by name. A general description of the class of 
eligible employees by title or class is sufficient, such as the chief 
executive officer and vice presidents, or all salaried employees, all 
executive officers, or all key employees.
    (iii) Description of business criteria--(A) In general. Disclosure 
of the business criteria on which the performance goal is based need not 
include the specific targets that must be satisfied under the 
performance goal. For example, if a bonus plan provides that a bonus 
will be paid if earnings per share increase by 10 percent, the 10-
percent figure is a target that need not be disclosed to shareholders. 
However, in that case, disclosure must be made that the bonus plan is 
based on an earnings-per-share business criterion. In the case of a plan 
under which employees may be granted stock options or stock appreciation 
rights, no specific description of the business criteria is required if 
the grants or awards are based on a stock price that is no less than 
current fair market value.
    (B) Disclosure of confidential information. The requirements of this 
paragraph (e)(4) may be satisfied even though information that otherwise 
would be a material term of a performance goal is not disclosed to 
shareholders, provided that the compensation committee determines that 
the information is confidential commercial or business information, the 
disclosure of which would have an adverse effect on the publicly held 
corporation. Whether disclosure would adversely affect the corporation 
is determined on the basis of the facts and circumstances. If the 
compensation committee makes such a determination, the disclosure to 
shareholders must state the compensation committee's belief that the 
information is confidential commercial or business information, the 
disclosure of which would adversely affect the company. In addition, the 
ability not to disclose confidential information does not eliminate the 
requirement that disclosure be made of the maximum amount of 
compensation that is payable to an individual under a performance goal. 
Confidential information does not include the identity of an executive 
or the class of executives to which a performance goal applies or the 
amount of compensation that is payable if the goal is satisfied.
    (iv) Description of compensation. Disclosure as to the compensation 
payable under a performance goal must be specific enough so that 
shareholders can determine the maximum amount of compensation that could 
be paid to any individual employee during a specified period. If the 
terms of the performance goal do not provide for a maximum dollar 
amount, the disclosure must include the formula under which the 
compensation would be calculated. Thus, if compensation attributable to 
the exercise of stock options is equal to the difference between the 
exercise price and the current value of the stock, then disclosure of 
the maximum number of shares for which grants may be made to any 
individual employee during a specified period and the exercise price of 
those options (for example, fair market value on date of grant) would 
satisfy the requirements of this paragraph (e)(4)(iv). In that case, 
shareholders could calculate the maximum amount of compensation that 
would be attributable to the exercise of options on the basis of their 
assumptions as to the future stock price.

[[Page 230]]

    (v) Disclosure requirements of the Securities and Exchange 
Commission. To the extent not otherwise specifically provided in this 
paragraph (e)(4), whether the material terms of a performance goal are 
adequately disclosed to shareholders is determined under the same 
standards as apply under the Exchange Act.
    (vi) Frequency of disclosure. Once the material terms of a 
performance goal are disclosed to and approved by shareholders, no 
additional disclosure or approval is required unless the compensation 
committee changes the material terms of the performance goal. If, 
however, the compensation committee has authority to change the targets 
under a performance goal after shareholder approval of the goal, 
material terms of the performance goal must be disclosed to and 
reapproved by shareholders no later than the first shareholder meeting 
that occurs in the fifth year following the year in which shareholders 
previously approved the performance goal.
    (vii) Shareholder vote. For purposes of this paragraph (e)(4), the 
material terms of a performance goal are approved by shareholders if, in 
a separate vote, a majority of the votes cast on the issue (including 
abstentions to the extent abstentions are counted as voting under 
applicable state law) are cast in favor of approval.
    (viii) Members of affiliated group. For purposes of this paragraph 
(e)(4), the shareholders of the publicly held member of the affiliated 
group are treated as the shareholders of all members of the affiliated 
group.
    (ix) Examples. This paragraph (e)(4) may be illustrated by the 
following examples:

    Example 1. Corporation X adopts a plan that will pay a specified 
class of its executives an annual cash bonus based on the overall 
increase in corporate sales during the year. Under the terms of the 
plan, the cash bonus of each executive equals $100,000 multiplied by the 
number of percentage points by which sales increase in the current year 
when compared to the prior year. Corporation X discloses to its 
shareholders prior to the vote both the class of executives eligible to 
receive awards and the annual formula of $100,000 multiplied by the 
percentage increase in sales. This disclosure meets the requirements of 
this paragraph (e)(4). Because the compensation committee does not have 
the authority to establish a different target under the plan, 
Corporation X need not redisclose to its shareholders and obtain their 
reapproval of the material terms of the plan until those material terms 
are changed.
    Example 2. The facts are the same as in Example 1 except that 
Corporation X discloses only that bonuses will be paid on the basis of 
the annual increase in sales. This disclosure does not meet the 
requirements of this paragraph (e)(4) because it does not include the 
formula for calculating the compensation or a maximum amount of 
compensation to be paid if the performance goal is satisfied.
    Example 3. Corporation Y adopts an incentive compensation plan in 
1995 that will pay a specified class of its executives a bonus every 3 
years based on the following 3 factors: increases in earnings per share, 
reduction in costs for specified divisions, and increases in sales by 
specified divisions. The bonus is payable in cash or in Corporation Y 
stock, at the option of the executive. Under the terms of the plan, 
prior to the beginning of each 3-year period, the compensation committee 
determines the specific targets under each of the three factors (i.e., 
the amount of the increase in earnings per share, the reduction in 
costs, and the amount of sales) that must be met in order for the 
executives to receive a bonus. Under the terms of the plan, the 
compensation committee retains the discretion to determine whether a 
bonus will be paid under any one of the goals. The terms of the plan 
also specify that no executive may receive a bonus in excess of 
$1,500,000 for any 3-year period. To satisfy the requirements of this 
paragraph (e)(4), Corporation Y obtains shareholder approval of the plan 
at its 1995 annual shareholder meeting. In the proxy statement issued to 
shareholders, Corporation Y need not disclose to shareholders the 
specific targets that are set by the compensation committee. However, 
Corporation Y must disclose that bonuses are paid on the basis of 
earnings per share, reductions in costs, and increases in sales of 
specified divisions. Corporation Y also must disclose the maximum amount 
of compensation that any executive may receive under the plan is 
$1,500,000 per 3-year period. Unless changes in the material terms of 
the plan are made earlier, Corporation Y need not disclose the material 
terms of the plan to the shareholders and obtain their reapproval until 
the first shareholders' meeting held in 2000.
    Example 4. The same facts as in Example 3, except that prior to the 
beginning of the second 3-year period, the compensation committee 
determines that different targets will be set under the plan for that 
period with regard to all three of the performance criteria (i.e., 
earnings per share, reductions in costs, and increases in sales). In 
addition, the compensation committee raises the maximum dollar amount 
that can be paid under the

[[Page 231]]

plan for a 3-year period to $2,000,000. The increase in the maximum 
dollar amount of compensation under the plan is a changed material term. 
Thus, to satisfy the requirements of this paragraph (e)(4), Corporation 
Y must disclose to and obtain approval by the shareholders of the plan 
as amended.
    Example 5. In 1998, Corporation Z establishes a plan under which a 
specified group of executives will receive a cash bonus not to exceed 
$750,000 each if a new product that has been in development is completed 
and ready for sale to customers by January 1, 2000. Although the 
completion of the new product is a material term of the performance goal 
under this paragraph (e)(4), the compensation committee determines that 
the disclosure to shareholders of the performance goal would adversely 
affect Corporation Z because its competitors would be made aware of the 
existence and timing of its new product. In this case, the requirements 
of this paragraph (e)(4) are satisfied if all other material terms, 
including the maximum amount of compensation, are disclosed and the 
disclosure affirmatively states that the terms of the performance goal 
are not being disclosed because the compensation committee has 
determined that those terms include confidential information, the 
disclosure of which would adversely affect Corporation Z.

    (5) Compensation committee certification. The compensation committee 
must certify in writing prior to payment of the compensation that the 
performance goals and any other material terms were in fact satisfied. 
For this purpose, approved minutes of the compensation committee meeting 
in which the certification is made are treated as a written 
certification. Certification by the compensation committee is not 
required for compensation that is attributable solely to the increase in 
the value of the stock of the publicly held corporation.
    (f) Companies that become publicly held, spinoffs, and similar 
transactions--(1) In general. In the case of a corporation that was not 
a publicly held corporation and then becomes a publicly held 
corporation, the deduction limit of paragraph (b) of this section does 
not apply to any remuneration paid pursuant to a compensation plan or 
agreement that existed during the period in which the corporation was 
not publicly held. However, in the case of such a corporation that 
becomes publicly held in connection with an initial public offering, 
this relief applies only to the extent that the prospectus accompanying 
the initial public offering disclosed information concerning those plans 
or agreements that satisfied all applicable securities laws then in 
effect. In accordance with paragraph (c)(1)(ii) of this section, a 
corporation that is a member of an affiliated group that includes a 
publicly held corporation is considered publicly held and, therefore, 
cannot rely on this paragraph (f)(1).
    (2) Reliance period. Paragraph (f)(1) of this section may be relied 
upon until the earliest of--
    (i) The expiration of the plan or agreement;
    (ii) The material modification of the plan or agreement, within the 
meaning of paragraph (h)(1)(iii) of this section;
    (iii) The issuance of all employer stock and other compensation that 
has been allocated under the plan; or
    (iv) The first meeting of shareholders at which directors are to be 
elected that occurs after the close of the third calendar year following 
the calendar year in which the initial public offering occurs or, in the 
case of a privately held corporation that becomes publicly held without 
an initial public offering, the first calendar year following the 
calendar year in which the corporation becomes publicly held.
    (3) Stock-based compensation. Paragraph (f)(1) of this section will 
apply to any compensation received pursuant to the exercise of a stock 
option or stock appreciation right, or the substantial vesting of 
restricted property, granted under a plan or agreement described in 
paragraph (f)(1) of this section if the grant occurs on or before the 
earliest of the events specified in paragraph (f)(2) of this section. 
This paragraph does not apply to any form of stock-based compensation 
other than the forms listed in the immediately preceding sentence. Thus, 
for example, compensation payable under a restricted stock unit 
arrangement or a phantom stock arrangement must be paid, rather than 
merely granted, on or before the occurrence of the earliest of the 
events specified in paragraph (f)(2) of this section in order for 
paragraph (f)(1) of this section to apply.
    (4) Subsidiaries that become separate publicly held corporations--
(i) In general.

[[Page 232]]

If a subsidiary that is a member of the affiliated group described in 
paragraph (c)(1)(ii) of this section becomes a separate publicly held 
corporation (whether by spinoff or otherwise), any remuneration paid to 
covered employees of the new publicly held corporation will satisfy the 
exception for performance-based compensation described in paragraph (e) 
of this section if the conditions in either paragraph (f)(4)(ii) or 
(f)(4)(iii) of this section are satisfied.
    (ii) Prior establishment and approval. Remuneration satisfies the 
requirements of this paragraph (f)(4)(ii) if the remuneration satisfies 
the requirements for performance-based compensation set forth in 
paragraphs (e)(2), (e)(3), and (e)(4) of this section (by application of 
paragraphs (e)(3)(viii) and (e)(4)(viii) of this section) before the 
corporation becomes a separate publicly held corporation, and the 
certification required by paragraph (e)(5) of this section is made by 
the compensation committee of the new publicly held corporation (but if 
the performance goals are attained before the corporation becomes a 
separate publicly held corporation, the certification may be made by the 
compensation committee referred to in paragraph (e)(3)(viii) of this 
section before it becomes a separate publicly held corporation). Thus, 
this paragraph (f)(4)(ii) requires that the outside directors and 
shareholders (within the meaning of paragraphs (e)(3)(viii) and 
(e)(4)(viii) of this section) of the corporation before it becomes a 
separate publicly held corporation establish and approve, respectively, 
the performance-based compensation for the covered employees of the new 
publicly held corporation in accordance with paragraphs (e)(3) and 
(e)(4) of this section.
    (iii) Transition period. Remuneration satisfies the requirements of 
this paragraph (f)(4)(iii) if the remuneration satisfies all of the 
requirements of paragraphs (e)(2), (e)(3), and (e)(5) of this section. 
The outside directors (within the meaning of paragraph (e)(3)(viii) of 
this section) of the corporation before it becomes a separate publicly 
held corporation, or the outside directors of the new publicly held 
corporation, may establish and administer the performance goals for the 
covered employees of the new publicly held corporation for purposes of 
satisfying the requirements of paragraphs (e)(2) and (e)(3) of this 
section. The certification required by paragraph (e)(5) of this section 
must be made by the compensation committee of the new publicly held 
corporation. However, a taxpayer may rely on this paragraph (f)(4)(iii) 
to satisfy the requirements of paragraph (e) of this section only for 
compensation paid, or stock options, stock appreciation rights, or 
restricted property granted, prior to the first regularly scheduled 
meeting of the shareholders of the new publicly held corporation that 
occurs more than 12 months after the date the corporation becomes a 
separate publicly held corporation. Compensation paid, or stock options, 
stock appreciation rights, or restricted property granted, on or after 
the date of that meeting of shareholders must satisfy all requirements 
of paragraph (e) of this section, including the shareholder approval 
requirement of paragraph (e)(4) of this section, in order to satisfy the 
requirements for performance-based compensation.
    (5) Example. The following example illustrates the application of 
paragraph (f)(4)(ii) of this section:

    Example. Corporation P, which is publicly held, decides to spin off 
Corporation S, a wholly owned subsidiary of Corporation P. After the 
spinoff, Corporation S will be a separate publicly held corporation. 
Before the spinoff, the compensation committee of Corporation P, 
pursuant to paragraph (e)(3)(viii) of this section, establishes a bonus 
plan for the executives of Corporation S that provides for bonuses 
payable after the spinoff and that satisfies the requirements of 
paragraph (e)(2) of this section. If, pursuant to paragraph (e)(4)(viii) 
of this section, the shareholders of Corporation P approve the plan 
prior to the spinoff, that approval will satisfy the requirements of 
paragraph (e)(4) of this section with respect to compensation paid 
pursuant to the bonus plan after the spinoff. However, the compensation 
committee of Corporation S will be required to certify that the goals 
are satisfied prior to the payment of the bonuses in order for the 
bonuses to be considered performance-based compensation.

    (g) Coordination with disallowed excess parachute payments. The 
$1,000,000 limitation in paragraph (b) of this section is reduced (but 
not below zero) by the amount (if any) that would have been

[[Page 233]]

included in the compensation of the covered employee for the taxable 
year but for being disallowed by reason of section 280G. For example, 
assume that during a taxable year a corporation pays $1,500,000 to a 
covered employee and no portion satisfies the exception in paragraph (d) 
of this section for commissions or paragraph (e) of this section for 
qualified performance-based compensation. Of the $1,500,000, $600,000 is 
an excess parachute payment, as defined in section 280G(b)(1) and is 
disallowed by reason of that section. Because the excess parachute 
payment reduces the limitation of paragraph (b) of this section, the 
corporation can deduct $400,000, and $500,000 of the otherwise 
deductible amount is nondeductible by reason of section 162(m).
    (h) Transition rules--(1) Compensation payable under a written 
binding contract which was in effect on February 17, 1993--(i) General 
rule. The deduction limit of paragraph (b) of this section does not 
apply to any compensation payable under a written binding contract that 
was in effect on February 17, 1993. The preceding sentence does not 
apply unless, under applicable state law, the corporation is obligated 
to pay the compensation if the employee performs services. However, the 
deduction limit of paragraph (b) of this section does apply to a 
contract that is renewed after February 17, 1993. A written binding 
contract that is terminable or cancelable by the corporation after 
February 17, 1993, without the employee's consent is treated as a new 
contract as of the date that any such termination or cancellation, if 
made, would be effective. Thus, for example, if the terms of a contract 
provide that it will be automatically renewed as of a certain date 
unless either the corporation or the employee gives notice of 
termination of the contract at least 30 days before that date, the 
contract is treated as a new contract as of the date that termination 
would be effective if that notice were given. Similarly, for example, if 
the terms of a contract provide that the contract will be terminated or 
canceled as of a certain date unless either the corporation or the 
employee elects to renew within 30 days of that date, the contract is 
treated as renewed by the corporation as of that date. Alternatively, if 
the corporation will remain legally obligated by the terms of a contract 
beyond a certain date at the sole discretion of the employee, the 
contract will not be treated as a new contract as of that date if the 
employee exercises the discretion to keep the corporation bound to the 
contract. A contract is not treated as terminable or cancelable if it 
can be terminated or canceled only by terminating the employment 
relationship of the employee.
    (ii) Compensation payable under a plan or arrangement. If a 
compensation plan or arrangement meets the requirements of paragraph 
(h)(1)(i) of this section, the compensation paid to an employee pursuant 
to the plan or arrangement will not be subject to the deduction limit of 
paragraph (b) of this section even though the employee was not eligible 
to participate in the plan as of February 17, 1993. However, the 
preceding sentence does not apply unless the employee was employed on 
February 17, 1993, by the corporation that maintained the plan or 
arrangement, or the employee had the right to participate in the plan or 
arrangement under a written binding contract as of that date.
    (iii) Material modifications. (A) Paragraph (h)(1)(i) of this 
section will not apply to any written binding contract that is 
materially modified. A material modification occurs when the contract is 
amended to increase the amount of compensation payable to the employee. 
If a binding written contract is materially modified, it is treated as a 
new contract entered into as of the date of the material modification. 
Thus, amounts received by an employee under the contract prior to a 
material modification are not affected, but amounts received subsequent 
to the material modification are not treated as paid under a binding, 
written contract described in paragraph (h)(1)(i) of this section.
    (B) A modification of the contract that accelerates the payment of 
compensation will be treated as a material modification unless the 
amount of compensation paid is discounted to reasonably reflect the time 
value of money. If the contract is modified to defer the payment of 
compensation,

[[Page 234]]

any compensation paid in excess of the amount that was originally 
payable to the employee under the contract will not be treated as a 
material modification if the additional amount is based on either a 
reasonable rate of interest or one or more predetermined actual 
investments (whether or not assets associated with the amount originally 
owed are actually invested therein) such that the amount payable by the 
employer at the later date will be based on the actual rate of return of 
the specific investment (including any decrease as well as any increase 
in the value of the investment).
    (C) The adoption of a supplemental contract or agreement that 
provides for increased compensation, or the payment of additional 
compensation, is a material modification of a binding, written contract 
where the facts and circumstances show that the additional compensation 
is paid on the basis of substantially the same elements or conditions as 
the compensation that is otherwise paid under the written binding 
contract. However, a material modification of a written binding contract 
does not include a supplemental payment that is equal to or less than a 
reasonable cost-of-living increase over the payment made in the 
preceding year under that written binding contract. In addition, a 
supplemental payment of compensation that satisfies the requirements of 
qualified performance-based compensation in paragraph (e) of this 
section will not be treated as a material modification.
    (iv) Examples. The following examples illustrate the exception of 
this paragraph (h)(1):

    Example 1. Corporation X executed a 3-year compensation arrangement 
with C on February 15, 1993, that constitutes a written binding contract 
under applicable state law. The terms of the arrangement provide for 
automatic extension after the 3-year term for additional 1-year periods, 
unless the corporation exercises its option to terminate the arrangement 
within 30 days of the end of the 3-year term or, thereafter, within 30 
days before each anniversary date. Termination of the compensation 
arrangement does not require the termination of C's employment 
relationship with Corporation X. Unless terminated, the arrangement is 
treated as renewed on February 15, 1996, and the deduction limit of 
paragraph (b) of this section applies to payments under the arrangement 
after that date.
    Example 2. Corporation Y executed a 5-year employment agreement with 
B on January 1, 1992, providing for a salary of $900,000 per year. 
Assume that this agreement constitutes a written binding contract under 
applicable state law. In 1992 and 1993, B receives the salary of 
$900,000 per year. In 1994, Corporation Y increases B's salary with a 
payment of $20,000. The $20,000 supplemental payment does not constitute 
a material modification of the written binding contract because the 
$20,000 payment is less than or equal to a reasonable cost-of-living 
increase from 1993. However, the $20,000 supplemental payment is subject 
to the limitation in paragraph (b) of this section. On January 1, 1995, 
Corporation Y increases B's salary to $1,200,000. The $280,000 
supplemental payment is a material modification of the written binding 
contract because the additional compensation is paid on the basis of 
substantially the same elements or conditions as the compensation that 
is otherwise paid under the written binding contract and it is greater 
than a reasonable, annual cost-of-living increase. Because the written 
binding contract is materially modified as of January 1, 1995, all 
compensation paid to B in 1995 and thereafter is subject to the 
deduction limitation of section 162(m).
    Example 3. Assume the same facts as in Example 2, except that 
instead of an increase in salary, B receives a restricted stock grant 
subject to B's continued employment for the balance of the contract. The 
restricted stock grant is not a material modification of the binding 
written contract because any additional compensation paid to B under the 
grant is not paid on the basis of substantially the same elements and 
conditions as B's salary because it is based both on the stock price and 
B's continued service. However, compensation attributable to the 
restricted stock grant is subject to the deduction limitation of section 
162(m).

    (2) Special transition rule for outside directors. A director who is 
a disinterested director is treated as satisfying the requirements of an 
outside director under paragraph (e)(3) of this section until the first 
meeting of shareholders at which directors are to be elected that occurs 
on or after January 1, 1996. For purposes of this paragraph (h)(2) and 
paragraph (h)(3) of this section, a director is a disinterested director 
if the director is disinterested within the meaning of Rule 16b-
3(c)(2)(i), 17 CFR 240.16b-3(c)(2)(i), under the Exchange Act (including 
the provisions of Rule 16b-3(d)(3), as in effect on April 30, 1991).

[[Page 235]]

    (3) Special transition rule for previously-approved plans--(i) In 
general. Any compensation paid under a plan or agreement approved by 
shareholders before December 20, 1993, is treated as satisfying the 
requirements of paragraphs (e)(3) and (e)(4) of this section, provided 
that the directors administering the plan or agreement are disinterested 
directors and the plan was approved by shareholders in a manner 
consistent with Rule 16b-3(b), 17 CFR 240.16b-3(b), under the Exchange 
Act or Rule 16b-3(a), 17 CFR 240.16b-3(a) (as contained in 17 CFR part 
240 revised April 1, 1990). In addition, for purposes of satisfying the 
requirements of paragraph (e)(2)(vi) of this section, a plan or 
agreement is treated as stating a maximum number of shares with respect 
to which an option or right may be granted to any employee if the plan 
or agreement that was approved by the shareholders provided for an 
aggregate limit, consistent with Rule 16b-3(b), 17 CFR 250.16b-3(b), on 
the shares of employer stock with respect to which awards may be made 
under the plan or agreement.
    (ii) Reliance period. The transition rule provided in this paragraph 
(h)(3) shall continue and may be relied upon until the earliest of--
    (A) The expiration or material modification of the plan or 
agreement;
    (B) The issuance of all employer stock and other compensation that 
has been allocated under the plan; or
    (C) The first meeting of shareholders at which directors are to be 
elected that occurs after December 31, 1996.
    (iii) Stock-based compensation. This paragraph (h)(3) will apply to 
any compensation received pursuant to the exercise of a stock option or 
stock appreciation right, or the substantial vesting of restricted 
property, granted under a plan or agreement described in paragraph 
(h)(3)(i) of this section if the grant occurs on or before the earliest 
of the events specified in paragraph (h)(3)(ii) of this section.
    (iv) Example. The following example illustrates the application of 
this paragraph (h)(3):

    Example. Corporation Z adopted a stock option plan in 1991. Pursuant 
to Rule 16b-3 under the Exchange Act, the stock option plan has been 
administered by disinterested directors and was approved by Corporation 
Z shareholders. Under the terms of the plan, shareholder approval is not 
required again until 2001. In addition, the terms of the stock option 
plan include an aggregate limit on the number of shares available under 
the plan. Option grants under the Corporation Z plan are made with an 
exercise price equal to or greater than the fair market value of 
Corporation Z stock. Compensation attributable to the exercise of 
options that are granted under the plan before the earliest of the dates 
specified in paragraph (h)(3)(ii) of this section will be treated as 
satisfying the requirements of paragraph (e) of this section for 
qualified performance-based compensation, regardless of when the options 
are exercised.

    (i) [Reserved]
    (j) Effective date--(1) In general. Section 162(m) and this section 
apply to compensation that is otherwise deductible by the corporation in 
a taxable year beginning on or after January 1, 1994.
    (2) Delayed effective date for certain provisions--(i) Date on which 
remuneration is considered paid. Notwithstanding paragraph (j)(1) of 
this section, the rules in the second sentence of each of paragraphs 
(e)(3)(ii)(A), (e)(3)(ii)(B), and (e)(3)(ii)(C) of this section for 
determining the date or dates on which remuneration is considered paid 
to a director are effective for taxable years beginning on or after 
January 1, 1995. Prior to those taxable years, taxpayers must follow the 
rules in paragraphs (e)(3)(ii)(A), (e)(3)(ii)(B), and (e)(3)(ii)(C) of 
this section or another reasonable, good faith interpretation of section 
162(m) with respect to the date or dates on which remuneration is 
considered paid to a director.
    (ii) Separate treatment of publicly held subsidiaries. 
Notwithstanding paragraph (j)(1) of this section, the rule in paragraph 
(c)(1)(ii) of this section that treats publicly held subsidiaries as 
separately subject to section 162(m) is effective as of the first 
regularly scheduled meeting of the shareholders of the publicly held 
subsidiary that occurs more than 12 months after December 2, 1994. The 
rule for stock-based compensation set forth in paragraph (f)(3) of this 
section will apply for this purpose, except that the grant must occur 
before the shareholder meeting specified in this paragraph (j)(2)(ii). 
Taxpayers may choose to rely on the rule

[[Page 236]]

referred to in the first sentence of this paragraph (j)(2)(ii) for the 
period prior to the effective date of the rule.
    (iii) Subsidiaries that become separate publicly held corporations. 
Notwithstanding paragraph (j)(1) of this section, if a subsidiary of a 
publicly held corporation becomes a separate publicly held corporation 
as described in paragraph (f)(4)(i) of this section, then, for the 
duration of the reliance period described in paragraph (f)(2) of this 
section, the rules of paragraph (f)(1) of this section are treated as 
applying (and the rules of paragraph (f)(4) of this section do not 
apply) to remuneration paid to covered employees of that new publicly 
held corporation pursuant to a plan or agreement that existed prior to 
December 2, 1994, provided that the treatment of that remuneration as 
performance-based is in accordance with a reasonable, good faith 
interpretation of section 162(m). However, if remuneration is paid to 
covered employees of that new publicly held corporation pursuant to a 
plan or agreement that existed prior to December 2, 1994, but that 
remuneration is not performance-based under a reasonable, good faith 
interpretation of section 162(m), the rules of paragraph (f)(1) of this 
section will be treated as applying only until the first regularly 
scheduled meeting of shareholders that occurs more than 12 months after 
December 2, 1994. The rules of paragraph (f)(4) of this section will 
apply as of that first regularly scheduled meeting. The rule for stock-
based compensation set forth in paragraph (f)(3) of this section will 
apply for purposes of this paragraph (j)(2)(iii), except that the grant 
must occur before the shareholder meeting specified in the preceding 
sentence if the remuneration is not performance-based under a 
reasonable, good faith interpretation of section 162(m). Taxpayers may 
choose to rely on the rules of paragraph (f)(4) of this section for the 
period prior to the applicable effective date referred to in the first 
or second sentence of this paragraph (j)(2)(iii).
    (iv) Bonus pools. Notwithstanding paragraph (j)(1) of this section, 
the rules in paragraph (e)(2)(iii)(A) that limit the sum of individual 
percentages of a bonus pool to 100 percent will not apply to 
remuneration paid before January 1, 2001, based on performance in any 
performance period that began prior to December 20, 1995.
    (v) Compensation based on a percentage of salary or base pay. 
Notwithstanding paragraph (j)(1) of this section, the requirement in 
paragraph (e)(4)(i) of this section that, in the case of certain 
formulas based on a percentage of salary or base pay, a corporation 
disclose to shareholders the maximum dollar amount of compensation that 
could be paid to the employee, will apply only to plans approved by 
shareholders after April 30, 1995.
    (vi) The modifications to paragraphs (e)(2)(vi)(A), (e)(2)(vii) 
Example 9, and (e)(4)(iv) of this section concerning the maximum number 
of shares with respect to which a stock option or stock appreciation 
right that may be granted and the amount of compensation that may be 
paid to any individual employee apply to compensation attributable to 
stock options and stock appreciation rights that are granted on or after 
June 24, 2011. The last two sentences of Sec.  1.162-27(f)(3) apply to 
remuneration that is otherwise deductible resulting from a stock option, 
stock appreciation right, restricted stock (or other property), 
restricted stock unit, or any other form of equity-based remuneration 
that is granted on or after April 1, 2015.

[T.D. 8650, 60 FR 65537, Dec. 20, 1995, as amended at 61 FR 4350, Feb. 
6, 1996; T.D. 9716, 80 FR 16972, Mar. 31, 2015]



Sec.  1.162-28  Allocation of costs to lobbying activities.

    (a) Introduction--(1) In general. Section 162(e)(1) denies a 
deduction for certain amounts paid or incurred in connection with 
activities described in section 162(e)(1) (A) and (D) (lobbying 
activities). To determine the nondeductible amount, a taxpayer must 
allocate costs to lobbying activities. This section describes costs that 
must be allocated to lobbying activities and prescribes rules permitting 
a taxpayer to use a reasonable method to allocate those costs. This 
section does not apply to taxpayers subject to section 162(e)(5)(A). In 
addition, this section does not apply for purposes of sections 4911 and 
4945 and the regulations thereunder.

[[Page 237]]

    (2) Recordkeeping. For recordkeeping requirements, see section 6001 
and the regulations thereunder.
    (b) Reasonable method of allocating costs--(1) In general. A 
taxpayer must use a reasonable method to allocate the costs described in 
paragraph (c) of this section to lobbying activities. A method is not 
reasonable unless it is applied consistently and is consistent with the 
special rules in paragraph (g) of this section. Except as provided in 
paragraph (b)(2) of this section, reasonable methods of allocating costs 
to lobbying activities include (but are not limited to)--
    (i) The ratio method described in paragraph (d) of this section;
    (ii) The gross-up method described in paragraph (e) of this section; 
and
    (iii) A method that applies the principles of section 263A and the 
regulations thereunder (see paragraph (f) of this section).
    (2) Taxpayers not permitted to use certain methods. A taxpayer 
(other than one subject to section 6033(e)) that does not pay or incur 
reasonable labor costs for persons engaged in lobbying activities may 
not use the gross-up method. For example, a partnership or sole 
proprietorship in which the lobbying activities are performed by the 
owners who do not receive a salary or guaranteed payment for services 
does not pay or incur reasonable labor costs for persons engaged in 
those activities and may not use the gross-up method.
    (c) Costs allocable to lobbying activities--(1) In general. Costs 
properly allocable to lobbying activities include labor costs and 
general and administrative costs.
    (2) Labor costs. For each taxable year, labor costs include costs 
attributable to full-time, part-time, and contract employees. Labor 
costs include all elements of compensation, such as basic compensation, 
overtime pay, vacation pay, holiday pay, sick leave pay, payroll taxes, 
pension costs, employee benefits, and payments to a supplemental 
unemployment benefit plan.
    (3) General and administrative costs. For each taxable year, general 
and administrative costs include depreciation, rent, utilities, 
insurance, maintenance costs, security costs, and other administrative 
department costs (for example, payroll, personnel, and accounting).
    (d) Ratio method--(1) In general. Under the ratio method described 
in this paragraph (d), a taxpayer allocates to lobbying activities the 
sum of its third-party costs (as defined in paragraph (d)(5) of this 
section) allocable to lobbying activities and the costs determined by 
using the following formula:
[GRAPHIC] [TIFF OMITTED] TR21JY95.001


    (2) Lobbying labor hours. Lobbying labor hours are the hours that a 
taxpayer's personnel spend on lobbying activities during the taxable 
year. A taxpayer may use any reasonable method to determine the number 
of labor hours spent on lobbying activities and may use the de minimis 
rule of paragraph (g)(1) of this section. A taxpayer may treat as zero 
the lobbying labor hours of personnel engaged in secretarial, clerical, 
support, and other administrative activities (as opposed to activities 
involving significant judgment with respect to lobbying activities). 
Thus, for example, the hours spent on lobbying activities by para-
professionals and analysts may not be treated as zero.
    (3) Total labor hours. Total labor hours means the total number of 
hours that a taxpayer's personnel spend on a taxpayer's trade or 
business during the taxable year. A taxpayer may make reasonable 
assumptions concerning total hours spent by personnel on the taxpayer's 
trade or business. For example, it may be reasonable, based on all the 
facts and circumstances, to assume that all full-time personnel spend 
1,800 hours per year on a taxpayer's trade or business. If, under 
paragraph (d)(2) of this section, a taxpayer treats as zero the lobbying 
labor hours of personnel engaged in secretarial, clerical, support, and 
other administrative activities, the taxpayer must also treat as zero 
the total labor hours of all personnel engaged in those activities.
    (4) Total costs of operations. A taxpayer's total costs of 
operations means the total costs of the taxpayer's trade or business for 
a taxable year, excluding third-party costs (as defined in paragraph 
(d)(5) of this section).

[[Page 238]]

    (5) Third-party costs. Third-party costs are amounts paid or 
incurred in whole or in part for lobbying activities conducted by third 
parties (such as amounts paid to taxpayers subject to section 
162(e)(5)(A) or dues or other similar amounts that are not deductible in 
whole or in part under section 162(e)(3)) and amounts paid or incurred 
for travel (including meals and lodging while away from home) and 
entertainment relating in whole or in part to lobbying activities.
    (6) Example. The provisions of this paragraph (d) are illustrated by 
the following example.

    Example. (i) In 1996, three full-time employees, A, B, and C, of 
Taxpayer W engage in both lobbying activities and nonlobbying 
activities. A spends 300 hours, B spends 1,700 hours, and C spends 1,000 
hours on lobbying activities, for a total of 3,000 hours spent on 
lobbying activities for W. W reasonably assumes that each of its three 
employees spends 2,000 hours a year on W's business.
    (ii) W's total costs of operations are $300,000. W has no third-
party costs.
    (iii) Under the ratio method, X allocates $150,000 to its lobbying 
activities for 1996, as follows:
[GRAPHIC] [TIFF OMITTED] TR21JY95.002

    (e) Gross-up method--(1) In general. Under the gross-up method 
described in this paragraph (e)(1), the taxpayer allocates to lobbying 
activities the sum of its third-party costs (as defined in paragraph 
(d)(5) of this section) allocable to lobbying activities and 175 percent 
of its basic lobbying labor costs (as defined in paragraph (e)(3) of 
this section) of all personnel.
    (2) Alternative gross-up method. Under the alternative gross-up 
method described in this paragraph (e)(2), the taxpayer allocates to 
lobbying activities the sum of its third-party costs (as defined in 
paragraph (d)(5) of this section) allocable to lobbying activities and 
225 percent of its basic lobbying labor costs (as defined in paragraph 
(e)(3)), excluding the costs of personnel who engage in secretarial, 
clerical, support, and other administrative activities (as opposed to 
activities involving significant judgment with respect to lobbying 
activities).
    (3) Basic lobbying labor costs. For purposes of this paragraph (e), 
basic lobbying labor costs are the basic costs of lobbying labor hours 
(as defined in paragraph (d)(2) of this section) determined for the 
appropriate personnel. For purposes of this paragraph (e), basic costs 
of lobbying labor hours are wages or other similar costs of labor, 
including, for example, guaranteed payments for services. Basic costs do 
not include pension, profit-sharing, employee benefits, and supplemental 
unemployment benefit plan costs, or other similar costs.
    (4) Example. The provisions of this paragraph (e) are illustrated by 
the following example.

    Example. (i) In 1996, three employees, A, B, and C, of Taxpayer X 
engage in both lobbying activities and nonlobbying activities. A spends 
300 hours, B spends 1,700 hours, and C spends 1,000 hours on lobbying 
activities.
    (ii) X has no third-party costs.
    (iii) For purposes of the gross-up method, X determines that its 
basic labor costs are $20 per hour for A, $30 per hour for B, and $25 
per hour for C. Thus, its basic lobbying labor costs are ($20 x 300) + 
($30 x 1,700) + ($25 x 1,000), or ($6,000 + $51,000 + $25,000), for 
total basic lobbying labor costs for 1996 of $82,000.
    (iv) Under the gross-up method, X allocates $143,500 to its lobbying 
activities for 1996, as follows:

[[Page 239]]

[GRAPHIC] [TIFF OMITTED] TR21JY95.003

    (f) Section 263A cost allocation methods--(1) In general. A taxpayer 
may allocate its costs to lobbying activities under the principles set 
forth in section 263A and the regulations thereunder, except to the 
extent inconsistent with paragraph (g) of this section. For this 
purpose, lobbying activities are considered a service department or 
function. Therefore, a taxpayer may allocate costs to lobbying 
activities by applying the methods provided in Sec. Sec.  1.263A-1 
through 1.263A-3. See Sec.  1.263A-1(e)(4), which describes service 
costs generally; Sec.  1.263A-1(f), which sets forth cost allocation 
methods available under section 263A; and Sec.  1.263A-1(g)(4), which 
provides methods of allocating service costs.
    (2) Example. The provisions of this paragraph (f) are illustrated by 
the following example.

    Example. (i) Three full-time employees, A, B, and C, work in the 
Washington office of Taxpayer Y, a manufacturing concern. They each 
engage in lobbying activities and nonlobbying activities. In 1996, A 
spends 75 hours, B spends 1,750 hours, and C spends 2,000 hours on 
lobbying activities. A's hours are not spent on direct contact lobbying 
as defined in paragraph (g)(2) of this section. All three work 2,000 
hours during 1996. The Washington office also employs one secretary, D, 
who works exclusively for A, B, and C.
    (ii) In addition, three departments in the corporate headquarters in 
Chicago benefit the Washington office: Public affairs, human resources, 
and insurance.
    (iii) Y is subject to section 263A and uses the step-allocation 
method to allocate its service costs. Prior to the amendments to section 
162(e), the Washington office was treated as an overall management 
function for purposes of section 263A. As such, its costs were fully 
deductible and no further allocations were made under Y's step 
allocation. Following the amendments to section 162(e), Y adopts its 
263A step-allocation methodology to allocate costs to lobbying 
activities. Y adds a lobbying department to its step-allocation program, 
which results in an allocation of costs to the lobbying department from 
both the Washington office and the Chicago office.
    (iv) Y develops a labor ratio to allocate its Washington office 
costs between the newly defined lobbying department and the overall 
management department. To determine the hours allocable to lobbying 
activities, Y uses the de minimis rule of paragraph (g)(1) of this 
section. Under this rule, A's hours spent on lobbying activities are 
treated as zero because less than 5 percent of A's time is spent on 
lobbying (75/2,000 = 3.75%). In addition, because D works exclusively 
for personnel engaged in lobbying activities, D's hours are not used to 
develop the allocation ratio. Y assumes that D's allocation of time 
follows the average time of all the personnel engaged in lobbying 
activities. Thus, Y's labor ratio is determined as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                    Departments
                                                                 -----------------------------------------------
                            Employee                                                  Overall
                                                                  Lobbying hours    management      Total hours
                                                                                       hours
----------------------------------------------------------------------------------------------------------------
A...............................................................               0           2,000           2,000
B...............................................................           1,750             250           2,000
C...............................................................           2,000               0           2,000
                                                                 -----------------------------------------------
      Totals....................................................           3,750           2,250           6,000
----------------------------------------------------------------------------------------------------------------


[[Page 240]]

[GRAPHIC] [TIFF OMITTED] TR21JY95.004

    (v) In 1996, the Washington office has the following costs:

------------------------------------------------------------------------
                           Account                               Amount
------------------------------------------------------------------------
Professional Salaries and Benefits...........................   $660,000
Clerical Salaries and Benefits...............................     50,000
Rent Expense.................................................    100,000
Depreciation on Furniture and Equip..........................     40,000
Utilities....................................................     15,000
Outside Payroll Service......................................      5,000
Miscellaneous................................................     10,000
Third-Party Lobbying (Law Firm)..............................     90,000
                                                              ----------
      Total Washington Costs.................................   $970,000
------------------------------------------------------------------------

    (vi) In addition, $233,800 of costs from the public affairs 
department, $30,000 of costs from the insurance department, and $5,000 
of costs from the human resources department are allocable to the 
Washington office from departments in Chicago. Therefore, the Washington 
office costs are allocated to the Lobbying and Overall Management 
departments as follows:

Total Washington department costs from above...............    $970,000
Plus Costs Allocated From Other Departments................     268,800
Less third-party costs directly allocable to lobbying......     (90,000)
                                                            ------------
      Total Washington office costs........................   1,148,800
 


------------------------------------------------------------------------
                                                               Overall
                                                  Lobbying    management
                                                 department   department
------------------------------------------------------------------------
Department Allocation Ratios..................        62.5%        37.5%
 x Washington Office Costs....................   $1,148,800   $1,148,800
= Costs Allocated to Departments..............     $718,000     $430,800
------------------------------------------------------------------------

    (vii) Y's step-allocation for its Lobbying Department is determined 
as follows:

------------------------------------------------------------------------
                                                               Lobbying
                     Y's step-allocation                      department
------------------------------------------------------------------------
Washington costs allocated to lobbying department...........    $718,000
Plus third-party costs......................................      90,000
                                                             -----------
      Total costs of lobbying activities....................     808,000
------------------------------------------------------------------------

    (g) Special rules. The following rules apply to any reasonable 
method of allocating costs to lobbying activities.
    (1) De minimis rule for labor hours. Subject to the exception 
provided in paragraph (g)(2) of this section, a taxpayer may treat time 
spent by an individual on lobbying activities as zero if less than five 
percent of the person's time is spent on lobbying activities. Reasonable 
methods must be used to determine if less than five percent of a 
person's time is spent on lobbying activities.
    (2) Direct contact lobbying labor hours. Notwithstanding paragraph 
(g)(1) of this section, a taxpayer must treat all hours spent by a 
person on direct contact lobbying (as well as the hours that person 
spends in connection with direct contact lobbying, including time spent 
traveling that is allocable to the direct contact lobbying) as labor 
hours allocable to lobbying activities. An activity is direct contact 
lobbying if it is a meeting, telephone conversation, letter, or other 
similar means of communication with a legislator (other than a local 
legislator) or covered executive branch official (as defined in section 
162(e)(6)) and otherwise qualifies as a lobbying activity. A person who 
engages in research, preparation, and other background activities 
related to direct contact lobbying but who does not make direct contact 
with a legislator or covered executive branch official is not engaged in 
direct contact lobbying.
    (3) Taxpayer defined. For purposes of this section, a taxpayer 
includes a tax-exempt organization subject to section 6033(e).
    (h) Effective date. This section is effective for amounts paid or 
incurred on or after July 21, 1995. Taxpayers must adopt a reasonable 
interpretation of sections 162(e)(1)(A) and (D) for amounts paid or 
incurred before this date.

[T.D. 8602, 60 FR 37573, July 21, 1995]



Sec.  1.162-29  Influencing legislation.

    (a) Scope. This section provides rules for determining whether an 
activity is influencing legislation for purposes of section 
162(e)(1)(A). This section does not apply for purposes of sections 4911 
and 4945 and the regulations thereunder.
    (b) Definitions. For purposes of this section--
    (1) Influencing legislation. Influencing legislation means--

[[Page 241]]

    (i) Any attempt to influence any legislation through a lobbying 
communication; and
    (ii) All activities, such as research, preparation, planning, and 
coordination, including deciding whether to make a lobbying 
communication, engaged in for a purpose of making or supporting a 
lobbying communication, even if not yet made. See paragraph (c) of this 
section for rules for determining the purposes for engaging in an 
activity.
    (2) Attempt to influence legislation. An attempt to influence any 
legislation through a lobbying communication is making the lobbying 
communication.
    (3) Lobbying communication. A lobbying communication is any 
communication (other than any communication compelled by subpoena, or 
otherwise compelled by Federal or State law) with any member or employee 
of a legislative body or any other government official or employee who 
may participate in the formulation of the legislation that--
    (i) Refers to specific legislation and reflects a view on that 
legislation; or
    (ii) Clarifies, amplifies, modifies, or provides support for views 
reflected in a prior lobbying communication.
    (4) Legislation. Legislation includes any action with respect to 
Acts, bills, resolutions, or other similar items by a legislative body. 
Legislation includes a proposed treaty required to be submitted by the 
President to the Senate for its advice and consent from the time the 
President's representative begins to negotiate its position with the 
prospective parties to the proposed treaty.
    (5) Specific legislation. Specific legislation includes a specific 
legislative proposal that has not been introduced in a legislative body.
    (6) Legislative bodies. Legislative bodies are Congress, state 
legislatures, and other similar governing bodies, excluding local 
councils (and similar governing bodies), and executive, judicial, or 
administrative bodies. For this purpose, administrative bodies include 
school boards, housing authorities, sewer and water districts, zoning 
boards, and other similar Federal, State, or local special purpose 
bodies, whether elective or appointive.
    (7) Examples. The provisions of this paragraph (b) are illustrated 
by the following examples.

    Example 1. Taxpayer P's employee, A, is assigned to approach members 
of Congress to gain their support for a pending bill. A drafts and P 
prints a position letter on the bill. P distributes the letter to 
members of Congress. Additionally, A personally contacts several members 
of Congress or their staffs to seek support for P's position on the 
bill. The letter and the personal contacts are lobbying communications. 
Therefore, P is influencing legislation.
    Example 2. Taxpayer R is invited to provide testimony at a 
congressional oversight hearing concerning the implementation of The 
Financial Institutions Reform, Recovery, and Enforcement Act of 1989. 
Specifically, the hearing concerns a proposed regulation increasing the 
threshold value of commercial and residential real estate transactions 
for which an appraisal by a state licensed or certified appraiser is 
required. In its testimony, R states that it is in favor of the proposed 
regulation. Because R does not refer to any specific legislation or 
reflect a view on any such legislation, R has not made a lobbying 
communication. Therefore, R is not influencing legislation.
    Example 3. State X enacts a statute that requires the licensing of 
all day-care providers. Agency B in State X is charged with writing 
rules to implement the statute. After the enactment of the statute, 
Taxpayer S sends a letter to Agency B providing detailed proposed rules 
that S recommends Agency B adopt to implement the statute on licensing 
of day-care providers. Because the letter to Agency B neither refers to 
nor reflects a view on any specific legislation, it is not a lobbying 
communication. Therefore, S is not influencing legislation.
    Example 4. Taxpayer T proposes to a State Park Authority that it 
purchase a particular tract of land for a new park. Even if T's proposal 
would necessarily require the State Park Authority eventually to seek 
appropriations to acquire the land and develop the new park, T has not 
made a lobbying communication because there has been no reference to, 
nor any view reflected on, any specific legislation. Therefore, T's 
proposal is not influencing legislation.
    Example 5. (i) Taxpayer U prepares a paper that asserts that lack of 
new capital is hurting State X's economy. The paper indicates that State 
X residents either should invest more in local businesses or increase 
their savings so that funds will be available to others interested in 
making investments. U forwards a summary of the unpublished paper to 
legislators in State X with a cover letter that states in part:
    You must take action to improve the availability of new capital in 
the state.

[[Page 242]]

    (ii) Because neither the summary nor the cover letter refers to any 
specific legislative proposal and no other facts or circumstances 
indicate that they refer to an existing legislative proposal, forwarding 
the summary to legislators in State X is not a lobbying communication. 
Therefore, U is not influencing legislation.
    (iii) Q, a member of the legislature of State X, calls U to request 
a copy of the unpublished paper from which the summary was prepared. U 
forwards the paper with a cover letter that simply refers to the 
enclosed materials. Because U's letter to Q and the unpublished paper do 
not refer to any specific legislation or reflect a view on any such 
legislation, the letter is not a lobbying communication. Therefore, U is 
not influencing legislation.
    Example 6. (i) Taxpayer V prepares a paper that asserts that lack of 
new capital is hurting the national economy. The paper indicates that 
lowering the capital gains rate would increase the availability of 
capital and increase tax receipts from the capital gains tax. V forwards 
the paper to its representatives in Congress with a cover letter that 
says, in part:
    I urge you to support a reduction in the capital gains tax rate.
    (ii) V's communication is a lobbying communication because it refers 
to and reflects a view on a specific legislative proposal (i.e., 
lowering the capital gains rate). Therefore, V is influencing 
legislation.
    Example 7. Taxpayer W, based in State A, notes in a letter to a 
legislator of State A that State X has passed a bill that accomplishes a 
stated purpose and then says that State A should pass such a bill. No 
such bill has been introduced into the State A legislature. The 
communication is a lobbying communication because it refers to and 
reflects a view on a specific legislative proposal. Therefore, W is 
influencing legislation.
    Example 8. (i) Taxpayer Y represents citrus fruit growers. Y writes 
a letter to a United States senator discussing how pesticide O has 
benefited citrus fruit growers and disputing problems linked to its use. 
The letter discusses a bill pending in Congress and states in part:
    This bill would prohibit the use of pesticide O. If citrus growers 
are unable to use this pesticide, their crop yields will be severely 
reduced, leading to higher prices for consumers and lower profits, even 
bankruptcy, for growers.
    (ii) Y's views on the bill are reflected in this statement. Thus, 
the communication is a lobbying communication, and Y is influencing 
legislation.
    Example 9. (i) B, the president of Taxpayer Z, an insurance company, 
meets with Q, who chairs the X state legislature's committee with 
jurisdiction over laws regulating insurance companies, to discuss the 
possibility of legislation to address current problems with surplus-line 
companies. B recommends that legislation be introduced that would create 
minimum capital and surplus requirements for surplus-line companies and 
create clearer guidelines concerning the risks that surplus-line 
companies can insure. B's discussion with Q is a lobbying communication 
because B refers to and reflects a view on a specific legislative 
proposal. Therefore, Z is influencing legislation.
    (ii) Q is not convinced that the market for surplus-line companies 
is substantial enough to warrant such legislation and requests that B 
provide information on the amount and types of risks covered by surplus-
line companies. After the meeting, B has employees of Z prepare 
estimates of the percentage of property and casualty insurance risks 
handled by surplus-line companies. B sends the estimates with a cover 
letter that simply refers to the enclosed materials. Although B's 
follow-up letter to Q does not refer to specific legislation or reflect 
a view on such legislation, B's letter supports the views reflected in 
the earlier communication. Therefore, the letter is a lobbying 
communication and Z is influencing legislation.

    (c) Purpose for engaging in an activity--(1) In general. The 
purposes for engaging in an activity are determined based on all the 
facts and circumstances. Facts and circumstances include, but are not 
limited to--
    (i) Whether the activity and the lobbying communication are 
proximate in time;
    (ii) Whether the activity and the lobbying communication relate to 
similar subject matter;
    (iii) Whether the activity is performed at the request of, under the 
direction of, or on behalf of a person making the lobbying 
communication;
    (iv) Whether the results of the activity are also used for a 
nonlobbying purpose; and
    (v) Whether, at the time the taxpayer engages in the activity, there 
is specific legislation to which the activity relates.
    (2) Multiple purposes. If a taxpayer engages in an activity both for 
the purpose of making or supporting a lobbying communication and for 
some nonlobbying purpose, the taxpayer must treat the activity as 
engaged in partially for a lobbying purpose and partially for a 
nonlobbying purpose. This division of the activity must result in a 
reasonable allocation of costs to influencing legislation. See Sec.  
1.162-28

[[Page 243]]

(allocation rules for certain expenditures to which section 162(e)(1) 
applies). A taxpayer's treatment of these multiple-purpose activities 
will, in general, not result in a reasonable allocation if it allocates 
to influencing legislation--
    (i) Only the incremental amount of costs that would not have been 
incurred but for the lobbying purpose; or
    (ii) An amount based solely on the number of purposes for engaging 
in that activity without regard to the relative importance of those 
purposes.
    (3) Activities treated as having no purpose to influence 
legislation. A taxpayer that engages in any of the following activities 
is treated as having done so without a purpose of making or supporting a 
lobbying communication--
    (i) Before evidencing a purpose to influence any specific 
legislation referred to in paragraph (c)(3)(i)(A) or (B) of this section 
(or similar legislation)--
    (A) Determining the existence or procedural status of specific 
legislation, or the time, place, and subject of any hearing to be held 
by a legislative body with respect to specific legislation; or
    (B) Preparing routine, brief summaries of the provisions of specific 
legislation;
    (ii) Performing an activity for purposes of complying with the 
requirements of any law (for example, satisfying state or federal 
securities law filing requirements);
    (iii) Reading any publications available to the general public or 
viewing or listening to other mass media communications; and
    (iv) Merely attending a widely attended speech.
    (4) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples.

    Example 1. (i) Facts. In 1997, Agency F issues proposed regulations 
relating to the business of Taxpayer W. There is no specific legislation 
during 1997 that is similar to the regulatory proposal. W undertakes a 
study of the impact of the proposed regulations on its business. W 
incorporates the results of that study in comments sent to Agency F in 
1997. In 1998, legislation is introduced in Congress that is similar to 
the regulatory proposal. Also in 1998, W writes a letter to Senator P 
stating that it opposes the proposed legislation. W encloses with the 
letter a copy of the comments it sent to Agency F.
    (ii) Analysis. W's letter to Senator P refers to and reflects a view 
on specific legislation and therefore is a lobbying communication. 
Although W's study of the impact of the proposed regulations is 
proximate in time and similar in subject matter to its lobbying 
communication, W performed the study and incorporated the results in 
comments sent to Agency F when no legislation with a similar subject 
matter was pending (a nonlobbying use). On these facts, W engaged in the 
study solely for a nonlobbying purpose.
    Example 2. (i) Facts. The governor of State Q proposes a budget that 
includes a proposed sales tax on electricity. Using its records of 
electricity consumption, Taxpayer Y estimates the additional costs that 
the budget proposal would impose upon its business. In the same year, Y 
writes to members of the state legislature and explains that it opposes 
the proposed sales tax. In its letter, Y includes its estimate of the 
costs that the sales tax would impose on its business. Y does not 
demonstrate any other use of its estimates.
    (ii) Analysis. The letter is a lobbying communication (because it 
refers to and reflects a view on specific legislation, the governor's 
proposed budget). Y's estimate of additional costs under the proposal 
supports the lobbying communication, is proximate in time and similar in 
subject matter to a specific legislative proposal then in existence, and 
is not used for a nonlobbying purpose. Based on these facts, Y estimated 
its additional costs under the budget proposal solely to support the 
lobbying communication.
    Example 3. (i) Facts. A senator in the State Q legislature announces 
her intention to introduce legislation to require health insurers to 
cover a particular medical procedure in all policies sold in the state. 
Taxpayer Y has different policies for two groups of employees, one of 
which covers the procedure and one of which does not. After the bill is 
introduced, Y's legislative affairs staff asks Y's human resources staff 
to estimate the additional cost to cover the procedure for both groups 
of employees. Y's human resources staff prepares a study estimating Y's 
increased costs and forwards it to the legislative affairs staff. Y's 
legislative staff then writes to members of the state legislature and 
explains that it opposes the proposed change in insurance coverage based 
on the study. Y's legislative affairs staff thereafter forwards the 
study, prepared for its use in opposing the statutory proposal, to its 
labor relations staff for use in negotiations with employees scheduled 
to begin later in the year.
    (ii) Analysis. The letter to legislators is a lobbying communication 
(because it refers to and reflects a view on specific legislation). The 
activity of estimating Y's additional costs under the proposed 
legislation relates to the same subject as the lobbying communication, 
occurs close in time to the lobbying communication, is conducted at the

[[Page 244]]

request of a person making a lobbying communication, and relates to 
specific legislation then in existence. Although Y used the study in its 
labor negotiations, mere use for that purpose does not establish that Y 
estimated its additional costs under the proposed legislation in part 
for a nonlobbying purpose. Thus, based on all the facts and 
circumstances, Y estimated the additional costs it would incur under the 
proposal solely to make or support the lobbying communication.
    Example 4. (i) Facts. After several years of developmental work 
under various contracts, in 1996, Taxpayer A contracts with the 
Department of Defense (DOD) to produce a prototype of a new generation 
military aircraft. A is aware that DOD will be able to fund the contract 
only if Congress appropriates an amount for that purpose in the upcoming 
appropriations process. In 1997, A conducts simulation tests of the 
aircraft and revises the specifications of the aircraft's expected 
performance capabilities, as required under the contract. A submits the 
results of the tests and the revised specifications to DOD. In 1998, 
Congress considers legislation to appropriate funds for the contract. In 
that connection, A summarizes the results of the simulation tests and of 
the aircraft's expected performance capabilities, and submits the 
summary to interested members of Congress with a cover letter that 
encourages them to support appropriations of funds for the contract.
    (ii) Analysis. The letter is a lobbying communication (because it 
refers to specific legislation (i.e., appropriations) and requests 
passage). The described activities in 1996, 1997, and 1998 relate to the 
same subject as the lobbying communication. The summary was prepared 
specifically for, and close in time to, that communication. Based on 
these facts, the summary was prepared solely for a lobbying purpose. In 
contrast, A conducted the tests and revised the specifications to comply 
with its production contract with DOD. A conducted the tests and revised 
the specifications solely for a nonlobbying purpose.
    Example 5. (i) Facts. C, president of Taxpayer W, travels to the 
state capital to attend a two-day conference on new manufacturing 
processes. C plans to spend a third day in the capital meeting with 
state legislators to explain why W opposes a pending bill unrelated to 
the subject of the conference. At the meetings with the legislators, C 
makes lobbying communications by referring to and reflecting a view on 
the pending bill.
    (ii) Analysis. C's traveling expenses (transportation and meals and 
lodging) are partially for the purpose of making or supporting the 
lobbying communications and partially for a nonlobbying purpose. As a 
result, under paragraph (c)(2) of this section, W must reasonably 
allocate C's traveling expenses between these two purposes. Allocating 
to influencing legislation only C's incremental transportation expenses 
(i.e., the taxi fare to meet with the state legislators) does not result 
in a reasonable allocation of traveling expenses.
    Example 6. (i) Facts. On February 1, 1997, a bill is introduced in 
Congress that would affect Company E. Employees in E's legislative 
affairs department, as is customary, prepare a brief summary of the bill 
and periodically confirm the procedural status of the bill through 
conversations with employees and members of Congress. On March 31, 1997, 
the head of E's legislative affairs department meets with E's President 
to request that B, a chemist, temporarily help the legislative affairs 
department analyze the bill. The President agrees, and suggests that B 
also be assigned to draft a position letter in opposition to the bill. 
Employees of the legislative affairs department continue to confirm 
periodically the procedural status of the bill. On October 31, 1997, B's 
position letter in opposition to the bill is delivered to members of 
Congress.
    (ii) Analysis. B's letter is a lobbying communication because it 
refers to and reflects a view on specific legislation. Under paragraph 
(c)(3)(i) of this section, the assignment of B to assist the legislative 
affairs department in analyzing the bill and in drafting a position 
letter in opposition to the bill evidences a purpose to influence 
legislation. Neither the activity of periodically confirming the 
procedural status of the bill nor the activity of preparing the routine, 
brief summary of the bill before March 31 constitutes influencing 
legislation. In contrast, periodically confirming the procedural status 
of the bill on or after March 31 relates to the same subject as, and is 
close in time to, the lobbying communication and is used for no 
nonlobbying purpose. Consequently, after March 31, E determined the 
procedural status of the bill for the purpose of supporting the lobbying 
communication by B.

    (d) Lobbying communication made by another. If a taxpayer engages in 
activities for a purpose of supporting a lobbying communication to be 
made by another person (or by a group of persons), the taxpayer's 
activities are treated under paragraph (b) of this section as 
influencing legislation. For example, if a taxpayer or an employee of 
the taxpayer (as a volunteer or otherwise) engages in an activity to 
assist a trade association in preparing its lobbying communication, the 
taxpayer's activities are influencing legislation even if the lobbying 
communication is made by the trade association and not

[[Page 245]]

the taxpayer. If, however, the taxpayer's employee, acting outside the 
employee's scope of employment, volunteers to engage in those 
activities, then the taxpayer is not influencing legislation.
    (e) No lobbying communication. Paragraph (e) of this section applies 
if a taxpayer engages in an activity for a purpose of making or 
supporting a lobbying communication, but no lobbying communication that 
the activity supports has yet been made.
    (1) Before the filing date. Under this paragraph (e)(1), if on the 
filing date of the return for any taxable year the taxpayer no longer 
expects, under any reasonably foreseeable circumstances, that a lobbying 
communication will be made that is supported by the activity, then the 
taxpayer will be treated as if it did not engage in the activity for a 
purpose of making or supporting a lobbying communication. Thus, the 
taxpayer need not treat any amount allocated to that activity for that 
year under Sec.  1.162-28 as an amount to which section 162(e)(1)(A) 
applies. The filing date for purposes of paragraph (e) of this section 
is the earlier of the time the taxpayer files its timely return for the 
year or the due date of the timely return.
    (2) After the filing date--(i) In general. If, at any time after the 
filing date, the taxpayer no longer expects, under any reasonably 
foreseeable circumstances, that a lobbying communication will be made 
that is supported by the activity, then any amount previously allocated 
under Sec.  1.162-28 to the activity and disallowed under section 
162(e)(1)(A) is treated as an amount that is not subject to section 
162(e)(1)(A) and that is paid or incurred only at the time the taxpayer 
no longer expects that a lobbying communication will be made.
    (ii) Special rule for certain tax-exempt organizations. For a tax-
exempt organization subject to section 6033(e), the amounts described in 
paragraph (e)(2)(i) of this section are treated as reducing (but not 
below zero) its expenditures to which section 162(e)(1) applies 
beginning with that year and continuing for subsequent years to the 
extent not treated in prior years as reducing those expenditures.
    (f) Anti-avoidance rule. If a taxpayer, alone or with others, 
structures its activities with a principal purpose of achieving results 
that are unreasonable in light of the purposes of section 162(e)(1)(A) 
and section 6033(e), the Commissioner can recast the taxpayer's 
activities for federal tax purposes as appropriate to achieve tax 
results that are consistent with the intent of section 162(e)(1)(A), 
section 6033(e) (if applicable), and this section, and the pertinent 
facts and circumstances.
    (g) Taxpayer defined. For purposes of this section, a taxpayer 
includes a tax-exempt organization subject to section 6033(e).
    (h) Effective date. This section is effective for amounts paid or 
incurred on or after July 21, 1995. Taxpayers must adopt a reasonable 
interpretation of section 162(e)(1)(A) for amounts paid or incurred 
before this date.

[T.D. 8602, 60 FR 37575, July 21, 1995]



Sec.  1.162-31  The $500,000 deduction limitation for remuneration 
provided by certain health insurance providers.

    (a) Scope. This section sets forth rules regarding the deduction 
limitation under section 162(m)(6), which provides that a covered health 
insurance provider's deduction for applicable individual remuneration 
(AIR) and deferred deduction remuneration (DDR) attributable to services 
performed by an applicable individual in a disqualified taxable year is 
limited to $500,000. Paragraph (b) of this section sets forth 
definitions of the terms used in this section. Paragraph (c) of this 
section explains the general limitation on deductions under section 
162(m)(6). Paragraph (d) of this section sets forth the methods that 
must be used to attribute AIR and DDR to services performed in one or 
more taxable years of a covered health insurance provider. Paragraph (e) 
of this section sets forth rules on how the deduction limit applies to 
AIR and DDR that is otherwise deductible under chapter 1 of the Internal 
Revenue Code (Code) but for the deduction limitation under section 
162(m)(6) (referred to in this section as remuneration that is otherwise 
deductible). Paragraph (f) of this section sets forth

[[Page 246]]

additional rules for persons participating in certain corporate 
transactions. Paragraph (g) of this section explains the interaction of 
section 162(m)(6) with sections 162(m)(1) and 280G. Paragraph (h) of 
this section sets forth rules for determining the amounts of 
remuneration that are not subject to the deduction limitation under 
section 162(m)(6) due to the statutory effective date (referred to in 
this section as grandfathered amounts). Paragraph (i) of this section 
sets forth transition rules for DDR that is attributable to services 
performed in taxable years beginning after December 31, 2009 and before 
January 1, 2013. Paragraph (j) of this section sets forth the effective 
and applicability dates of the rules in this section.
    (b) Definitions--(1) Health insurance issuer. For purposes of this 
section, a health insurance issuer is a health insurance issuer as 
defined in section 9832(b)(2).
    (2) Aggregated group. For purposes of this section, an aggregated 
group is a health insurance issuer and each other person that is treated 
as a single employer with the health insurance issuer at any time during 
the taxable year of the health insurance issuer under sections 414(b) 
(controlled groups of corporations), 414(c) (partnerships, 
proprietorships, etc. under common control), 414(m) (affiliated service 
groups), or 414(o), except that the rules in section 1563(a)(2) and (3) 
(with respect to corporations) and Sec.  1.414(c)-2(c) and (d) (with 
respect to trades or businesses under common control) for brother-sister 
groups and combined groups are disregarded.
    (3) Parent entity--(i) In general. For purposes of this section, a 
parent entity is either--
    (A) The common parent of a parent-subsidiary controlled group of 
corporations (within the meaning of section 414(b)) or a parent-
subsidiary group of trades or businesses under common control (within 
the meaning of section 414(c)) that includes a health insurance issuer, 
or
    (B) the health insurance issuer in an aggregated group that is an 
affiliated service group (within the meaning of section 414(m)) or a 
group described in section 414(o).
    (ii) Certain aggregated groups with multiple health insurance 
issuers--(A) In general. If two or more health insurance issuers are 
members of an aggregated group that is an affiliated service group 
(within the meaning of section 414(m)) or group described in section 
414(o), the parent entity is the health insurance issuer in the 
aggregated group that is designated in writing by the other members of 
the aggregated group to act as the parent entity.
    (B) Successor parent entities. If a health insurance issuer that is 
the parent entity of an aggregated group pursuant to paragraph 
(b)(3)(ii)(A) of this section (a predecessor parent entity) ceases to be 
a member of the aggregated group (for example, as a result of a 
corporate transaction) and, after the predecessor parent entity ceases 
to be a member of the aggregated group, two or more health insurance 
issuers are members of the aggregated group, the new parent entity (the 
successor parent entity) is another member of the aggregated group 
designated in writing by the remaining members of the aggregated group. 
The successor parent entity must be a health insurance issuer in the 
aggregated group that has the same taxable year as the predecessor 
parent entity; provided, however, that if no health insurance issuer in 
the aggregated group has the same taxable year as the predecessor parent 
entity, the members of the aggregated group may designate in writing any 
other health insurance issuer in the aggregated group to be the parent 
entity.
    (C) Failure to designate a parent entity. If the members of an 
aggregated group that includes two or more health insurance issuers and 
that is an affiliated service group (within the meaning of section 
414(m)) or a group described in section 414(o) fail to designate in 
writing a health insurance issuer to act as the parent entity of the 
aggregated group, the parent entity of the aggregated group for all 
taxable years is deemed to be an entity with a taxable year that is the 
calendar year (without regard to whether the aggregated group includes 
or has ever included an entity with a calendar year taxable year) for 
all purposes under this section for which a parent entity's taxable year 
is relevant.

[[Page 247]]

    (4) Covered health insurance provider--(i) In general. For purposes 
of this section and except as otherwise provided in this paragraph 
(b)(4), a covered health insurance provider is--
    (A) A health insurance issuer for any of its taxable years beginning 
after December 31, 2012 in which at least 25 percent of the gross 
premiums it receives from providing health insurance coverage (as 
defined in section 9832(b)(1)) are from providing minimum essential 
coverage (as defined in section 5000A(f)),
    (B) a health insurance issuer for any of its taxable years beginning 
after December 31, 2009 and before January 1, 2013 in which it receives 
premiums from providing health insurance coverage (as defined in section 
9832(b)(1)),
    (C) the parent entity of an aggregated group of which one or more 
health insurance issuers described in paragraphs (b)(4)(i)(A) or (B) of 
this section are members for the taxable year of the parent entity with 
which, or in which, ends the taxable year of any such health insurance 
issuer; however, if the parent entity of an aggregated group is a health 
insurance issuer described in paragraphs (b)(4)(i)(A) or (B) of this 
section, that health insurance issuer is a covered health insurance 
provider for any taxable year that it is otherwise a covered health 
insurance provider, without regard to whether the taxable year of any 
other health insurance issuer described in paragraphs (b)(4)(i)(A) or 
(B) of this section ends with or within its taxable year, and
    (D) each other member of an aggregated group of which one or more 
health insurance issuers described in paragraphs (b)(4)(i)(A) or (B) of 
this section are members for the taxable year of the other member ending 
with, or within, the parent entity's taxable year.
    (ii) Parent entities with short taxable years. If for any reason a 
parent entity has a taxable year that is less than 12 months (for 
example, because the taxable year of a predecessor parent entity ends 
when it ceases to be a member of an aggregated group), then, for 
purposes of determining whether the parent entity and each other member 
of the aggregated group is a covered health insurance provider with 
respect to the parent entity's short taxable year (that is, for purposes 
of determining whether the taxable year of a health insurance issuer 
described in paragraph (b)(4)(i)(A) or (B) of this section ends with or 
within the short taxable year of the parent entity and for purposes of 
determining whether another member of the aggregated group has a taxable 
year ending with or within the short taxable year of the parent entity), 
the taxable year of the parent entity is treated as the 12-month period 
ending on the last day of the short taxable year. Accordingly, a parent 
entity is a covered health insurance provider for its short taxable year 
if it is a health insurance issuer described in paragraph (b)(4)(i)(A) 
or (B) of this section or if the taxable year of a health insurance 
issuer described in paragraph (b)(4)(i)(A) or (B) of this section in an 
aggregated group with the parent entity ends with or within the 12-month 
period ending on the last day of the parent entity's short taxable year. 
Similarly, each other member of the parent entity's aggregated group is 
a covered health insurance provider for its taxable year ending with or 
within the 12-month period ending on the last day of the parent entity's 
short taxable year.
    (iii) Predecessor and successor parent entities. If the parent 
entity of an aggregated group changes, the members of the aggregated 
group may be covered health insurance providers based on their 
relationship to either or both parent entities with respect to the 
taxable years of the parent entities in which the change occurs.
    (iv) Self-insured plans. For purposes of this section, a person is 
not a covered health insurance provider solely because it maintains a 
self-insured medical reimbursement plan. For this purpose, a self-
insured medical reimbursement plan is a separate written plan for the 
benefit of employees (including former employees) that provides for 
reimbursement of medical expenses referred to in section 105(b) and does 
not provide for reimbursement under an individual or group policy of 
accident or health insurance issued by a licensed insurance company or 
under an arrangement in the nature of a prepaid health care plan that is 
regulated

[[Page 248]]

under federal or state law in a manner similar to the regulation of 
insurance companies, and may include a plan maintained by an employee 
organization described in section 501(c)(9).
    (v) De minimis exception--(A) In general. A health insurance issuer 
and any member of its aggregated group that would otherwise be a covered 
health insurance provider under paragraph (b)(4)(i), (ii), or (iii) of 
this section for a taxable year beginning after December 31, 2012 is not 
a covered health insurance provider under this section for that taxable 
year if the premiums received by the health insurance issuer and any 
other health insurance issuers in its aggregated group from providing 
health insurance coverage (as defined in section 9832(b)(1)) that 
constitutes minimum essential coverage (as defined in section 5000A(f)) 
are less than two percent of the gross revenues of the health insurance 
issuer and all other members of its aggregated group for that taxable 
year. A health insurance issuer and any member of its aggregated group 
that would otherwise be a covered health insurance provider under 
paragraph (b)(4)(i), (ii), or (iii) of this section for a taxable year 
beginning after December 31, 2009 and before January 1, 2013 is not a 
covered health insurance provider for purposes of this section for that 
taxable year if the premiums received by the health insurance issuer and 
any other health insurance issuers in its aggregated group from 
providing health insurance coverage (as defined in section 9832(b)(1)) 
are less than two percent of the gross revenues of the health insurance 
issuer and all other members of its aggregated group for that taxable 
year. In determining whether premiums constitute less than two percent 
of gross revenues, the amount of gross revenues must be determined in 
accordance with generally accepted accounting principles. For the 
definition of the term premiums, see paragraph (b)(5) of this section. A 
person that would be a covered health insurance provider for a taxable 
year in an aggregated group with a predecessor parent entity and that 
would also be a covered health insurance provider for that taxable year 
in an aggregated group with a successor parent entity is not a covered 
health insurance provider under the de minimis exception only if the 
aggregated groups of which the person is a member meet the requirements 
of the de minimis exception based on both the taxable year of the 
predecessor parent entity and the taxable year of the successor parent 
entity.
    (B) One-year de minimis exception transition period. If a health 
insurance issuer or a member of an aggregated group is not a covered 
health insurance provider for a taxable year solely by reason of the de 
minimis exception described in paragraph (b)(4)(v)(A) of this section, 
but fails to meet the requirements of the de minimis exception described 
in paragraph (b)(4)(v)(A) of this section for the immediately following 
taxable year, that health insurance issuer or member of an aggregated 
group will not be a covered health insurance provider for that 
immediately following taxable year.
    (vi) Examples. The following examples illustrate the principles of 
this paragraph (b)(4). For purposes of these examples, each corporation 
has a taxable year that is the calendar year, unless the example 
provides otherwise.

    Example 1. (i) Corporations Y and Z are members of an aggregated 
group under paragraph (b)(2) of this section. Y is a health insurance 
issuer that is a covered health insurance provider pursuant to paragraph 
(b)(4)(i)(A) of this section and receives premiums from providing health 
insurance coverage that is minimum essential coverage during its 2015 
taxable year in an amount that is less than two percent of the combined 
gross revenues of Y and Z for their 2015 taxable years. Z is not a 
health insurance issuer.
    (ii) Y and Z are not covered health insurance providers under 
paragraph (b)(4) of this section for their 2015 taxable years because 
they meet the requirements of the de minimis exception under paragraph 
(b)(4)(v)(A) of this section.
    Example 2. (i) Corporations V, W, and X are members of an aggregated 
group under paragraph (b)(2) of this section. V is a health insurance 
issuer that is a covered health insurance provider pursuant to paragraph 
(b)(4)(i)(A) of this section, but neither W nor X is a health insurance 
issuer. W is the parent entity of the aggregated group. V's taxable year 
ends on December 31, W's taxable year ends on June 30, and X's taxable 
year ends on September 30. For its taxable year ending December 31, 
2016, V receives $3x of premiums from providing minimum essential

[[Page 249]]

coverage and has no other revenue. For its taxable year ending June 30, 
2017, W has $100x in gross revenue. For its taxable year ending 
September 30, 2016, X has $60x in gross revenue.
    (ii) But for the de minimis exception, V (the health insurance 
issuer) would be a covered health insurance provider for its taxable 
year ending December 31, 2016; W (the parent entity) would be a covered 
health insurance provider for its taxable year ending June 30, 2017 (its 
taxable year with which, or within which, ends the taxable year of the 
health insurance issuer); and X (the other member of the aggregated 
group) would be a covered health insurance provider for its taxable year 
ending on September 30, 2016 (its taxable year ending with, or within, 
the taxable year of the parent entity). However, the premiums received 
by V (the health insurance issuer) from providing minimum essential 
coverage during the taxable year that it would otherwise be a covered 
health insurance provider under paragraph (b)(4)(i)(A) of this section 
are less than two percent of the combined gross revenues of V, W, and X 
for the related taxable years that they would otherwise be covered 
health insurance providers under paragraph (b)(4)(i) of this section 
($3x is less than $3.26x (two percent of $163x)). Therefore, the de 
minimis exception of paragraph (b)(4)(v)(A) of this section applies, and 
V, W, and X are not covered health insurance providers for these taxable 
years.
    Example 3. (i) The facts are the same as Example 2, except that V 
receives $4x of premiums for providing minimum essential coverage for 
its taxable year ending December 31, 2016. In addition, the members of 
the VWX aggregated group were not covered health insurance providers for 
their taxable years ending December 31, 2015, June 30, 2016, and 
September 30, 2015, respectively (their immediately preceding taxable 
years) solely by reason of the de minimis exception of paragraph 
(b)(4)(v)(A) of this section.
    (ii) Although the premiums received by the members of the aggregated 
group from providing minimum essential coverage are more than two 
percent of the gross revenues of the aggregated group for the taxable 
years during which the members would otherwise be treated as covered 
health insurance providers under paragraph (b)(4)(i) of this section 
($4x is greater than $3.28x (two percent of $164x)), they were not 
covered health insurance providers for their immediately preceding 
taxable years solely because of the de minimis exception of paragraph 
(b)(4)(v)(A) of this section. Therefore, V, W, and X are not covered 
health insurance providers for their taxable years ending on December 
31, 2016, June 30, 2017, and September 30, 2016, respectively, because 
of the one-year transition period under paragraph (b)(4)(v)(B) of this 
section. However, the members of the VWX aggregated group will be 
covered health insurance providers for their subsequent taxable years if 
they would otherwise be covered health insurance providers for those 
taxable years under paragraph (b)(4) of this section.
    Example 4. (i) Corporations W, X, Y, and Z are members of a 
controlled group described in section 414(b)) that is an aggregated 
group under paragraph (b)(2) of this section. W and X are health 
insurance issuers. Y and Z are not health insurance issuers. W is the 
parent entity of the aggregated group. W's and Y's taxable years end on 
December 31; X's taxable year ends on March 31; and Z's taxable year 
ends on June 30. As a result of a corporate transaction, W is no longer 
a member of the WXYZ aggregated group as of September 30, 2016, and W's 
taxable year ends on that date. Following the corporate transaction, X 
becomes the parent entity of the XYZ aggregated group.
    (ii) Because W's taxable year is treated as the 12-month period 
ending on September 30, 2016, W is the parent entity for X's taxable 
year ending March 31, 2016, Z's taxable year ending June 30, 2016, and 
Y's taxable year ending December 31, 2015. Because X's taxable year 
begins on April 1, 2016 and ends on March 31, 2017, for purposes of 
paragraph (b)(4) of this section, X is the parent entity for Z's taxable 
year ending June 30, 2016, Y's taxable year ending December 31, 2016, 
and W's taxable year ending September 30, 2016.
    Example 5. (i) The facts are the same as Example 4. In addition, W 
receives $4x of premiums for providing minimum essential coverage and no 
other revenue for its taxable year beginning January 1, 2016 and ending 
September 30, 2016. X receives $2x of premiums for providing minimum 
essential coverage and has no other revenue for its taxable year ending 
March 31, 2016. X receives $1x of premiums for providing minimum 
essential coverage and no other revenue for its taxable year ending 
March 31, 2017. For its taxable year ending December 31, 2015, Y has 
$100x in gross revenue. For its taxable year ending December 31, 2016, Y 
has $200x in gross revenue. For its taxable year ending June 30, 2016, Z 
has $120x in gross revenue (none of which constitute premiums for 
providing health insurance coverage that constitutes minimum essential 
coverage (as defined in section 5000A(f)). W, X, Y, and Z did not 
qualify for the de minimis exception in any prior taxable years.
    (ii) For its taxable year ending June 30, 2016, Z does not meet the 
requirements for the de minimis exception described in paragraph 
(b)(4)(v)(A). Even though Z meets the requirements for the de minimis 
exception with respect to the taxable year of parent entity X ending 
March 31, 2017 ($5x is less than two percent of $325x), Z does not meet 
the requirements for the de minimis exception based on the premiums and 
gross revenues of the taxable years of its aggregated group members 
ending with or within the deemed

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12-month taxable year of parent entity W ending September 30, 2016 ($6x 
is more than two percent of $226x). Therefore, Z is a covered health 
insurance provider for its June 30, 2016 taxable year.
    (iii) For its taxable year ending December 31, 2015, Y does not meet 
the requirements for the de minimis exception described in paragraph 
(b)(4)(v)(A) ($6x is more than two percent of $226x). For its taxable 
year ending December 31, 2016, Y meets the requirements for the de 
minimis exception described in paragraph (b)(4)(v)(A) ($5x is less than 
two percent of $325x). Therefore, Y is a covered health insurance 
provider for its December 31, 2015 taxable year, but is not a covered 
health insurance provider for its December 31, 2016 taxable year.
    (iv) For its taxable year ending September 30, 2016, W does not meet 
the requirements for the de minimis exception described in paragraph 
(b)(4)(v)(A). Even though W meets the requirements for the de minimis 
exception with respect to X's taxable year ending March 31, 2017 ($5x is 
less than two percent of $325x), W does not meet the requirements for 
the de minimis exception with respect its taxable year ending September 
30, 2016 ($6x is more than two percent of $226x). Therefore, W is a 
covered health insurance provider for its September 30, 2016 taxable 
year.
    (v) For its taxable year ending March 31, 2016, X does not meet the 
requirements for the de minimis exception ($6x is more than two percent 
of $226x). For its taxable year ending March, 31 2017, X meets the 
requirements for the de minimis exception ($5x is less than two percent 
of $325x). Therefore, X is a covered health insurance provider for its 
March 31, 2016 taxable year, but is not a covered health insurance 
provider for its March 31, 2017 taxable year.

    (5) Premiums--(i) For purposes of this section, the term premiums 
means premiums written (including premiums written for assumption 
reinsurance, but reduced by assumption reinsurance ceded (as described 
in paragraph (b)(5)(ii) of this section), excluding indemnity 
reinsurance written (as described in paragraph (b)(5)(iii) of this 
section) and direct service payments (as described in paragraph 
(b)(5)(iv) of this section), but without reduction for ceding 
commissions or medical loss ratio rebates, determined in a manner 
consistent with the requirements for reporting under the Supplemental 
Health Care Exhibit published by the National Association of Insurance 
Commissioners or the MLR Annual Reporting Form filed with the Center for 
Medicare & Medicaid Services' Center for Consumer Information and 
Insurance Oversight of the U.S. Department of Health and Human Services 
(or any successor or replacement exhibits or forms).
    (ii) Assumption reinsurance. For purposes of this paragraph (b)(5), 
the term assumption reinsurance means reinsurance for which there is a 
novation and the reinsurer takes over the entire risk of loss pursuant 
to a new contract.
    (iii) Indemnity reinsurance. For purposes of this paragraph (b)(5), 
the term indemnity reinsurance means reinsurance provided pursuant to an 
agreement between a health insurance issuer and a reinsuring company 
under which the reinsuring company agrees to indemnify the health 
insurance issuer for all or part of the risk of loss under policies 
specified in the agreement, and the health insurance issuer retains its 
liability to provide health insurance coverage (as defined in section 
9832(b)(1)) to, and its contractual relationship with, the insured.
    (iv) Direct service payments. For purposes of this paragraph (b)(5), 
the term direct service payment means a capitated, prepaid, periodic, or 
other payment made by a health insurance issuer or another entity that 
receives premiums from providing health insurance coverage (as defined 
in section 9832(b)(1)) to another organization as compensation for 
providing, managing, or arranging for the provision of healthcare 
services by physicians, hospitals, or other healthcare providers, 
regardless of whether the organization that receives the compensation is 
subject to healthcare provider, health insurance, health plan licensing, 
financial solvency, or other similar regulatory requirements under state 
insurance law.
    (6) Disqualified taxable year. For purposes of this section, the 
term disqualified taxable year means, with respect to any person, any 
taxable year for which the person is a covered health insurance 
provider.
    (7) Applicable individual--(i) In general. For purposes of this 
section, except as provided in paragraph (b)(7)(ii) of this section, the 
term applicable individual means, with respect to any covered health 
insurance provider for any

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disqualified taxable year, any individual (or any other person described 
in guidance of general applicability published in the Internal Revenue 
Bulletin)--
    (A) who is an officer, director, or employee in that taxable year, 
or
    (B) who provides services for or on behalf of the covered health 
insurance provider during that taxable year.
    (ii) Independent contractors--Remuneration for services performed by 
an independent contractor for a covered health insurance provider is 
subject to the deduction limitation under section 162(m)(6). However, an 
independent contractor is not an applicable individual with respect to a 
covered health insurance provider for a disqualified taxable year if 
each of the following requirements is satisfied:
    (A) The independent contractor is actively engaged in the trade or 
business of providing services to recipients, other than as an employee 
or as a member of the board of directors of a corporation (or similar 
position with respect to an entity that is not a corporation);
    (B) The independent contractor provides significant services (as 
defined in Sec.  1.409A-1(f)(2)(iii)) to two or more persons to which 
the independent contractor is not related and that are not related to 
one another (as defined in Sec.  1.409A-1(f)(2)(ii)); and
    (C) The independent contractor is not related to the covered health 
insurance provider or any member of its aggregated group, applying the 
definition of related person contained in Sec.  1.409A-1(f)(2)(ii), 
subject to the modification that for purposes of applying the references 
to sections 267(b) and 707(b)(1), the language ``20 percent'' is not 
used instead of ``50 percent'' each place ``50 percent'' appears in 
sections 267(b) and 707(b)(1).
    (8) Service provider. For purposes of this section, the term service 
provider means, with respect to a covered health insurance provider for 
any period, an individual who is an officer, director, or employee, or 
who provides services for, or on behalf of, the covered health insurance 
provider or any member of its aggregated group.
    (9) Remuneration--(i) In general. For purposes of this section, 
except as provided in paragraph (b)(9)(ii) of this section, the term 
remuneration has the same meaning as the term applicable employee 
remuneration, as defined in section 162(m)(4), but without regard to the 
exceptions under section 162(m)(4)(B) (remuneration payable on a 
commission basis), section 162(m)(4)(C) (performance-based 
compensation), and section 162(m)(4)(D) (existing binding contracts), 
and the regulations under those sections.
    (ii) Exceptions. For purposes of this section, remuneration does not 
include--
    (A) A payment made to, or for the benefit of, an applicable 
individual from or to a trust described in section 401(a) within the 
meaning of section 3121(a)(5)(A),
    (B) A payment made under an annuity plan described in section 403(a) 
within the meaning of section 3121(a)(5)(B),
    (C) A payment made under a simplified employee pension plan 
described in section 408(k)(1) within the meaning of section 
3121(a)(5)(C),
    (D) A payment made under an annuity contract described in section 
403(b) within the meaning of section 3121(a)(5)(D),
    (E) Salary reduction contributions described in section 3121(v)(1), 
and
    (F) Remuneration consisting of any benefit provided to, or on behalf 
of, an employee if, at the time the benefit is provided, it is 
reasonable to believe that the employee will be able to exclude the 
value of the benefit from gross income.
    (10) Applicable Individual Remuneration or AIR. For purposes of this 
section, the term applicable individual remuneration or AIR means, with 
respect to any applicable individual for any disqualified taxable year, 
the aggregate amount allowable as a deduction under this chapter for 
that taxable year (determined without regard to section 162(m)) for 
remuneration for services performed by that applicable individual 
(whether or not in that taxable year). AIR does not include any DDR with 
respect to services performed during any taxable year. AIR for a 
disqualified taxable year may include remuneration for services 
performed in a taxable year before the

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taxable year in which the deduction for the remuneration is allowable. 
For example, a discretionary bonus granted and paid to an applicable 
individual in a disqualified taxable year in recognition of services 
performed in prior taxable years is AIR for the disqualified taxable 
year in which the bonus is granted and paid. In addition, a grant of 
restricted stock in a disqualified taxable year with respect to which an 
applicable individual makes an election under section 83(b) is AIR for 
the disqualified taxable year of the covered health insurance provider 
in which the grant of the restricted stock is made. See paragraph 
(b)(9)(ii) of this section for certain remuneration that is not treated 
as AIR for purposes of this section.
    (11) Deferred Deduction Remuneration or DDR. For purposes of this 
section, the term deferred deduction remuneration or DDR means 
remuneration that would be AIR for services performed in a disqualified 
taxable year but for the fact that the deduction (determined without 
regard to section 162(m)(6)) for the remuneration is allowable in a 
subsequent taxable year. Whether remuneration is DDR is determined 
without regard to when the remuneration is paid, except to the extent 
that the timing of the payment affects the taxable year in which the 
remuneration is otherwise deductible. For example, payments that are 
otherwise deductible by a covered health insurance provider in an 
initial taxable year, but are paid to an applicable individual by the 
15th day of the third month of the immediately subsequent taxable year 
of the covered health insurance provider (as described in Sec.  
1.404(b)-1T, Q&A-2(b)(1)), are AIR for the initial taxable year (and not 
DDR) because the deduction for the payments is allowable in the initial 
taxable year, and not a subsequent taxable year. Except as otherwise 
provided in paragraph (i) of this section (regarding transition rules 
for certain DDR attributable to services performed in taxable years 
beginning before January 1, 2013), DDR that is attributable to services 
performed in a disqualified taxable year of a covered health insurance 
provider is subject to the section 162(m)(6) deduction limitation even 
if the taxable year in which the remuneration is otherwise deductible is 
not a disqualified taxable year. Similarly, DDR is subject to the 
section 162(m)(6) deduction limitation regardless of whether an 
applicable individual is a service provider of the covered health 
insurance provider in the taxable year in which the DDR is otherwise 
deductible. However, remuneration that is attributable to services 
performed in a taxable year that is not a disqualified taxable year is 
not DDR even if the remuneration is otherwise deductible in a 
disqualified taxable year. See also paragraph (b)(9)(ii) of this section 
for certain remuneration that is not treated as DDR for purposes of this 
section.
    (12) Substantial risk of forfeiture. For purposes of this section, 
the term substantial risk of forfeiture has the same meaning as provided 
in Sec.  1.409A-1(d).
    (13) In-service payment. An in-service payment is any amount that is 
paid with respect to an applicable individual from an account balance 
plan described in Sec.  1.409A-1(c)(2)(i)(A) or (B) or a nonaccount 
balance plan described in Sec.  1.409A-1(c)(2)(i)(C) in a taxable year 
of a covered health insurance provider during which at any time the 
applicable individual is a service provider (including amounts that 
became otherwise deductible, but were not paid, in a previous taxable 
year of a covered health insurance provider). Amounts that are paid in 
the last year that an applicable individual is a service provider (for 
example, amounts paid at separation from service) are in-service 
payments if the applicable individual is a service provider at any time 
during the taxable year of the covered health insurance provider in 
which the payment is made.
    (14) Payment year. For purposes of this section, the term payment 
year means the taxable year of a covered health insurance provider for 
which remuneration becomes otherwise deductible.
    (15) Measurement date. For purposes of this section, the term 
measurement date means the last day of the taxable year of a covered 
health insurance provider.
    (c) Deduction Limitation--(1) AIR. For any disqualified taxable year 
beginning after December 31, 2012, no deduction is allowed under this 
chapter for AIR

[[Page 253]]

that is attributable to services performed by an applicable individual 
in that taxable year to the extent that the amount of that remuneration 
exceeds $500,000.
    (2) DDR. For any taxable year beginning after December 31, 2012, no 
deduction is allowed under this chapter for DDR that is attributable to 
services performed by an applicable individual in any disqualified 
taxable year beginning after December 31, 2009, to the extent that the 
amount of such remuneration exceeds $500,000 reduced (but not below 
zero) by the sum of:
    (i) The AIR for that applicable individual for that disqualified 
taxable year; and
    (ii) The portion of the DDR for those services that was subject to 
the deduction limitation under section 162(m)(6)(A)(ii) and this 
paragraph (c)(2) in a preceding taxable year, or would have been subject 
to the deduction limitation under section 162(m)(6)(A)(ii) and this 
paragraph (c)(2) in a preceding taxable year if section 162(m)(6) was 
effective for taxable years beginning after December 31, 2009 and before 
January 1, 2013.
    (d) Services to which remuneration is attributable--(1) Attribution 
to a taxable year--(i) In general. The deduction limitation under 
section 162(m)(6) applies to AIR and DDR attributable to services 
performed by an applicable individual in a disqualified taxable year of 
a covered health insurance provider. When an amount of AIR or DDR 
becomes otherwise deductible (and not before that time), that 
remuneration must be attributed to services performed by an applicable 
individual in a taxable year of the covered health insurance provider in 
accordance with the rules of this paragraph (d). After the remuneration 
has been attributed to services performed by an applicable individual in 
a taxable year of a covered health insurance provider, the rules of 
paragraph (e) of this section are then applied to determine whether the 
deduction with respect to the remuneration is limited by section 
162(m)(6).
    (ii) Overview. Paragraphs (d)(1)(iii) through (v) of this section, 
and paragraph (d)(2) of this section, set forth rules of general 
applicability for attributing remuneration to services performed by an 
applicable individual in a taxable year of a covered health insurance 
provider. Paragraph (d)(3) sets forth two methods for attributing 
remuneration provided under an account balance plan--the account balance 
ratio method (described in paragraph (d)(3)(ii) of this section) and the 
principal additions method (described in paragraph (d)(3)(iii) of this 
section). Paragraph (d)(4) of this section sets forth two methods for 
attributing remuneration provided under a nonaccount balance plan--the 
present value ratio method (described in paragraph (d)(4)(ii) of this 
section) and the formula benefit ratio method (described in paragraph 
(d)(4)(iii) of this section). Paragraph (d)(5) of this section sets 
forth rules for attributing remuneration resulting from equity-based 
remuneration (such as stock options, stock appreciation rights, 
restricted stock, and restricted stock units). Paragraph (d)(6) of this 
section sets forth rules for attributing remuneration that is 
involuntary separation pay. Paragraph (d)(7) of this section sets forth 
rules for attributing remuneration that is received under a 
reimbursement arrangement, and paragraph (d)(8) of this section sets 
forth rules for attributing remuneration that results from a split-
dollar life insurance arrangement.
    (iii) No attribution to taxable years during which no services are 
performed or before a legally binding right arises--(A) In general. For 
purposes of this section, remuneration is not attributable--
    (1) To a taxable year of a covered health insurance provider ending 
before the later of the date the applicable individual begins providing 
services to the covered health insurance provider (or any member of its 
aggregated group) and the date the applicable individual obtains a 
legally binding right to the remuneration, or
    (2) To any other taxable year of a covered health insurance provider 
during which the applicable individual is not a service provider.
    (B) Attribution of remuneration before the commencement of services 
or a legally binding right arises. To the extent that

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remuneration would otherwise be attributable in accordance with 
paragraphs (d)(2) through (11) of this section to a taxable year ending 
before the later of the date an applicable individual begins providing 
services to a covered health insurance provider (or any member of its 
aggregated group) and the date the applicable individual obtains a 
legally binding right to the remuneration, the remuneration is 
attributed to services performed in the taxable year in which the later 
of these dates occurs. For example, if an applicable individual obtains 
a contractual right to remuneration in a taxable year of a covered 
health insurance provider and the remuneration would otherwise be 
attributable to that taxable year pursuant to paragraph (d)(2) of this 
section, but the applicable individual does not begin providing services 
to the covered health insurance provider until the next taxable year, 
the remuneration is attributable to the taxable year in which the 
applicable individual begins providing services.
    (iv) Attribution to 12-month periods. To the extent that a covered 
health insurance provider is required to attribute remuneration on a 
daily pro rata basis under this paragraph (d), it may treat any 12-month 
period as having 365 days (and so may ignore the extra day in leap 
years).
    (v) Remuneration subject to nonlapse restriction or similar formula. 
For purposes of this section, if stock or other property is subject to a 
nonlapse restriction (as defined in Sec.  1.83-3(h)), or if the 
remuneration payable to an applicable individual is determined under a 
formula that, if applied to stock or other property, would be a nonlapse 
restriction, the amount of the remuneration and the attribution of that 
remuneration to taxable years must be determined based upon application 
of the nonlapse restriction or formula. For example, if the earnings or 
losses on an account under an account balance plan are determined based 
upon the performance of company stock, the valuation of which is based 
on a formula that if applied to the stock would be a nonlapse 
restriction, then that formula must be used consistently for purposes of 
determining the amount of the remuneration credited to that account 
balance in taxable years and the attribution of that remuneration to 
taxable years.
    (2) Legally binding right. Unless attributable to services performed 
in a different taxable year pursuant to paragraphs (d)(3) through (11) 
of this section, remuneration is attributable to services performed in 
the taxable year of a covered health insurance provider in which an 
applicable individual obtains a legally binding right to the 
remuneration. An applicable individual does not have a legally binding 
right to remuneration if the remuneration may be reduced unilaterally or 
eliminated by a covered health insurance provider or other person after 
the services creating the right to the remuneration have been performed. 
However, if the facts and circumstances indicate that the discretion to 
reduce or eliminate the remuneration is available or exercisable only 
upon a condition, or the discretion to reduce or eliminate the 
remuneration lacks substantive significance, an applicable individual 
will be considered to have a legally binding right to the remuneration. 
For this purpose, remuneration is not considered to be subject to 
unilateral reduction or elimination merely because it may be reduced or 
eliminated by operation of the objective terms of a plan, such as the 
application of a nondiscretionary, objective provision creating a 
substantial risk of forfeiture.
    (3) Account balance plans--(i) In general. When remuneration for 
services performed by an applicable individual for a covered health 
insurance provider becomes otherwise deductible (for example, because 
the amount was paid or made available during that taxable year) from a 
plan described in Sec.  1.409A-1(c)(2)(i)(A) or (B) (an account balance 
plan), that remuneration must be attributed to services performed by the 
applicable individual in a taxable year of the covered health insurance 
provider in accordance with an attribution method described in either 
paragraph (d)(3)(ii) or (d)(3)(iii) of this section. However, except as 
provided in paragraphs (d)(3)(ii)(D) and (f)(3) of this section, the 
covered health insurance provider and all members of its aggregated 
group must apply the same attribution

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method under this paragraph (d)(3) consistently for all taxable years 
beginning after September 23, 2014 for all amounts that become otherwise 
deductible under all account balance plans.
    (ii) Account balance ratio method--(A) In general. Under this 
method, remuneration for services performed by an applicable individual 
for a covered health insurance provider that becomes otherwise 
deductible under an account balance plan must be attributed to services 
performed by the applicable individual in each taxable year of the 
covered health insurance provider ending with or before the payment year 
during which the applicable individual was a service provider and for 
which the account balance of the applicable individual increased 
(determined in accordance with paragraph (d)(3)(ii)(B) and (C) of this 
section). The amount attributed to each such taxable year is equal to 
the amount of remuneration that becomes otherwise deductible multiplied 
by a fraction, the numerator of which is the increase in the applicable 
individual's account balance under the plan for the taxable year, and 
the denominator of which is the sum of all such increases for all 
taxable years during which the applicable individual was a service 
provider. Thus, remuneration that becomes otherwise deductible under a 
plan is attributed to a taxable year of the covered health insurance 
provider in proportion to the increase in the applicable individual's 
account balance for that taxable year.
    (B) Increase in the account balance. For purposes of this paragraph 
(d)(3)(ii), an increase in an account balance under an account balance 
plan occurs for a taxable year if the account balance as of the 
measurement date in that taxable year is greater than the account 
balance as of the measurement date in every earlier taxable year. In 
that case, the amount of the increase for that taxable year is equal to 
the excess of the applicable individual's account balance as of the 
measurement date for that taxable year over the greatest of the 
applicable individual's account balances under the plan as of the 
measurement date in every earlier taxable year. If the applicable 
individual's account balance as of the measurement date in a taxable 
year is less than or equal to the applicable individual's account 
balance as of the measurement date in any earlier taxable year, there is 
no increase in the account balance for that later taxable year.
    (C) Certain account balance adjustments. For purposes of determining 
the account balance on a measurement date under paragraph (d)(3)(ii)(B) 
of this section, the account balance is adjusted as provided in this 
paragraph (d)(3)(ii)(C).
    (1) In-service payments. If an in-service payment is made from the 
account of an applicable individual under an account balance plan in any 
taxable year of a covered health insurance provider, then the rules of 
this paragraph (d)(3)(ii)(C)(1) apply.
    (i) Solely for purposes of determining the increase in the 
applicable individual's account balance as of the measurement date in 
the payment year (and not for purposes of attributing any amount that 
becomes otherwise deductible in any later taxable year), the account 
balance as of the measurement date for that taxable year is increased by 
the amount of all in-service payments made from the plan during that 
taxable year.
    (ii) For purposes of attributing any amount that becomes otherwise 
deductible under the plan in any taxable year after the payment year of 
the in-service payment--
    (A) the account balance as of the measurement date in each taxable 
year that ends before the taxable year to which the in-service payment 
is attributed pursuant to this paragraph (d)(3)(ii) is reduced by the 
sum of the amount of the in-service payment that is attributed to that 
taxable year and the amount of the in-service payment that is attributed 
to each taxable year that ends before that taxable year, if any, and
    (B) to the extent that the in-service payment includes an amount 
that was deductible by the covered health insurance provider in a 
previous taxable year and, therefore, was previously attributable to 
services performed by the applicable individual in one or more taxable 
years of the covered health insurance provider (for example, because

[[Page 256]]

the amount was made available in a previous taxable year but was not 
paid at that time), the account balance as of the measurement date for 
each taxable year that ends before the taxable year to which the in-
service payment is attributed pursuant to this paragraph (d)(3)(ii) is 
reduced by the sum of the amount of the in-service payment previously 
attributable to that taxable year and the amount of the in-service 
payment previously attributable to each taxable year that ends before 
that taxable year, if any.
    (2) Certain increases after ceasing to be a service provider. Any 
addition (other than income or earnings) to an account balance plan made 
in a taxable year that begins after an applicable individual ceases to 
be a service provider (and that ends before the applicable individual 
becomes a service provider again, if applicable) is added to the account 
balance of the applicable individual as of the measurement date of the 
first preceding taxable year in which the applicable individual was a 
service provider.
    (3) Account balance adjustments for grandfathered amounts. If a 
covered health insurance provider uses the principal additions method 
for determining grandfathered amounts for an applicable individual under 
paragraph (h) of this section, then, for purposes of determining the 
increase in the applicable individual's account balance, the account 
balance as of any measurement date is reduced by the amount of any 
grandfathered amounts otherwise included in the account balance.
    (D) Transition rule for amounts attributed before the applicability 
date of the final regulations. Amounts that become otherwise deductible 
in taxable years beginning before September 23, 2014 may be attributed 
to services performed in taxable years of a covered health insurance 
provider under the rules set forth in the proposed regulations. If a 
covered health insurance provider attributes an amount paid to an 
applicable individual pursuant to a method permitted under the proposed 
regulations and then chooses to use the account balance ratio method to 
attribute amounts that subsequently become otherwise deductible with 
respect to that applicable individual, then, for purposes of applying 
the account balance ratio method to attribute any amount that becomes 
otherwise deductible under the plan after the taxable year in which the 
last payment was made that was attributed pursuant to the proposed 
regulations, the account balance as of the measurement date for each 
taxable year that ends before the taxable year in which the last payment 
that was attributed pursuant to the proposed regulations is reduced by 
the sum of the amount previously attributed to that taxable year under 
the proposed regulations and the amount previously attributable to each 
taxable year that ends prior to that taxable year under the proposed 
regulations, if any.
    (iii) Principal additions method--(A) In general. Under this method, 
remuneration that becomes otherwise deductible under an account balance 
plan during a payment year must be attributed to services performed by 
the applicable individual in the taxable year of the covered health 
insurance provider during which the applicable individual was a service 
provider and in which the principal addition to which the amount relates 
is credited under the plan (determined in accordance with paragraph 
(d)(3)(iii)(B) and (C) of this section). An amount relates to a 
principal addition if the amount is a payment of the principal addition 
or earnings on the principal addition, based on a separate accounting of 
these amounts. The principal additions method described in this 
paragraph may be used to attribute amounts that become otherwise 
deductible under an account balance plan only if the covered health 
insurance provider separately accounts for each principal addition to 
the plan (and any earnings thereon) and traces each amount that becomes 
otherwise deductible under the plan to a principal addition made in a 
taxable year of the covered health insurance provider.
    (B) Principal addition--(1) For purposes of this paragraph 
(d)(3)(iii), the excess (if any) of the sum of the account balance of an 
applicable individual in an account balance plan as of the last day of a 
taxable year and any payments made during the taxable year over the 
account balance as of the last day of the immediately preceding

[[Page 257]]

taxable year, that is not due to earnings or losses (as described in 
paragraph (d)(3)(iii)(C) of this section), is treated as a principal 
addition that is credited to the plan in that taxable year if the 
applicable individual was a service provider during that taxable year. 
If the applicable individual was not a service provider during that 
taxable year, the excess described in the preceding sentence is treated 
as a principal addition that is credited to the plan in accordance with 
paragraph (d)(3)(iii)(B)(2) of this section.
    (2) Principal additions after termination of employment. Any 
principal addition to an account balance plan made in a taxable year 
that begins after an applicable individual ceases to be a service 
provider (and that ends before the applicable individual becomes a 
service provider again, if applicable) is treated as a principal 
addition that is credited in the first preceding taxable year in which 
the applicable individual was a service provider.
    (C) Earnings. Whether remuneration constitutes earnings on a 
principal addition is determined under the principles defining income 
attributable to an amount taken into account under Sec.  31.3121(v)(2)-
1(d)(2). Therefore, for an account balance plan, earnings on an amount 
deferred generally include an amount credited on behalf of an applicable 
individual under the terms of the arrangement that reflects a rate of 
return that does not exceed either the rate of return on a predetermined 
actual investment (as defined in Sec.  31.3121(v)(2)-1(d)(2)(i)(B)), or, 
if the income does not reflect the rate of return on a predetermined 
actual investment, a rate of return that reflects a reasonable rate of 
interest (as defined in Sec.  31.3121(v)(2)-1(d)(2)(i)(C)). For purposes 
of this paragraph (d)(3)(iii), the use of a rate of return that is not 
based on a predetermined actual investment or a reasonable rate of 
interest generally will result in the treatment of some or all of the 
remuneration as a principal addition that is attributable to services 
performed by an applicable individual in a taxable year of a covered 
health insurance provider in accordance with this paragraph (d)(3)(iii) 
of this section.
    (4) Nonaccount balance plans--(i) In general. When remuneration for 
services performed by an applicable individual for a covered health 
insurance provider becomes otherwise deductible under a plan described 
in Sec.  1.409A-1(c)(2)(i)(C) (a nonaccount balance plan), that 
remuneration must be attributed to services performed by the applicable 
individual in a taxable year of the covered health insurance provider in 
accordance with the attribution method described in either paragraph 
(d)(4)(ii) or (d)(4)(iii) of this section. However, except as provided 
in paragraphs (d)(4)(ii)(D) and (d)(4)(iii)(D) and (f)(3) of this 
section, the covered health insurance provider and all members of its 
aggregated group must apply the same attribution method under this 
paragraph (d)(4) consistently for all taxable years beginning after 
September 23, 2014 for all amounts that become deductible under all 
nonaccount balance plans.
    (ii) Present value ratio attribution method--(A) In general. Under 
this method, remuneration for services performed by an applicable 
individual for a covered health insurance provider that becomes 
otherwise deductible under a nonaccount balance plan must be attributed 
to services performed by the applicable individual in each taxable year 
of the covered health insurance provider ending with or before the 
payment year during which the applicable individual was a service 
provider for which the present value of the future payment(s) to be made 
to or on behalf of the applicable individual under the plan increased 
(determined in accordance with paragraph (d)(3)(ii)(B) and (C) of this 
section). The amount attributed to each such taxable year is equal to 
the amount of remuneration that becomes otherwise deductible under the 
plan multiplied by a fraction, the numerator of which is the increase in 
the present value of the future payment(s) to which the applicable 
individual has a legally binding right under the plan for the taxable 
year, and the denominator of which is the sum of all such increases for 
all taxable years during which the applicable individual was a service 
provider.

[[Page 258]]

Thus, remuneration that becomes otherwise deductible under a plan is 
attributed to a taxable year of the covered health insurance provider in 
proportion to the increase in the present value of the future payment(s) 
under the plan for that taxable year.
    (B) Increase in present value of future payments. For purposes of 
this paragraph (d)(4)(ii), for a taxable year of a covered health 
insurance provider, an increase in the present value of the future 
payment(s) to which an applicable individual has a legally binding right 
under a nonaccount balance plan occurs if the present value of the 
future payment(s) as of the measurement date in the taxable year is 
greater than the present value of the future payment(s) as of the 
measurement date in every earlier taxable year. In that case, the amount 
of the increase for that taxable year is equal to the excess of the 
present value of the future payment(s) to which the applicable 
individual has a legally binding right under the plan as of the 
measurement date for that taxable year over the greatest present value 
of the future payment(s) to which the applicable individual had a 
legally binding right under the plan as of the measurement date in every 
earlier taxable year. If the present value of the future payment(s) as 
of a measurement date in a taxable year is less than or equal to the 
present value of the future payment(s) as of the measurement date in any 
earlier taxable year, then there is no increase in the present value of 
the future payment(s) to which the applicable individual has a legally 
binding right under the plan for that later taxable year. For purposes 
of determining the increase (or decrease) in the present value of a 
future payment(s) under a nonaccount balance plan, the rules of Sec.  
31.3121(v)(2)-1(c)(2) apply (including the requirement that reasonable 
actuarial assumptions and methods be used).
    (C) Certain present value adjustments. For purposes of determining 
the present value of the future payment(s) to which an applicable 
individual has a legally binding right to receive as of a measurement 
date under paragraph (d)(4)(ii)(B) of this section, the present value is 
adjusted as provided in this paragraph (d)(3)(iii)(C).
    (1) In-service payments. If an in-service payment is made to or on 
behalf of an applicable individual under a nonaccount balance plan in 
any taxable year of a covered health insurance provider, then the rules 
of this paragraph (d)(3)(iii)(C)(1) apply.
    (i) Solely for purposes of determining the increase in the present 
value of the future payment(s) under the plan for the payment year (and 
not for purposes of attributing any amount that becomes otherwise 
deductible in any later taxable year), the present value of the future 
payment(s) under the plan as of the measurement date in the payment year 
is increased by the amount of any reduction in the present value of the 
future payment(s) resulting from the in-service payment made from the 
plan during that taxable year.
    (ii) For purposes of attributing any amount that becomes otherwise 
deductible under the plan in any taxable year after the payment year of 
the in-service payment, the present value of the future payment(s) as of 
the measurement date for each taxable year that ends before the payment 
year is reduced by the present value of the future payment to which the 
applicable individual had a legally binding right to be paid on the date 
of the in-service payment (determined as of the measurement date based 
upon all of the applicable factors under the plan as of the measurement 
date, such as compensation and years of service on that date).
    (2) Increases in the present value of future payments after ceasing 
to be a service provider. Any increase in the present value of the 
future payment(s) under a plan in a taxable year that begins after an 
applicable individual ceases to be a service provider (and that ends 
before the applicable individual becomes a service provider again, if 
applicable) that is not due merely to the passage of time or a change in 
the reasonable actuarial assumptions used to determine the present value 
of the future payment(s) is added to the present value of the future 
payment(s) for the applicable individual as of the measurement date of 
the most recent preceding taxable year in which the applicable 
individual was a service provider.

[[Page 259]]

    (D) Transition rule for amounts attributed before the effective date 
of the final regulations. Amounts that become otherwise deductible in 
taxable years beginning before September 23, 2014 may be attributed 
under the rules set forth in the proposed regulations. If a covered 
health insurance provider attributes an amount paid to an applicable 
individual pursuant to the proposed regulations and then chooses to use 
the present value ratio method to attribute amounts that subsequently 
become otherwise deductible with respect to that applicable individual, 
then, for purposes of applying the present value ratio method to 
attribute any amount that becomes otherwise deductible under the plan in 
any taxable year after the taxable year in which the last payment was 
made that was attributed pursuant to the proposed regulations, the 
present value of the future payment(s) as of the measurement date for 
each taxable year that ends before the taxable year in which the last 
payment that was attributed pursuant to the proposed regulations is 
reduced by the present value of each future payment to which the 
applicable individual had a legally binding right to be paid that was 
attributed pursuant to the proposed regulations (determined as of the 
measurement date based upon all of the applicable factors under the plan 
as of the measurement date, such as compensation and years of service on 
that date), with no adjustment for an amount that became otherwise 
deductible, but was not paid.
    (iii) Formula benefit ratio method--(A) In general. Under this 
method, remuneration that becomes otherwise deductible under a 
nonaccount balance plan on a date (referred to for these purposes as the 
date of payment) must be attributed to services performed by the 
applicable individual in each taxable year of the covered health 
insurance provider ending with or before the payment year during which 
the applicable individual was a service provider and for which the 
formula benefit of the applicable individual under the plan increased 
(determined in accordance with paragraph (d)(3)(iii)(B), (C) and (D) of 
this section). The amount attributed to each such taxable year is equal 
to the amount of remuneration that becomes otherwise deductible under 
the plan on the date of payment multiplied by a fraction, the numerator 
of which is the increase in the applicable individual's formula benefit 
under the plan for the taxable year and the denominator of which is the 
sum of all such increases for all taxable years during which the 
applicable individual was a service provider (which will generally be 
the amount that becomes otherwise deductible under the plan on the date 
of payment). Thus, remuneration that becomes otherwise deductible under 
a plan is attributed to a taxable year of the covered health insurance 
provider in proportion to the increase in the applicable individual's 
formula benefit under the plan in that taxable year.
    (B) Formula benefit. For purposes of this paragraph (d)(4)(iii), an 
applicable individual's formula benefit as of any date is the benefit 
(or portion thereof) to which the applicable individual has a legally 
binding right under a nonaccount balance plan as of that date determined 
based upon all of the applicable factors under the plan (for example, 
compensation and years of service as of that date), disregarding any 
substantial risk of forfeiture and assuming that the applicable 
individual meets any applicable eligibility requirements for the benefit 
as of that date. For this purpose, the formula benefit is expressed in 
the form that it has become otherwise deductible. For example, if an 
applicable individual's benefit under a plan is paid in the form of a 
single lump sum, then the applicable individual's formula benefit under 
the plan is expressed in the form of a single lump sum for all purposes 
under this paragraph (d)(4)(iii). If the amount that becomes otherwise 
deductible is payable in more than one form of payment (for example, 50 
percent of the benefit is paid in the form of a lump sum and 50 percent 
is paid in the form of a life annuity), then each separate form of 
payment is treated as a separate formula benefit to which this paragraph 
(d)(4)(iii) is applied separately.
    (C) Increase in formula benefit. For purposes of this paragraph 
(d)(4)(iii), an increase in an applicable individual's formula benefit 
under a nonaccount balance plan occurs for a taxable year

[[Page 260]]

of a covered health insurance provider if the formula benefit as of the 
measurement date in that taxable year is greater than the formula 
benefit as of the measurement date in every earlier taxable year. In 
that case, the amount of the increase for that taxable year is equal to 
excess of the formula benefit as of the measurement date in that taxable 
year over the greatest formula benefit as of any measurement date in any 
earlier taxable year. If the applicable individual's formula benefit as 
of a measurement date in a taxable year is less than or equal to the 
applicable individual's formula benefit as of the measurement date in 
any earlier taxable year, there is no increase in the formula benefit to 
which the applicable individual has a legally binding right under the 
plan for that later taxable year.
    (D) Certain adjustments. For purposes of determining the increase in 
the formula benefit as of a date of payment under paragraph 
(d)(4)(iii)(C) of this section, the rules of this paragraph 
(d)(3)(iii)(D) apply--
    (1) Attribution to payment year. Solely for purposes of attributing 
a payment under this paragraph (d)(4)(iii) (including an in-service 
payment), the date of payment is substituted for the measurement date in 
the payment year to determine whether an increase in the formula benefit 
occurs in the payment year and the amount of any such increase.
    (2) Amounts not paid. If an amount becomes otherwise deductible 
under a nonaccount balance plan, but is not paid, the formula benefit 
for that amount must be determined using the form in which it will be 
paid, if that form is known, or any form in which it may be paid, if the 
actual form of payment is unknown.
    (3) Increases in the formula benefit after ceasing to be a service 
provider. Any increase in the formula benefit with respect to an 
applicable individual resulting from a legally binding right arising in 
a taxable year that begins after the applicable individual ceases to be 
a service provider (and that ends before the applicable individual 
becomes a service provider again, if applicable) is added to the formula 
benefit with respect to the applicable individual as of the measurement 
date of the first preceding taxable year in which the applicable 
individual was a service provider. However, any increase in the formula 
benefit resulting from a legally binding right arising in a taxable year 
that begins before the applicable individual ceases to be a service 
provider is added to the formula benefit with respect to the applicable 
individual as of the measurement date of the taxable year in which the 
legally binding right arises, even if the increase is not reflected 
until after the applicable individual ceases to be a service provider 
(such as in the case of a cost of living adjustment).
    (5) Equity-based remuneration--(i) Stock options and stock 
appreciation rights--(A) In general. Except as provided in paragraph 
(d)(5)(i)(B) of this section, remuneration resulting from the exercise 
of a stock option (including compensation income arising at the time of 
a disqualifying disposition of an incentive stock option described in 
section 422 or an option under an employee stock purchase plan described 
in section 423) or a stock appreciation right (SAR) is attributable to 
services performed by an applicable individual for a covered health 
insurance provider on a daily pro rata basis over the period beginning 
on the date of grant (within the meaning of Sec.  1.409A-1(b)(5)(vi)(B)) 
of the stock option or SAR and ending on the date that the stock option 
or SAR is exercised, excluding any days on which the applicable 
individual is not a service provider.
    (B) Stock options or SARs subject to a substantial risk of 
forfeiture. If a stock option or SAR is subject to a substantial risk of 
forfeiture, a covered health insurance provider may attribute 
remuneration resulting from the exercise of the stock option or SAR to 
services performed by an applicable individual in a taxable year on a 
daily pro rata basis over the period beginning on the date of grant 
(within the meaning of Sec.  1.409A-1(b)(5)(vi)(B)) of the stock option 
or SAR and ending on the first date that the stock option or SAR is no 
longer subject to a substantial risk of forfeiture, but only if the 
covered health insurance provider uses this attribution method 
consistently for all

[[Page 261]]

stock options or SARs exercised in taxable years of a covered health 
insurance provider beginning after September 23, 2014, except as 
provided in paragraph (f)(3) of this section.
    (ii) Restricted stock. Remuneration resulting from restricted stock, 
for which an election under section 83(b) has not been made, that 
becomes substantially vested or transferred is attributed on a daily pro 
rata basis to services performed by an applicable individual for a 
covered health insurance provider over the period, excluding any days on 
which the applicable individual is not a service provider, beginning on 
the date the applicable individual obtains a legally binding right to 
the restricted stock and ending on the earliest of--
    (A) The date the restricted stock becomes substantially vested, or
    (B) The date the restricted stock is transferred by the applicable 
individual.
    (iii) Restricted stock units. Remuneration resulting from a 
restricted stock unit (RSU) is attributed on a daily pro rata basis to 
services performed by an applicable individual for a covered health 
insurance provider over the period beginning on the date the applicable 
individual obtains a legally binding right to the RSU and ending on the 
date the remuneration is paid or made available, excluding any days on 
which the applicable individual is not a service provider.
    (iv) Partnership interests and other equity. [Reserved]
    (6) Involuntary separation pay. Involuntary separation pay is 
attributable to services performed by an applicable individual for a 
covered health insurance provider in the taxable year in which the 
involuntary separation from service occurs. Alternatively, the covered 
health insurance provider may attribute involuntary separation pay to 
services performed by an applicable individual on a daily pro rata basis 
beginning on the date that the applicable individual obtains a legally 
binding right to the involuntary separation pay and ending on the date 
of the involuntary separation from service. Involuntary separation pay 
to different individuals may be attributed using different methods; 
however, if involuntary separation payments are made to the same 
individual over multiple taxable years, all the payments must be 
attributed using the same method. For purposes of this section, the term 
involuntary separation pay means remuneration to which an applicable 
individual has a right to payment solely as a result of the individual's 
involuntary separation from service (within the meaning of Sec.  1.409A-
1(n)). To the extent that involuntary separation pay is attributed to 
services performed in two or more taxable years of a covered health 
insurance provider as permitted under this paragraph, any amount of 
involuntary separation pay that is paid or made available must be 
attributed to services performed in all of those taxable years in the 
same proportion that the total involuntary separation pay is attributed 
to taxable years of the covered health insurance provider.
    (7) Reimbursements. Remuneration that is provided in the form of a 
reimbursement or benefit provided in-kind (other than cash) is 
attributable to services performed by an applicable individual in the 
taxable year of a covered health insurance provider in which the 
applicable individual makes a payment for which the applicable 
individual has a right to reimbursement or receives an in-kind benefit, 
except that remuneration provided in the form of a reimbursement or in-
kind benefit during a taxable year of a covered health insurance 
provider in which an applicable individual is not a service provider is 
attributable to services performed in the most recent preceding taxable 
year of the covered health insurance provider in which the applicable 
individual is a service provider.
    (8) Split-dollar life insurance. Remuneration resulting from a 
split-dollar life insurance arrangement (as defined in Sec.  1.61-22(b)) 
under which an applicable individual has a legally binding right to 
economic benefits described in Sec.  1.61-22(d)(2)(ii) (policy cash 
value to which the non-owner has current access within the meaning of 
Sec.  1.61-22(d)(4)(ii)) or Sec.  1.61-22(d)(2)(iii) (any other economic 
benefits provided to the non-owner) is attributable to services 
performed in the taxable year of the covered health insurance provider 
in which the legally binding right

[[Page 262]]

arises. Split-dollar life insurance arrangements under which payments 
are treated as split-dollar loans under Sec.  1.7872-15 generally will 
not give rise to DDR within the meaning of paragraph (b)(11) of this 
section, although they may give rise to AIR. However, in certain 
situations, this type of arrangement may give rise to DDR for purposes 
of section 162(m)(6), for example, if amounts due on a split-dollar loan 
are waived, cancelled, or forgiven.
    (9) Examples. The following examples illustrate the principles of 
paragraphs (d)(1) through (8) of this section. For purposes of these 
examples, each corporation has a taxable year that is the calendar year 
and is a covered health insurance provider for all relevant taxable 
years, DDR is otherwise deductible in the taxable year in which it is 
paid, and amounts payable under nonaccount balance plans are not 
forfeitable upon the death of the applicable individual. For purposes of 
these examples, the interest rates used in these examples are assumed to 
be reasonable.

    Example 1 (Account balance plan--account balance ratio method with 
earnings and a single payment). (i) B is an applicable individual of 
corporation Y for all relevant taxable years. On January 1, 2016, B 
begins participating in a nonqualified deferred compensation plan of Y 
that is an account balance plan. Under the terms of the plan, all 
amounts are fully vested at all times, and Y will pay B's entire account 
balance on January 1, 2019. B's account earns five percent interest per 
year, compounded annually. Y credits $10,000 to B under the plan 
annually on January 1 for three years beginning on January 1, 2016. 
Thus, B's account balance is $10,500 ($10,000 + ($10,000 x 5%)) on 
December 31, 2016; $21,525 ($10,500 + $10,000 + ($20,500 x 5%)) on 
December 31, 2017; and $33,101 ($21,525 + $10,000 + ($31,525 x 5%)) on 
December 31, 2018. On January 1, 2019, Y pays B $33,101, the entire 
account balance. Y attributes payments under its account balance plans 
using the account balance ratio method described in paragraph (d)(3)(i) 
of this section.
    (ii) The increase in B's account balance during 2016 is $10,500 
($10,500 - zero); the increase in B's account balance for 2017 is 
$11,025 ($21,525 - $10,500); and the increase in B's account balance for 
2018 is $11,576 ($33,101 - $21,525). The sum of all the increases is 
$33,101 ($10,500 + $11,025 + $11,576). Accordingly, for Y's 2016 taxable 
year, the attribution fraction is .3172 ($10,500/$33,101); for Y's 2017 
taxable year, the attribution fraction is .3331 ($11,025/$33,101); and 
for Y's 2018 taxable year, the attribution fraction is .3497 ($11,576/
$33,101).
    (iii) With respect to the $33,301 payment made on January 1, 2019, 
$10,500 ($33,101 x .3172) of DDR is attributable to services performed 
by B in Y's 2016 taxable year; $11,026 ($33,101 x .3331) of DDR is 
attributable to services performed by B in Y's 2017 taxable year; and 
$11,575 ($33,101 x .3497) of DDR is attributable to services performed 
by B in Y's 2018 taxable year.
    Example 2 (Account balance plan--principal additions method with 
earnings and a single payment. (i) The facts are the same as in Example 
1, except that Y attributes remuneration using the principal additions 
method described in paragraph (d)(3)(ii) of this section.
    (ii) The $10,000 principal addition made on January 1, 2016 and 
$1,576 of earnings thereon (interest on the 2016 $10,000 principal 
addition at five percent for three years compounded annually) are 
attributable to services performed by B in Y's 2016 taxable year; the 
principal addition of $10,000 on January 1, 2017 and $1,025 of earnings 
thereon (interest on the 2017 $10,000 principal addition at five percent 
for two years compounded annually) are attributable to services 
performed by B in Y's 2017 taxable year; and the principal addition of 
$10,000 to B's account on January 1, 2018 and $500 of earnings thereon 
(interest on the 2018 $10,000 principal addition at five percent for one 
year compounded annually) are attributable to services performed by B in 
Y's 2018 taxable year. Accordingly, with respect to the $33,301 payment 
made on January 1, 2019, $11,576 ($10,000 + $1,576) is attributable to 
services performed by B in Y's 2016 taxable year; $11,025 ($10,000 + 
$1,025) is attributable to services performed in Y's 2017 taxable year; 
and $10,500 ($10,000 + $500) is attributable to services performed by B 
in Y's 2018 taxable year.
    Example 3 (Account balance plan--account balance ratio method with 
earnings and losses). (i) J is an applicable individual of corporation Z 
for all relevant taxable years. On January 1, 2016, J begins 
participating in a nonqualified deferred compensation plan of Z that is 
an account balance plan. Under the terms of the plan, all amounts are 
fully vested at all times, and Z will pay J's entire account balance on 
January 1, 2019. Z credits $10,000 to J under the plan on January 1, 
2016 and January 1, 2018. Earnings under the terms of the plan are based 
on a predetermined actual investment (as defined in Sec.  31.3121(v)(2)-
1(e)(2)(i)(B)), which results in J's account balance increasing by five 
percent in the 2016 taxable year, decreasing by five percent in the 2017 
taxable year, and increasing again by five percent in the 2018 taxable 
year. Therefore, on December 31, 2016, J's account balance is $10,500 
($10,000 + ($10,000 x 5%)); on December 31, 2017, J's account balance is 
$9,975 ($10,500 - ($10,500 x 5%)); and on December 31, 2018, J's account

[[Page 263]]

balance is $20,974 ($9,975 + $10,000 + ($19,975 x 5%)). On January 1, 
2019, Z pays J the entire account balance of $20,974.
    (ii) The increase in J's account balance for 2016 is $10,500 
($10,500 - zero); the increase in J's account balance for 2017 is zero 
(because J's account balance decreased by $525 ($9,975 - $10,500)); the 
increase in J's account balance for 2018 is $10,474 ($20,974 - $10,500, 
which is the highest account balance in any prior taxable year). The sum 
of all the increases is $20,974 ($10,500 + $10,474). Thus, for Z's 2016 
taxable year the attribution fraction is .5006 ($10,500/$20,974); for 
Z's 2017 taxable year the attribution fraction is zero because there was 
a decrease in the account balance for the year; and for Z's 2018 taxable 
year the attribution fraction is .4994 ($10,474/$20,974).
    (iii) Accordingly, with respect to the $20,974 payment made on 
January 1, 2019, $10,499 ($20,974 x .5006) of DDR is attributable to 
services performed by J in Z's 2016 taxable year, and $10,474 
($20,973.75 x .4994) of DDR is attributable to services performed by J 
in Z's 2018 taxable year. No amount is attributable to services 
performed by J in Z's 2017 taxable year because there was no increase in 
the account balance for that taxable year.
    Example 4 (Account balance plan--principal additions method with 
earnings and losses). (i) The facts are the same as in Example 3, except 
that Z attributes remuneration using the principal additions method 
described in paragraph (d)(3)(ii) of this section.
    (ii) The $10,000 principal addition made on January 1, 2016 and the 
$474 of net earnings thereon ($500 of earnings for 2016, $525 of losses 
for 2017, and $499 of earnings for 2018) are attributable to services 
performed by J in Z's 2016 taxable year; and the $10,000 principal 
addition made on January 1, 2018 and the $500 of earnings thereon are 
attributable to services performed by J in Z's 2018 taxable year. 
Accordingly, with respect to the $20,974 payment made on January 1, 
2019, $10,474 ($10,000 + $474) of DDR is attributable to services 
performed by J in Z's 2016 taxable year, and $10,500 ($10,000 + $500) of 
DDR is attributable to services performed by J in Z's 2018 taxable year.
    Example 5 (Account balance plan--account balance ratio method with 
losses and an in-service payment). (i) N is an applicable individual of 
corporation M for all relevant taxable years. On January 1, 2016, N 
begins participating in a nonqualified deferred compensation plan 
sponsored by M that is an account balance plan. Under the plan, all 
amounts are fully vested at all times. The balances in N's account are 
$110,000 on December 31, 2016; $90,000 on December 31, 2017; $250,000 on 
December 31, 2018; and $240,000 on December 31, 2019. N ceases providing 
services to N on December 31, 2019. In accordance with the plan terms, M 
pays to N $10,000 on September 30, 2017, $150,000 on January 1, 2021, 
and $100,000 on January 1, 2022. M attributes payments under its account 
balance plans using the account balance ratio method described in 
paragraph (d)(3)(i) of this section.
    (ii) For purposes of attributing the $10,000 payment made on 
September 30, 2017 to taxable years, the increase in N's account balance 
for 2016 is $110,000 ($110,000 - zero). N's account balance for 2017 is 
treated as $100,000 ($90,000 + $10,000 payment on September 30, 2017), 
but, because the account balance of $100,000 is less than the account 
balance in an earlier year, the increase in N's account balance for 2017 
is zero. The sum of all the increases in N's account balance is $110,000 
($110,000 + $0). Thus, the attribution fraction for 2016 is 1 ($110,000/
$110,000), and the attribution fraction for 2017 is zero ($0/$110,000). 
Accordingly, with respect to the $10,000 payment made on September 30, 
2017, the entire $10,000 is attributable to services performed by N in 
M's 2016 taxable year, and no amount is attributable to services 
performed by N in M's 2017 taxable year.
    (iii) After attributing the September 30, 2017 payment of $10,000 to 
2016, N's account balance for 2016 is treated as being $100,000 
($110,000 - $10,000), and the increase for 2016 is likewise treated as 
$100,000; N's account balance for 2017 decreased; the increase in N's 
account balance for 2018 is $150,000 ($250,000 - $100,000); and N's 
account balance for 2018 decreased. The sum of all the increases is 
$250,000 ($100,000 + $150,000). Thus, the attribution fraction for 2016 
is .40 ($100,000/$250,000); the attribution fraction for 2017 is zero 
($0/$250,000); the attribution fraction for 2018 is .60 ($150,000/
$250,000); and the attribution fraction for 2019 is zero ($0/$250,000).
    (iv) Accordingly, with respect to the $150,000 payment made on 
January 1, 2021, $60,000 ($150,000 x .40) is attributable to services 
performed by N in M's 2016 taxable year, and $90,000 ($150,000 x .60) is 
attributable to services performed by N in M's 2018 taxable year. With 
respect to the $100,000 payment made on January 1, 2022, $40,000 
($100,000 x .40) is attributable to services performed by N in M's 2016 
taxable year, and $60,000 ($100,000 x .60) is attributable to services 
performed by N in M's 2018 taxable year. No amount is attributable to 
services performed by N in M's 2017 and 2019 taxable years.
    Example 6 (Account balance plan--principal additions method with 
multiple payments). (i) O is an applicable individual of corporation L 
for all relevant taxable years. On January 1, 2016, O begins 
participating in a nonqualified deferred compensation plan sponsored by 
L that is an account balance plan. Under the plan, all amounts are fully 
vested at all times. L credits principal additions to O's account each 
year, and credits earnings based on a predetermined actual investment 
within the meaning of Sec.  31.3121(v)(2)-1(d)(2)(i)(B). L makes 
principal additions of $90,000 on June 30, 2016; $140,000 on June 30, 
2017; and $180,000

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on June 30, 2018. The predetermined actual investment earns five percent 
for 2016, seven percent for 2017; eight percent for 2018; and nine 
percent for 2019. Thus, as of December 31, 2018, the earnings with 
respect to the $90,000 principal addition made on June 30, 2016 are 
$16,605, for a total of $106,605; and the earnings with respect to the 
$140,000 principal addition made on June 30, 2017 are $16,492, for a 
total of $156,492. As of January 1, 2020, the earnings with respect to 
the $180,000 principal addition made on June 30, 2018 are $24,048, for a 
total of $204,048. Under the terms of the plan, the principal addition 
(and earnings thereon) made on June 30, 2016 and June 30, 2017 are 
payable on December 31, 2018, and the principal addition (and earnings 
thereon) made on June 30, 2018 is payable on January 1, 2020. On 
December 31, 2018, L pays O $263,097 in accordance with the plan terms. 
On January 1, 2020, L pays O the remaining account balance of $204,048 
in accordance with the plan terms.
    (ii) The $263,097 payment made on December 31, 2018 is attributed to 
services performed by O in the 2016 and 2017 taxable years. Of the 
$263,097 payment, $106,605 is attributable to services performed by O in 
L's 2016 taxable year because this amount represents the $90,000 
principal addition made on June 30, 2016 and earnings thereon. The 
remaining $156,492 is attributable to services performed by O in L's 
2017 taxable year because this amount represents the $140,000 principal 
addition made on June 30, 2017 and earnings thereon. The $204,048 
payment made on January 1, 2020 is attributable to services performed by 
O in L's 2018 taxable year because this amount represents the $180,000 
principal addition made on June 30, 2018 and earnings thereon.
    Example 7 (Account balance plan--account balance ratio method with 
an employer contribution after the applicable individual ceases to be a 
service provider). (i) A is an applicable individual of corporation Z 
for all relevant taxable years. On January 1, 2016, A begins 
participating in a nonqualified deferred compensation plan of Z that is 
an account balance plan. Under the terms of the plan, all amounts are 
fully vested at all times. The balances in A's account (including 
employer contributions and earnings) are $20,000 on December 31, 2016, 
and $60,000 on December 31, 2017. On December 31, 2017, A ceases 
providing services to Z. On January 1, 2019, Z makes a discretionary 
contribution of $30,000 to A's account balance plan. On December 31, 
2019, in accordance with the plan terms, Z pays $120,000 to A, which is 
N's entire account balance. Z attributes payments under its account 
balance plans using the account balance ratio method described in 
paragraph (d)(3)(i) of this section.
    (ii) The increase in A's account balance for 2016 is $20,000; the 
increase in A's account balance for 2017 is $40,000. The discretionary 
contribution made on January 1, 2019 of $30,000 is added to the account 
balance for 2017. Thus, the discretionary contribution of $30,000 on 
January 1, 2019, is treated as increasing A's account balance for 2017 
by $30,000. The increase in A's account balance for 2016 is $20,000, and 
the increase in A's account balance for 2017 is $70,000 ($40,000 + 
$30,000). The sum of all the increases is $90,000 ($20,000 + $70,000).
    (iii) Thus, the attribution fraction for 2016 is .2222 ($20,000/
$90,000); and the attribution fraction for 2017 is .7778 ($70,000/
$90,000). Accordingly, with respect to the $120,000 payment made on 
January 1, 2019, $26,664 ($120,000 x .2222) is attributable to services 
performed by A in Z's 2016 taxable year, and $93,336 ($120,000 x .7778) 
is attributable to services performed by A in Z's 2017 taxable year.
    Example 8 (Account balance plan--principal additions method with a 
principal addition after the applicable individual ceases to be a 
service provider). (i) C is an applicable individual of corporation X 
for all relevant taxable years. On January 1, 2016, C begins 
participating in a nonqualified deferred compensation plan of X that is 
an account balance plan. Earnings under the terms of the plan are based 
on a predetermined actual investment (as defined in Sec.  31.3121(v)(2)-
1(e)(2)(i)(B)). Under the terms of the plan, all amounts are fully 
vested at all times. X credits a $10,000 principal addition to C under 
the plan on April 1, 2016, and a $20,000 principal addition to C on 
April 1, 2017. C ceases providing services to X on December 31, 2017. On 
January 1, 2019, X credits $30,000 to C's account in recognition of C's 
past services. The $10,000 principal addition made on April 1, 2016 
increases to $15,000 as of December 31, 2019, as a result of earnings. 
The $20,000 principal addition made on April 1, 2017, increases to 
$28,000 as of December 31, 2019 as a result of earnings. The January 1, 
2019, contribution of $30,000 increases to $33,000 as of December 31, 
2019, as a result of earnings. On December 31, 2019, in accordance with 
the plan terms, X pays C's entire account balance of $76,000. X 
attributes payments under its account balance plans using the principal 
additions method described in paragraph (d)(3)(ii) of this section.
    (ii) When the $76,000 payment is made to C on December 31, 2019, the 
remuneration becomes attributable to service performed by C in prior 
taxable years. The $10,000 principal addition in 2016 plus earnings 
thereon of $5,000 are attributable to services performed by C in X's 
2016 taxable year, and the $20,000 principal addition in 2017 (plus 
earnings thereon of $8,000) are attributable to services performed by C 
in X's 2017 taxable year. The principal addition of $30,000 plus 
earnings thereon of $3,000 ($33,000) are also attributable to services 
performed by C in X's 2017

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taxable year. Thus, $16,500 of the $33,000 is attributed to services 
performed by C in X's 2017 taxable year.
    (iii) Accordingly, with respect to the $76,000 payment by X to C on 
December 31, 2019, $15,000 ($10,000 + $5,000) is attributed to services 
performed by C in X's 2016 taxable year, and $61,000 ($20,000 + $8,000 + 
$33,000) is attributed to services performed by C in X's 2017 taxable 
year.
    Example 9 (Nonaccount balance plan--present value ratio method with 
a single payment). (i) C is an applicable individual of corporation X 
for all relevant taxable years. On January 1, 2015, X grants C a vested 
right to a $100,000 payment on January 1, 2020. C ceases providing 
services on December 31, 2019. The payment of $100,000 is made on 
January 1, 2020. X determines the present value of the payment using an 
interest rate of five percent for all years.
    (ii) The present value of $100,000 payable on January 1, 2020, 
determined using a five percent interest rate, is $82,270 as of December 
31, 2015; $86,384 as of December 31, 2016; $90,703 as of December 31, 
2017; $95,238 as of December 31, 2018, and $100,000 as of December 31, 
2019. Accordingly, $82,270 is the amount of the increase in the present 
value of the future payment of $100,000 for X's 2015 taxable year 
($82,270 - $0); $4,114 ($86,384 - $82,270) is the increase in the 
present value of the future payment for X's 2016 taxable year; $4,319 
($90,703 - $86,384) is the increase in the present value of the future 
payment for X's 2017 taxable year; $4,535 ($95,238 - $90,703) is the 
increase in the present value of the future payment for X's 2018 taxable 
year; and $4,762 ($100,000 - $95,238) is the increase in the present 
value of the future payment for X's 2019 taxable year. The sum of all 
the increases is $100,000 ($82,270 + $4,114 + $4,319 + $4,535 + $4,762). 
Thus, the attribution fraction for 2015 is .8227 ($82,270/$100,000); the 
attribution fraction for 2016 is .0411 ($4,114/$100,000); the 
attribution fraction for 2017 is .0432 ($4,319/$100,000); the 
attribution fraction for 2018 is .0454 ($4,535/$100,000); and the 
attribution fraction for 2019 is .0476 ($4,762/$100,000).
    (iii) The $100,000 payment made on January 1, 2020 is multiplied by 
the attribution fraction for each taxable year, and the result is the 
amount that is attributable to service performed by C for that taxable 
year. Accordingly, $82,270 ($100,000 x .8227) is attributable to 
services performed by C in X's 2015 taxable year; $4,114 ($100,000 x 
.0411) is attributable to services performed by C in X's 2016 taxable 
year; $4,319 ($100,000 x .0432) is attributable to services performed by 
C in X's 2017 taxable year; $4,535 ($100,000 x .0454) is attributable to 
services performed by C in X's 2018 taxable year; and $4,762 ($100,000 x 
.0476) is attributable to services performed by C in X's 2019 taxable 
year.
    Example 10. (Nonaccount balance plan--present value ratio method 
with an in-service payment). (i) The facts are the same as Example 9, 
except that X grants C a vested right to a $40,000 payment on June 30, 
2018 and a vested right to a $60,000 payment on January 1, 2020.
    (ii) The present value of the future payments ($40,000 payable on 
June 30, 2018 and $60,000 payable on January 1, 2020), determined using 
a five percent interest rate, is $84,758 as of December 31, 2015; 
$88,996 as of December 31, 2016; $93,446 as of December 31, 2017; and 
$57,143 as of December 31, 2018. However, for purposes of determining 
the increase in the present value of the future payments during 2018 
(the year of the in-service payment), $57,143 must be increased by 
$40,000, the amount of the in-service payment, resulting in a present 
value of future payments as of December 31, 2018, of $97,143 solely for 
purposes of attributing the $40,000 in-service payment. Accordingly, 
$84,758 is the amount of the increase in the present value of the future 
payments for X's 2015 taxable year, $4,238 ($88,896 - $84,758) is the 
increase in the present value of the future payments for X's 2016 
taxable year, $4,450 ($93,446 - $88,996) is the increase in the present 
value of the future payments for X's 2017 taxable year, and $3,697 
($97,143 - $93,446) is the increase in the present value of the future 
payments for X's 2018 taxable year. The sum of all the increases is 
$97,143 ($84,758 + $4,238 + $4,450 + $3,697). Thus, the attribution 
fraction for 2015 is .8725 ($84,758/$97,143); the attribution fraction 
for 2016 is .0436 ($4,238/$97,143); the attribution fraction for 2017 is 
.0458 ($4,450/$97,143); and the attribution fraction for 2018 is .0381 
($3,697/$97,143).
    (iii) Accordingly, with respect to the $40,000 payment made on June 
30, 2018, $34,900 ($40,000 x .8725) is attributable to services 
performed by C in X's 2015 taxable year; $1,744 ($40,000 x .0436) is 
attributable to services performed by C in X's 2016 taxable year; $1,832 
($40,000 x .0458) is attributable to services performed by C in X's 2017 
taxable year; and $1,524 ($40,000 x .0381) is attributable to services 
performed by C in X's 2018 taxable year.
    (iv) For purposes of attributing the $60,000 payment made on January 
1, 2020, the present value of the future payments for each taxable year 
that ends prior to the taxable year in which the $40,000 in-service 
payment is paid is reduced by the present value of the future payment to 
which the applicable individual had a legally binding right to be paid 
on the date the $40,000 in-service is paid (based on the applicable 
factors and plan provisions as of the measurement date in each such 
taxable year). The present value of that future payment is $35,396 as of 
December 31, 2015; $37,166 as of December 31, 2016; and $39,024 as of 
December 31, 2017. Therefore, for purposes of attributing the $60,000 
payment on January 1, 2020, the

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present value of future payments as of December 31, 2015, is $49,362 
($84,758 - $35,396); the present value of future payments as of December 
31, 2016, is $51,830 ($88,996 - $37,166); the present value of future 
payments as of December 31, 2017, is $54,422 ($93,446 - $39,024). The 
present value of future payments as of December 31, 2018, is $57,143. 
Accordingly, $49,362 is the increase in the present value of the future 
payment of $60,000 for X's 2015 taxable year; $2,468 ($51,830 - $49,362) 
is the increase in the present value of the future payment for X's 2016 
taxable year; $2,592 ($54,422 - $51,830) is the increase in the future 
value of the payment for X's 2017 taxable year; $2,721 ($57,143 - 
$54,422) is the increase in the future value of the payments for X's 
2018 taxable year; and $2,857 ($60,000 - $57,143) is the increase in the 
future value of the payment for X's 2019 taxable year. The sum of all 
the increases is $60,000 ($49,362 + $2,468 + $2,592 + $2,721 + $2,857). 
Thus, the attribution fraction for 2015 is .8227 ($49,362/$60,000); the 
attribution fraction for 2016 is .0411 ($2,468/$60,000); the attribution 
fraction for 2017 is .0432 ($2,592/$60,000); the attribution fraction 
for 2018 is .0454 ($2,721/$60,000); and the attribution fraction for 
2019 is .0476 ($2,857/$60,000).
    (v) Accordingly, with respect to the $60,000 payment made on January 
1, 2020, $49,362 ($60,000 x .8227) is attributable to services performed 
by C in X's 2015 taxable year; $2,468 ($60,000 x .0411) is attributable 
to services performed by C in X's 2016 taxable year; $2,592($60,000 x 
.0432) is attributable to services performed by C in X's 2017 taxable 
year; $2,721 ($60,000 x .0454) is attributable to services performed by 
C in X's 2018 taxable year; and $2,857 ($60,000 x .0476) is attributable 
to services performed by C in X's 2019 taxable year.
    Example 11 (Nonaccount balance plan--formula benefit ratio method 
with losses and multiple payments). (i) D is an applicable individual of 
W for all relevant taxable years. D becomes a participant in a 
nonaccount balance plan sponsored by R on January 1, 2018. The plan 
provides W with the vested right to receive a five annual installments 
each equal to $20,000 times the full years of service that D completes. 
The first payment is to be made on the later of December 31, 2027, or on 
the December 31 of the first year in which D is no longer a service 
provider. D has a break in service in 2020 and does not accrue an 
additional benefit during 2020. D ceases to be a service provider on 
December 31, 2022, after having completed four years of service, 
entitling D to five annual payments equal to $80,000 per year commencing 
on December 31, 2027. W determines the present value of amounts to be 
paid under the plan using an interest rate of five percent for 2018 and 
2019, and seven percent for 2021, 2022, and 2023. W uses the formula 
benefit ratio method described in paragraph (d)(4)(ii) of this section.
    (ii) Under the plan formula, in 2018, E accrued the right to a 
$20,000 annual payment for five years, and E accrued an additional 
$20,000 in annual payments in 2019, 2021, and 2022, resulting in the 
right to receive an annual payment of $80,000 commencing on December 31, 
2027. Thus, the attribution fraction is .25 for 2018 ($20,000/$80,000), 
.25 for 2019 ($20,000/$80,000), .25 for 2021 ($20,000/$80,000), and .25 
for 2022 ($20,000/$80,000). The attribution fraction for 2020 is zero 
because no additional formula benefit accrued during that year.
    (iii) The attribution fraction for each disqualified taxable year is 
multiplied by each payment and the result is attributed to that taxable 
year. Accordingly, with respect to each $80,000 payment, $20,000 
($80,000 x .25) is attributable to services performed by D in W's 2018 
taxable year; $20,000 ($80,000 x .25) is attributable to services 
performed by D in W's 2019 taxable year; $20,000 ($80,000 x .25) is 
attributable to services performed by D in W's 2021 taxable year; and 
$20,000 ($80,000 x .25) is attributable to services performed by D in 
W's 2022 taxable year. No amount is attributable to services performed 
by D in W's 2020 taxable year.
    Example 12 (Stock option). (i) E is an applicable individual of 
corporation V for all relevant taxable years. On January 1, 2016, V 
grants E an option to purchase 100 shares of V common stock at an 
exercise price of $50 per share (the fair market value of V common stock 
on the date of grant). The stock option is not subject to a substantial 
risk of forfeiture. On December 31, 2017, E ceases to be a service 
provider of V or any member of V's aggregated group. On January 1, 2019, 
E resumes providing services for V and again becomes both a service 
provider and an applicable individual of V. On December 31, 2020, when 
the fair market value of V common stock is $196 per share, E exercises 
the stock option. The remuneration resulting from the stock option 
exercise is $14,600 (($196 -- $50) x 100).
    (ii) The $14,600 is attributed pro rata over the 1,460 days from 
January 1, 2016 to December 31, 2017 and from January 1, 2019 to 
December 31, 2020 (365 days per year for the 2016, 2017, 2019, and 2020 
taxable years), so that $10 ($14,600 divided by 1,460) is attributed to 
each calendar day in this period, and $3,650 (365 days x $10) of 
remuneration is attributed to services performed by E in each of V's 
2016, 2017, 2019, and 2020 taxable years.
    Example 13 (Stock option subject to a substantial risk of 
forfeiture). (i) The facts are the same as Example 14, except that the 
stock option is subject to a substantial risk of forfeiture that lapses 
on December 31, 2017, and is not transferable until that date, and V 
chooses to attribute remuneration resulting from the exercise of stock 
options that are subject to a substantial risk of forfeiture over the 
period beginning on the date of

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grant and ending on the date the substantial risk of forfeiture lapses, 
as permitted under paragraph (d)(5)(i)(B) of this section.
    (ii) The $14,600 is attributed pro rata over the 730 days from 
January 1, 2016 to December 31, 2017 (365 days per year for the 2016 and 
2017 taxable years), so that $20 ($14,600 divided by 730) is attributed 
to each calendar day in this period, and $7,300 (365 days x $20) is 
attributed to services performed by E in each of V's 2016 and 2017 
taxable years.
    Example 14 (Restricted stock). (i) F is an applicable individual of 
corporation U for all relevant taxable years. On January 1, 2017, U 
grants to F 1000 shares of restricted U common stock. Under the terms of 
the grant, the shares will be forfeited if F voluntarily terminates 
employment before December 31, 2019 (so that the shares are subject to a 
substantial risk of forfeiture through that date) and are 
nontransferable until the substantial risk of forfeiture lapses. F does 
not make an election under section 83(b) and continues in employment 
with U through December 31, 2019, at which time F's rights in the stock 
become substantially vested within the meaning of Sec.  1.83-3(b) and 
the fair market value of a share of the stock is $109.50. The 
remuneration resulting from the vesting of the restricted stock is 
$109,500 ($109.50 x 1000).
    (ii) The $109,500 of remuneration is attributed to services 
performed by F over the 1,095 days between January 1, 2017 and December 
31, 2019 (365 days per year for the 2017, 2018, and 2019 taxable years), 
so that $100 ($109,500 divided by 1,095) is attributed to each calendar 
day in this period, and remuneration of $36,500 (365 days x $100) is 
attributed to services performed by F in each of U's 2017, 2018, and 
2019 taxable years.
    Example 15 (RSUs). (i) G is an applicable individual of corporation 
T for all relevant taxable years. On January 1, 2018, T grants to G 1000 
RSUs. Under the terms of the grant, T will pay G an amount on December 
31, 2020 equal to the fair market value of 1000 shares of T common stock 
on that date, but only if G continues to provide substantial services to 
T (so that the RSU is subject to a substantial risk of forfeiture) 
through December 31, 2020. G remains employed by T through December 31, 
2020, at which time the fair market value of a share of the stock is 
$219, and T pays G $219,000 ($219 x 1000).
    (ii) The $219,000 in remuneration is attributed to services 
performed by G over the 1,095 days beginning on January 1, 2018 and 
ending on December 31, 2020 (365 days per year for the 2018, 2019, and 
2020 taxable years), so that $200 ($219,000/1,095) is attributed to each 
calendar day in this period, and $73,000 (365 days x $200) is attributed 
to service performed by G in each of T's 2018, 2019, and 2020 taxable 
years.
    Example 16 (Involuntary separation pay). (i) H is an applicable 
individual of corporation S. On January 1, 2015, H and S enter into an 
employment contract providing that S will make two payments of $150,000 
each to H if H has an involuntary separation from service. Under the 
terms of the contract, the first payment is due on January 1 following 
the involuntary separation from service, and the second payment is due 
on January 1 of the following year. On December 31, 2016, H has an 
involuntary separation from service. S pays H $150,000 on January 1, 
2017 and $150,000 on January 1, 2018.
    (ii) Pursuant to paragraph (d)(6) of this section, involuntary 
separation pay may be attributed to services performed by H in the 
taxable year of S in which the involuntary separation from service 
occurs. Alternatively, involuntary separation pay may be attributed to 
services performed by H on a daily pro rata basis beginning on the date 
H obtains a legally binding right to the involuntary separation pay and 
ending on the date of the involuntary separation from service. The 
entire $300,000 amount, including both $150,000 payments, must be 
attributed using the same method. Therefore, the entire $300,000 amount 
(comprised of two $150,000 payments) may be attributed to services 
performed by H in S's 2016 taxable year, which is the taxable year in 
which the involuntary separation from service occurs. Alternatively, 
each $150,000 payment may be attributed on a daily pro rata basis to the 
period beginning on January 1, 2015 and ending December 31, 2016, so 
that $410.96 (($150,000 x 2)/(365 x 2)) is attributed to each day of S's 
2015 and 2016 taxable years. Accordingly, $150,000 is attributed to 
services performed by H in each of S's 2015 and 2016 taxable years.
    Example 17 (Reimbursement after termination of services). (i) I is 
an applicable individual of corporation R. On January 1, 2018, I enters 
into an agreement with R under which R will reimburse I's country club 
dues for two years following I's separation from service. On December 
31, 2020, I ceases to be a service provider of R. I pays $50,000 in 
country club dues on January 1, 2021 and $50,000 on January 2, 2022. 
Pursuant to the agreement, R reimburses I $50,000 for the country club 
dues in 2021 and $50,000 in 2022.
    (ii) $100,000 is attributed to services performed in R's 2020 
taxable year, the taxable year in which I ceases to be a service 
provider.

    (10) Certain remuneration subject to a substantial risk of 
forfeiture. If remuneration is attributable in accordance with 
paragraphs (d)(2) (legally binding right), (d)(3) (account balance 
plan), or (d)(4) (nonaccount balance plan) of this section to services 
performed in a period that includes two or more taxable years of a 
covered health insurance

[[Page 268]]

provider during which the remuneration is subject to a substantial risk 
of forfeiture, that remuneration must be attributed using a two-step 
process. First, the remuneration must be attributed to the taxable years 
of the covered health insurance provider in accordance with paragraph 
(d)(2), (3), or (4) of this section, as applicable. Second, the 
remuneration attributed to the period during which the remuneration is 
subject to a substantial risk of forfeiture (the vesting period) must be 
reattributed on a daily pro rata basis over that period beginning on the 
date that the applicable individual obtains a legally binding right to 
the remuneration and ending on the date that the substantial risk of 
forfeiture lapses. If a vesting period begins on a day other than the 
first day of a covered health insurance provider's taxable year or ends 
on a day other than the last day of the covered health insurance 
provider's taxable year, the remuneration attributable to that taxable 
year under the first step of the attribution process is divided between 
the portion of the taxable year that includes the vesting period and the 
portion of the taxable year that does not include the vesting period. 
The amount attributed to the portion of the taxable year that includes 
the vesting period is equal to the total amount of remuneration that 
would be attributable to the taxable year under the first step of the 
attribution process, multiplied by a fraction, the numerator of which is 
the number of days during the taxable year that the amount is subject to 
a substantial risk of forfeiture and the denominator of which is the 
number of days in such taxable year. The remaining amount is attributed 
to the portion of the taxable year that does not include the vesting 
period and, therefore, is not reattributed under the second step of the 
attribution process.
    (11) Example. The following example illustrates the principles of 
paragraph (d)(10) of this section. For purposes of this example, the 
corporation has a taxable year that is the calendar year and is a 
covered health insurance provider for all relevant taxable years, DDR is 
otherwise deductible in the taxable year in which it is paid, and 
amounts payable under nonaccount balance plans are not forfeitable upon 
the death of the applicable individual.

    Example (Account balance plan subject to a substantial risk of 
forfeiture using the principal additions method). (i) J is an applicable 
individual of corporation Q for all relevant taxable years. On January 
1, 2016, J begins participating in a nonqualified deferred compensation 
plan that is an account balance plan. Under the terms of the plan, Q 
will pay J's account balance on January 1, 2021, but only if J continues 
to provide substantial services to Q through December 31, 2018 (so that 
the amount credited to J's account is subject to a substantial risk of 
forfeiture through that date). Q credits $10,000 to J's account annually 
for five years on January 1 of each year beginning on January 1, 2016. 
The account earns interest at a fixed rate of five percent per year, 
compounded annually, which solely for the purposes of this example, is 
assumed to be a reasonable rate of interest. Q attributes increases in 
account balances under the plan using the principal additions method 
described in paragraph (d)(3)(ii) of this section.
    (ii) Earnings on a principal addition are attributed to the same 
disqualified taxable year of Q to which the principal addition is 
attributed; therefore, the amount initially attributable to Q's 2016 
taxable year is $12,763 (the $10,000 principal addition in 2016 at five 
percent interest for five years); the amount initially attributable to 
Q's 2017 taxable year is $12,155 (the $10,000 principal addition in 2017 
at five percent interest for four years); the amount initially 
attributable to Q's 2018 taxable year is $11,576 (the $10,000 principal 
addition in 2018 at five percent interest for three years); the amount 
attributable to Q's 2019 taxable year is $11,025 (the $10,000 principal 
addition in 2019 at five percent interest for two years); and the amount 
attributable to Q's 2020 taxable year is $10,500 (the $10,000 principal 
addition in 2020 at five percent interest for one year).
    (iii) Remuneration that is attributable to two or more taxable years 
of Q during which it is subject to a substantial risk of forfeiture must 
be reattributed on a daily pro rata basis to the period beginning on the 
date that J obtains a legally binding right to the remuneration and 
ending on the date that the substantial risk of forfeiture lapses. 
Therefore, $36,494 ($12,763 + $12,155 + $11,576) is reattributed on a 
daily pro rata basis over the period beginning on January 1, 2016, and 
ending on December 31, 2018. Thus, $12,165 is attributed to services 
performed by J in each of Q's 2016, 2017, and 2018 taxable years.

    (e) Application of the deduction limitation--(1) Application to 
aggregate amounts. The $500,000 deduction limitation is applied to the 
aggregate amount

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of AIR and DDR attributable to services performed by an applicable 
individual in a disqualified taxable year. The aggregate amount of AIR 
and DDR attributable to services performed by an applicable individual 
in a disqualified taxable year that exceeds the $500,000 deduction limit 
is not allowed as a deduction in any taxable year. Therefore, for 
example, if an applicable individual has more than $500,000 of AIR 
attributable to services performed for a covered health insurance 
provider in a disqualified taxable year, the amount of that AIR that 
exceeds $500,000 is not deductible in any taxable year, and no DDR 
attributable to services performed by the applicable individual in that 
disqualified taxable year is deductible in any taxable year. However, if 
an applicable individual has AIR for a disqualified taxable year that is 
$500,000 or less and DDR attributable to services performed in the same 
disqualified taxable year that, when combined with the AIR for the year, 
exceeds $500,000, all of the AIR is deductible in that disqualified 
taxable year, but the amount of DDR attributable to that taxable year 
that is deductible in future taxable years is limited to an amount equal 
to $500,000 less the amount of the AIR for that taxable year.
    (2) Order of application and calculation of deduction limitation--
(i) In general. The deduction limitation with respect to any applicable 
individual for any disqualified taxable year is applied to AIR and DDR 
attributable to services performed by that applicable individual in that 
disqualified taxable year at the time that the remuneration becomes 
otherwise deductible, and each time the deduction limitation is applied 
to an amount that is otherwise deductible, the deduction limit is 
reduced (but not below zero) by the amount against which it is applied. 
Accordingly, the deduction limitation is applied first to an applicable 
individual's AIR attributable to services performed in a disqualified 
taxable year and is reduced (but not below zero) by the amount of the 
AIR to which the deduction limit is applied. If the applicable 
individual also has an amount of DDR attributable to services performed 
in that disqualified taxable year that becomes otherwise deductible in a 
subsequent taxable year, the deduction limit, as reduced, is applied to 
that amount of DDR in the first taxable in which the DDR becomes 
otherwise deductible. The deduction limit is then further reduced (but 
not below zero) by the amount of the DDR to which the deduction limit is 
applied. If the applicable individual has an additional amount of DDR 
attributable to services performed in the original disqualified taxable 
year that becomes otherwise deductible in a subsequent taxable year, the 
deduction limit, as further reduced, is applied to that amount of DDR in 
the taxable year in which it is otherwise deductible. This process 
continues for future taxable years in which DDR attributable to services 
performed by the applicable individual in the original disqualified 
taxable year is otherwise deductible. No deduction is allowed in any 
taxable year for any AIR or DDR attributable to services performed by an 
applicable individual in a disqualified taxable year for the excess of 
those amounts over the deduction limit (as reduced, if applicable) for 
that disqualified taxable year at the time the deduction limitation is 
applied to the remuneration.
    (ii) Application to payments--(A) In general. Any payment of 
remuneration may include amounts that are attributable to services 
performed by an applicable individual in one or more taxable years of a 
covered health insurance provider pursuant to paragraphs (d)(2) through 
(11) of this section. In that case, a separate deduction limitation 
applies to each portion of the payment that is attributed to services 
performed in a different disqualified taxable year. Any portion of a 
payment that is attributed to a taxable year that is a disqualified 
taxable year is deductible only to the extent that it does not exceed 
the deduction limit that applies with respect to the applicable 
individual for that disqualified taxable year, as reduced by the amount, 
if any, of AIR and DDR attributable to services performed in that 
disqualified taxable year that was deductible in an earlier taxable 
year.
    (3) Examples. The following examples illustrate the rules of 
paragraphs (e)(1) and (2) of this section. For purposes of

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these examples, each corporation has a taxable year that is the calendar 
year and is a covered health insurance provider for all relevant taxable 
years; DDR is otherwise deductible in the taxable year in which it is 
paid; and amounts payable under nonaccount balance plans are not 
forfeitable upon the death of the applicable individual.

    Example 1 (Lump-sum payment of DDR attributable to a single taxable 
year). (i) L is an applicable individual of corporation O. During O's 
2015 taxable year, O pays L $550,000 in salary, which is AIR, and grants 
L a right to $50,000 of DDR payable upon L's separation from service 
from O. L has a separation from service in 2020, at which time O pays L 
the $50,000 of DDR attributable to services performed by L in O's 2015 
taxable year.
    (ii) The $500,000 deduction limitation for 2015 is applied first to 
L's $550,000 of AIR for 2015. Because the $550,000 of AIR in 2015 is 
greater than the deduction limit, O may deduct only $500,000 of the AIR 
for 2015, and $50,000 of the $550,000 of AIR is not deductible for any 
taxable year. The deduction limit for remuneration attributable to 
services provided by L in O's 2015 taxable year is then reduced to zero. 
Because the $50,000 in DDR attributable to services performed by L in 
2015 exceeds the reduced deduction limit of zero, that $50,000 is not 
deductible for any taxable year.
    Example 2 (Installment payments of DDR attributable to a single 
taxable year). (i) M is an applicable individual of corporation N. 
During N's 2016 taxable year, N pays M $300,000 in salary, which is AIR, 
and grants M a right to $220,000 of DDR payable on a fixed schedule 
beginning upon M's separation from service. The $220,000 is attributable 
to services provided by M in N's 2016 taxable year. M ceases providing 
services on December 31, 2016. In 2020, N pays M $120,000 of DDR that is 
attributable to services performed in N's 2016 taxable year. In 2021, N 
pays M the remaining $100,000 of DDR attributable to services performed 
by M in N's 2016 taxable year.
    (ii) The $500,000 deduction limitation for 2016 is applied first to 
M's $300,000 of AIR for 2016. Because the deduction limit is greater 
than the AIR, N may deduct the entire $300,000 of AIR paid in 2016. The 
$500,000 deduction limit is then reduced to $200,000 because the 
limitation is reduced by the amount of AIR ($500,000 - $300,000). The 
reduced deduction limit is then applied to M's $120,000 of DDR 
attributable to services performed by M in N's 2016 taxable year that is 
paid in 2020. Because the reduced deduction limit of $200,000 is greater 
than the $120,000 of DDR, N may deduct the entire $120,000 of DDR paid 
in 2020. The $200,000 deduction limit is reduced to $80,000 by the 
$120,000 in DDR because the limit is reduced by the amount of DDR to 
which the deduction limit applied ($200,000 - $120,000). The reduced 
deduction limit of $80,000 is then applied to the remaining $100,000 
payment of DDR attributable to services performed by M in N's 2016 
taxable year. Because the $100,000 payment by N for 2021 exceeds the 
reduced deduction limit of $80,000, N may deduct only $80,000 of the 
payment for the 2021 taxable year, and $20,000 of the $100,000 payment 
is not deductible by N for any taxable year.
    Example 3 (Lump-sum payment attributable to multiple years from an 
account balance plan using the account balance ratio method). (i) N is 
an applicable individual of corporation M for all relevant taxable 
years. On January 1, 2015, N begins participating in a nonqualified 
deferred compensation plan sponsored by M that is an account balance 
plan. Under the plan, all amounts are fully vested at all times. The 
balances in N's account (including earnings) are $50,000 on December 31, 
2015, $100,000 on December 31, 2016, and $200,000 on December 31, 2017. 
N's AIR from M is $425,000 for 2015, $450,000 for 2016, and $500,000 for 
2017. On January 1, 2018, in accordance with the plan terms, M pays 
$200,000 to N, which is a payment of N's entire account balance under 
the plan. M uses the account balance ratio method to attribute amounts 
to services performed in taxable years.
    (ii) To determine the extent to which M is entitled to a deduction 
for any portion of the $200,000 payment under the plan, the payment must 
first be attributed to services performed by N in M's taxable years in 
accordance with the attribution rules set forth in paragraph (d) of this 
section. The increase in N's account balance during 2015 is $50,000 
($50,000 - zero); the increase in N's account balance for 2016 is 
$50,000 ($100,000 - $50,000); and the increase in N's account balance 
for 2017 is $100,000 ($200,000 - $100,000). The sum of all the increases 
is $200,000 ($50,000 + $50,000 + $100,000). Accordingly, for N's 2015 
taxable year, the attribution fraction is .25 ($50,000/$200,000); for 
N's 2016, taxable year, the attribution fraction is .25 ($50,000/
$200,000); and for N's 2017 taxable year, the attribution fraction is 
.50 ($100,000/$200,000).
    (iii) With respect to the $200,000 payment made on January 1, 2018, 
$50,000 ($200,000 x .25) of DDR is attributable to services performed by 
N in M's 2015 taxable year; $50,000 ($200,000 x .25) of DDR is 
attributable to services performed by N in M's 2016 taxable year; and 
$100,000 ($200,000 x .50) of DDR is attributable to services performed 
by N in M's 2017 taxable year.
    (iv) The $500,000 deduction limitation for 2015 is applied first to 
N's $425,000 of AIR for 2015. Because the deduction limit is greater 
than the AIR, M may deduct the entire $425,000 of AIR paid in 2015. The 
$500,000 deduction limit is then reduced to $75,000 by

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the amount of AIR against which it is applied ($500,000 - $425,000). The 
reduced deduction limit is then applied to N's $50,000 of DDR 
attributable to services performed by N in M's 2015 taxable year that is 
paid in 2018. Because $50,000 does not exceed the reduced deduction 
limit of $75,000, all $50,000 of the DDR attributable to services 
performed by N in M's 2015 taxable year is deductible for 2018, the year 
of payment. The deduction limit for remuneration attributable to 
services performed by N in 2015 is then reduced to $25,000 ($75,000 - 
$50,000), and this reduced limit is applied to any future payment of DDR 
attributable to services performed by N in 2015. With respect to M's 
2016 taxable year, the $500,000 deduction limit for 2016 is applied 
first to N's $450,000 of AIR for 2016. Because the deduction limit is 
greater than the AIR, M may deduct the entire $450,000 of AIR paid in 
2016. The $500,000 deduction limit is then reduced to $50,000 by the AIR 
($500,000 - $450,000). The reduced deduction limit is then applied to 
N's $50,000 of DDR attributable to services performed by N in M's 2016 
taxable year that is paid in 2018. Because $50,000 does not exceed the 
reduced deduction limit of $50,000, all $50,000 of the DDR attributed to 
M's 2016 taxable year is deductible for 2018, the year of payment. The 
deduction limit for remuneration attributable to services performed by N 
in 2016 is then reduced to zero, and this reduced limit is applied to 
any future payment of DDR attributable to services performed by N in 
2016. With respect to M's 2017 taxable year, the $500,000 deduction 
limit for 2017 is applied first to N's $500,000 of AIR for 2017. Because 
the deduction limit is not greater than the AIR, M may deduct the entire 
$500,000 of AIR paid in 2017. The $500,000 deduction limit is then 
reduced to zero by the amount of the AIR against which it is applied 
($500,000 - $500,000). The reduced deduction limit is applied to N's 
$100,000 of DDR attributable to services performed by N in M's 2017 
taxable year that is paid in 2018. Because $100,000 exceeds the reduced 
deduction limit of zero, the $100,000 of the DDR attributed to services 
performed by N in M's 2017 taxable year is not deductible for the year 
of payment (or any other taxable year). As a result, $100,000 of the 
$200,000 payment ($50,000 + $50,000 + $0) is deductible by M for M's 
2018 taxable year, and the remaining $100,000 is not deductible by M for 
any taxable year.
    Example 4 (Installment payments and in-service payment attributable 
to multiple taxable years from an account balance plan using the account 
balance ratio method). (i) O is an applicable individual of corporation 
L for all relevant taxable years. On January 1, 2016, O begins 
participating in a nonqualified deferred compensation plan sponsored by 
L that is an account balance plan. Under the plan, all amounts are fully 
vested at all times. L makes contributions to O's account each year and 
credits earnings based on a predetermined actual investment within the 
meaning of Sec.  31.3121(v)(2)-1(d)(2)(i)(B). The closing balances in 
O's account (including contributions, earnings, and distributions made 
during the year) are $100,000 on December 31, 2016, $250,000 on December 
31, 2017, and $50,000 on December 31, 2018. O's AIR from L is $500,000 
for 2016, $300,000 for 2017, and $450,000 for 2018. On December 31, 
2018, L pays O $400,000 in accordance with the plan terms. On December 
31, 2019, O's account balance is $200,000, reflecting additional credits 
of $125,000 made during the year and earnings on the account. O's AIR 
from L is $200,000 for 2019. O ceases providing services to L on 
December 31, 2019. On January 1, 2020, L pays O $200,000 in accordance 
with the plan terms. L uses the account balance ratio method to 
attribute amounts to services performed in taxable years.
    (ii) To determine the extent to which L is entitled to a deduction 
for any portion of either of the payments under the plan, O's payments 
under the plan must first be attributed to services performed by O in 
L's taxable years in accordance with the attribution rules set forth in 
paragraph (d) of this section. For purposes of attributing the $400,000 
payment made on December 31, 2018 to a taxable year, the increase in O's 
account balance during 2016 is $100,000 ($100,000 - zero); the increase 
in O's account balance for 2017 is $150,000 ($250,000 - $100,000); and 
the increase in O's account balance for 2018 is $200,000 ($50,000 - 
$250,000 + $400,000 (payment on December 31, 2018)). The sum of all the 
increases is $450,000 ($100,000 + $150,000 + $200,000). Thus, for L's 
2016 taxable year, the attribution fraction is .2222 ($100,000/
$450,000); for L's 2017 taxable year, the attribution fraction is .3333 
($150,000/$450,000); and for L's 2018 taxable year, the attribution 
fraction is .4444 ($200,000/$450,000). Accordingly, with respect to the 
$400,000 payment made on December 31, 2019, $88,889 ($400,000 x .2222) 
is attributable to services performed by O in L's 2016 taxable year; 
$133,333 ($400,000 x .3333) is attributable to services performed by O 
in L's 2017 taxable year; and $177,778 ($400,000 x .4444) is 
attributable to services performed by O in L's 2018 taxable year.
    (iii) The portion of the $400,000 payment attributed to services 
performed in a disqualified taxable year under paragraph (d) of this 
section that exceeds the deduction limit for that disqualified taxable 
year, as reduced through the date of payment, is not deductible in any 
taxable year. The $500,000 deduction limit for 2016 is applied first to 
O's $500,000 of AIR for 2016. Because the deduction limit is equal to 
the $500,000 of AIR, L may deduct the entire $500,000 of AIR paid in 
2016. The $500,000 deduction limit is then reduced to zero by the amount 
of the AIR ($500,000 - $500,000). The reduced deduction

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limit is applied to O's $88,889 of DDR attributable to services 
performed by O in L's 2016 taxable year that is paid in 2018. Because 
$88,889 exceeds the reduced deduction limit of zero, the $88,889 of DDR 
attributed to 2016 is not deductible for L's 2018 taxable year or any 
other taxable year. With respect to L's 2017 taxable year, the $500,000 
deduction limitation for 2017 is applied first to O's $300,000 of AIR 
for 2017. Because the $500,000 deduction limit is greater than the 
$300,000 of AIR, L may deduct the entire $300,000 of AIR paid in 2017. 
The $500,000 deduction limit is reduced to $200,000 by the amount of the 
AIR ($500,000 - $300,000). The reduced deduction limit is then applied 
to O's $133,333 of DDR attributable to services performed by O in L's 
2017 taxable year that is paid in 2018. Because $133,333 does not exceed 
that reduced deduction limit of $200,000, the $133,333 is deductible for 
2018. The deduction limit for remuneration attributable to services 
performed by O in 2017 is then reduced to $66,667 ($200,000 - $133,333), 
and this reduced limit is applied to any future payment of DDR 
attributable to services performed by O in 2017. With respect to L's 
2018 taxable year, the $500,000 deduction limit for 2018 is applied 
first to O's $450,000 of AIR for 2018. Because the deduction limit is 
greater than the AIR, L may deduct the entire $450,000 of AIR paid in 
2017. The $500,000 deduction limit is reduced to $50,000 by the amount 
of the AIR ($500,000 - $450,000). The reduced deduction limit is applied 
to O's $177,778 attributable to services performed by O in L's 2018 
taxable year that is paid in 2018. Because the $177,778 exceeds the 
reduced deduction limit of $50,000, $50,000 of DDR is deductible for L's 
2018 taxable year, and $127,778 of the $177,778 is not deductible for 
L's 2018 taxable year or any other taxable year. As a result, $183,333 
of the $400,000 payment ($0 + $133,333 + $50,000) is deductible by L for 
L's 2018 taxable year, and the remaining $216,667 is not deductible by L 
for any taxable year.
    (iv) For purposes of attributing amounts paid or made available from 
the plan in future taxable years, the following adjustments are made to 
O's account balances to reflect the in-service payment of $400,000 in 
2018. O's account balance as of December 31, 2016 is reduced by the 
$88,889 attributable to 2016; and for 2017 is reduced by the sum of the 
$133,333 attributable to 2017 and the $88,889 attributable to 2016. 
Therefore, after attributing the $400,000 payment, O's adjusted closing 
account balance as of December 31, 2016, is $11,111 ($100,000 - 
$88,889), and as of December 31, 2017, is $27,778 ($250,000 - $133,333 - 
$88,889).
    (v) For purposes of attributing the $200,000 payment made on January 
1, 2020, to services performed in the taxable years of S, the increase 
in O's account balance during 2016 is $11,111 ($11,111 - $0); the 
increase in O's account balance for 2017 is $16,667 ($27,778 - $11,111); 
the increase in O's account balance for 2018 is $22,222 ($50,000 - 
$27,778), and the increase in O's account balance for 2019 is $150,000 
($200,000 - $50,000). The sum of all such increases is $200,000 ($11,111 
+ $16,667 + $22,222 + $150,000). Thus, for O's 2016 taxable year, the 
attribution fraction is .0556 ($11,111/$200,000); for O's 2017, taxable 
year, the attribution fraction is .0833 ($16,667/$200,000); for O's 2018 
taxable year, the attribution fraction is .1111 ($22,222/$200,000); for 
O's 2019 taxable year, the attribution fraction is .7500 ($150,000/
$200,000). Accordingly, with respect to the $200,000 payment made on 
January 1, 2020, $11,111 ($200,000 x .0556) of DDR is attributable to 
services performed by O in L's 2016 taxable year; $16,667 ($200,000 x 
.0833) of DDR is attributable to services performed by O in L's 2017 
taxable year; $22,222 ($200,000 x .1111) of DDR is attributable to 
services performed by O in L's 2018 taxable year; and $150,000 ($200,000 
x .7500) of DDR is attributable to services performed by O in L's 2019 
taxable year.
    (vi) The portion of the DDR attributed to a disqualified taxable 
year under paragraph (d) of this section that exceeds the deduction 
limit for that disqualified taxable year, as reduced, is not deductible 
for any taxable year. For L's 2016 taxable year, the deduction limit is 
reduced to zero by the $500,000 of AIR for that year. Because $11,111 
exceeds the reduced deduction limit of zero, $11,111 of the DDR is not 
deductible for L's 2020 taxable year or any other taxable year. For L's 
2017 taxable year, the deduction limit is reduced to $200,000 by the 
$300,000 of AIR for that year and further reduced to $66,667 by the 
$133,333 of DDR previously attributed to 2017. Because $16,667 does not 
exceed the $66,667 deduction limit, the $16,667 of DDR is deductible for 
L's 2020 taxable year, the year of payment. The deduction limit for 
remuneration attributable to services performed by O in 2017 is then 
reduced to $50,000 ($66,667 - $16,667), and this reduced limit is 
applied to any future payment attributable to services performed by O in 
2017. For L's 2018 taxable year, the deduction limit is reduced to zero 
by the $450,000 of AIR for that year and the $50,000 of DDR previously 
attributed to 2018. Because $22,222 exceeds the reduced deduction limit 
of zero for 2018, the $22,222 of DDR is not deductible for L's 2020 
taxable year or any other taxable year. For L's 2019 taxable year, the 
$500,000 deduction limit for 2019 is applied first to O's $200,000 of 
AIR for 2019. Because the deduction limit is greater than the AIR, L may 
deduct the entire $200,000 of AIR paid in 2019. The $500,000 deduction 
limit is reduced to $300,000 by the amount of the AIR ($500,000 - 
$200,000). The reduced deduction limit is applied to O's $150,000 of DDR 
attributable to services performed by O in L's 2019 taxable year that is 
paid in 2020. Because $150,000 does not exceed

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the $300,000 limit, the $150,000 of DDR is deductible for L's 2020 
taxable year, the year of payment. The deduction limit for remuneration 
attributable to services performed by O in 2019 is then reduced to 
$150,000 ($500,000 - $200,000 - $150,000), and this reduced limit is 
applied to any future payment attributable to services performed by O in 
2019. As a result, $166,667 of the $200,000 payment ($0 + $16,667 + $0 + 
$150,000) is deductible by L for L's 2020 taxable year, the year of 
payment, and the remaining $33,333 is not deductible by L for any 
taxable year.
    Example 5 (Installment payments and in-service payment attributable 
to multiple taxable years from an account balance plan using the 
principal additions method). (i) The facts are the same as set forth in 
Example 4, paragraph (i), except that L uses the principal additions 
method for attributing remuneration from an account balance plan; 
principal additions under the plan are $100,000 in 2016, $125,000 in 
2017, $150,000 in 2018, and $125,000 in 2019; as of the December 31, 
2018 initial date of payment, earnings on the 2016, 2017, and 2018 
principal additions are $40,000, $30,000, and $5,000 respectively. Under 
the terms of the plan, the $400,000 payment made on December 31, 2018, 
is from principal additions in 2016, 2017, and 2018, and earnings 
thereon, and the $200,000 payment made on January 1, 2020, is from 
principal additions in 2018 and 2019, and earnings thereon.
    (ii) To determine the extent to which L is entitled to a deduction 
for any portion of either payment under the plan, the payments to O 
under the plan must first be attributed to services performed by O in 
F's taxable years in accordance with the attribution rules set forth in 
paragraph (d) of this section. Under the rules in paragraph (d)(3)(ii) 
of this section, the $400,000 payment on January 1, 2019, is attributed 
to services performed by O in the taxable year to which the payment 
relates under the terms of the plan. DDR including principal additions 
and earnings thereon are attributed to services performed by O in a 
taxable year of L when the $400,000 payment is made to O on December 31, 
2018. Under the terms of the plan, the $400,000 payment made on December 
31, 2018 is attributed to services performed by O in L's 2016 taxable 
year in the amount of $140,000, and is attributed to services performed 
by O in L's 2017 taxable year in the amount of $155,000, and the 
remaining $105,000 ($400,000 - $140,000 - $155,000) is attributed to 
services performed by O in L's 2018 taxable year.
    (iii) The portion of the DDR attributable to services performed in a 
disqualified taxable year under paragraph (d) of this section that 
exceeds the deduction limit for that disqualified taxable year, as 
reduced, is not deductible for any taxable year. The $500,000 deduction 
limitation for 2016 is applied first to O's $500,000 of AIR for 2016. 
Because the deduction limit is equal to the $500,000 of AIR, L may 
deduct the entire $500,000 of AIR paid in 2016. The $500,000 deduction 
limit is then reduced to zero by the amount of the AIR ($500,000 - 
$500,000). The reduced deduction limit is applied to O's $140,000 of DDR 
attributable to services performed by O in L's 2016 taxable year that is 
paid in 2018. Because $140,000 exceeds the reduced deduction limit of 
zero, the $140,000 is not deductible for L's 2018 taxable year (the year 
of payment), or any other taxable year. For L's 2017 taxable year, the 
$500,000 deduction limit for 2017 is applied first to O's $300,000 of 
AIR for 2017. Because the deduction limit is greater than the AIR, L may 
deduct the entire $300,000 of AIR paid in 2017. The $500,000 deduction 
limit is then reduced to $200,000 by the amount of the AIR ($500,000 - 
$300,000). The reduced deduction limit is applied to O's $155,000 of DDR 
attributable to services performed by O in L's 2017 taxable year that is 
paid in 2018. Because $155,000 does not exceed the reduced deduction 
limit of $200,000, the $155,000 payment is deductible for 2018. For L's 
2018 taxable year, the $500,000 deduction limitation for 2018 is applied 
first to O's $450,000 of AIR for 2018. Because the deduction limit is 
greater than the AIR, L may deduct the entire $450,000 of AIR paid in 
2018. The $500,000 deduction limit is then reduced to $50,000 by the 
amount of the AIR ($500,000 - $450,000). The reduced deduction limit is 
applied to O's $105,000 of DDR attributable to services performed by O 
in L's 2018 taxable year that is paid in 2018. Because $105,000 exceeds 
the reduced deduction limit of $50,000, $55,000 of the $105,000 
attributable to L's 2018 taxable year is not deductible for 2018 (the 
year of payment), or any other taxable year. As a result, $205,000 of 
the $400,000 payment ($0 + $155,000 + $50,000) is deductible by L for 
L's 2018 taxable year (the year of payment) and the remaining $195,000 
is not deductible by L for any taxable year.
    (iv) Earnings through January 1, 2020 on the principal addition for 
L's 2018 taxable year ($50,000) that was not paid as part of the 
December 31, 2018 payment are $5,000. Earnings through January 1, 2020 
on the $125,000 credited to O's account on January 1, 2019 are $20,000. 
On December 31, 2018, after the $400,000 payment is applied to 2016, 
2017, and 2018, the account balance for 2016 and 2017 is reduced to 
zero, and the account balance for 2018 is reduced to $50,000 ($150,000 + 
$5,000 (earnings) - $105,000). Under the terms of the plan, the $200,000 
payment made on January 1, 2020, is attributable to services performed 
by O in L's 2018 and 2019 taxable years. Therefore, the $200,000 payment 
on January 1, 2020 is attributed to services performed by O in L's 
taxable years as follows: $55,000 ($50,000 + $5,000) to 2018 and 
$145,000 ($125,000 + $20,000) to 2019.
    (v) The portion of the DDR attributed to a disqualified taxable year 
under paragraph (d)

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of this section that exceeds the deduction limit for that disqualified 
taxable year, as reduced, is not deductible for any taxable year. For 
L's 2018 taxable year, the deduction limit is reduced to zero by the 
$450,000 of AIR for that year and the payment of $50,000 of DDR 
attributable to that year. Because $55,000 exceeds the reduced deduction 
limit of zero, the $55,000 is not deductible for 2020, the year of 
payment (or any other taxable year). With respect to L's 2019 taxable 
year, the $500,000 deduction limit for 2019 is applied first to O's 
$200,000 of AIR for 2019. Because the deduction limit is greater than 
the AIR, L may deduct the entire $200,000 of AIR paid in 2019. The 
$500,000 deduction limit is then reduced to $300,000 by the amount of 
the AIR ($500,000 - $200,000). The reduced deduction limit is applied to 
O's $145,000 of DDR attributable to services performed by O in L's 2019 
taxable year that is paid in 2020. Because $145,000 does not exceed the 
$300,000 reduced limit, the $145,000 is deductible for 2020 (the year of 
payment). As a result, $145,000 of the $200,000 payment ($0 + $145,000) 
is deductible for L's 2020 taxable year, and the remaining $55,000 is 
not deductible by L for any taxable year.

    (4) Application of deduction limitation to aggregated groups of 
covered health insurance providers--(i) In general. The total combined 
deduction for AIR and DDR attributable to services performed by an 
applicable individual in a disqualified taxable year allowed for all 
members of an aggregated group that are covered health insurance 
providers for any taxable year is limited to $500,000. Therefore, if two 
or more members of an aggregated group that are covered health insurance 
providers may otherwise deduct AIR or DDR attributable to services 
performed by an applicable individual in a disqualified taxable year, 
the AIR and DDR otherwise deductible by all members of the aggregated 
group is combined, and the deduction limitation is applied to the total 
amount.
    (ii) Proration of deduction limitation. If the total amount of AIR 
or DDR attributable to services performed by an applicable individual in 
a disqualified taxable year that is otherwise deductible by two or more 
members of an aggregated group in any taxable year exceeds the $500,000 
deduction limit (as reduced by previously deductible AIR or DDR, if 
applicable), the deduction limit is prorated based on the AIR or DDR 
otherwise deductible by the members of the aggregated group in the 
taxable year and allocated to each member of the aggregated group. The 
deduction limit allocated to each member of the aggregated group is 
determined by multiplying the deduction limit for the disqualified 
taxable year (as previously reduced, if applicable) by a fraction, the 
numerator of which is the AIR or DDR otherwise deductible by that member 
in that taxable year that is attributable to services performed by the 
applicable individual in the disqualified taxable year, and the 
denominator of which is the total AIR or DDR otherwise deductible by all 
members of the aggregated group in that taxable year that is 
attributable to services performed by the applicable individual in the 
disqualified taxable year. The amount of AIR or DDR otherwise deductible 
by a member of the aggregated group in excess of the portion of the 
deduction limit allocated to that member is not deductible in any 
taxable year. If a covered health insurance provider is a member of more 
than one aggregated group, the deduction limit for that covered health 
insurance provider under section 162(m)(6) may in no event exceed 
$500,000 for AIR and DDR attributable to services performed by an 
applicable individual in a disqualified taxable year.
    (5) Examples. The following examples illustrate the rules of 
paragraph (e)(4) of this section. For purposes of these examples, each 
corporation has a taxable year that is the calendar year and is a 
covered health insurance provider for all relevant taxable years, and 
DDR is otherwise deductible by the covered health insurance provider in 
the taxable year in which it is paid.

    Example 1. (i) Corporations I, J, and K are members of the same 
aggregated group under paragraph (b)(3) of this section. At separate 
times during 2016, C is an employee of, and performs services for, I, J, 
and K. C's total AIR for 2016 is $1,500,000, which consists of $750,000 
of AIR for services performed to K; $450,000 of AIR for services 
provided to J; and $300,000 of AIR for services to I.
    (ii) Because I, J, and K are members of the same aggregated group, 
the AIR otherwise deductible by them is aggregated for purposes of 
applying the deduction limitation. Further, because the aggregate AIR 
otherwise deductible by I, J, and K for 2016 exceeds the deduction 
limitation for C for that taxable year, the deduction limit is prorated

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and allocated to the members of the aggregated group in proportion to 
the AIR otherwise deductible by each member of the aggregated group for 
that taxable year. Therefore, the deduction limit that applies to the 
AIR otherwise deductible by K is $250,000 ($500,000 x ($750,000/
$1,500,000)); the deduction limit that applies to the AIR otherwise 
deductible by J is $150,000 ($500,000 x ($450,000/$1,500,000)); and the 
deduction limit that applies to AIR otherwise deductible by I is 
$100,000 ($500,000 x ($300,000/$1,500,000)). For the 2016 taxable year, 
K may not deduct $500,000 of the $750,000 of AIR paid to C ($750,000 - 
$250,000); J may not deduct $300,000 of the $450,000 of AIR paid to C 
($450,000 - $150,000); and I may not deduct $200,000 of the $300,000 of 
AIR paid to C ($300,000 - $100,000).
    Example 2. (i) The facts are the same as Example 1, except that C's 
total AIR for 2016 is $400,000, which consists of $75,000 for services 
provided to K; $150,000 for services provided to J; and $175,000 for 
services provided to I. In addition, C becomes entitled to $60,000 of 
DDR attributable to services provided to K in 2016, which is payable 
(and paid) on April 1, 2018, and $75,000 of DDR attributable to services 
provided to J in 2016, which is payable (and paid) on April 1, 2019.
    (ii) Because C's total AIR of $400,000 for 2016 for services 
provided to K, J, and I do not exceed the $500,000 limitation, K, J, and 
I may deduct $75,000, $150,000, and $175,000, respectively, for 2016. 
The deduction limit is then reduced to $100,000 by the total AIR 
deductible by all members of the aggregated group ($500,000 - $400,000). 
The deduction limit, as reduced, is then applied to any DDR attributable 
to services provided by C in 2016 in the first subsequent taxable year 
that DDR becomes deductible. The first year that DDR for 2016 becomes 
deductible is 2018, due to the $60,000 payment made on April 1, 2018. 
Because the $60,000 of DDR otherwise deductible by K does not exceed the 
2016 $100,000 deduction limit, K may deduct the entire $60,000 for its 
2018 taxable year. The $100,000 deduction limit is then reduced by the 
$60,000 of DDR deductible by K for 2018, and the reduced deduction limit 
of $40,000 ($100,000 - $60,000) is applied to the $75,000 of DDR that is 
otherwise deductible for 2019. Because the DDR of $75,000 otherwise 
deductible by J exceeds the reduced deduction limit of $40,000, J may 
deduct only $40,000, and the remaining $35,000 ($75,000 - $40,000) is 
not deductible by J for that taxable year or any other taxable year.
    Example 3. (i) The facts are the same as Example 2, except that C's 
DDR of $75,000 attributable to services performed by C in J's 2016 
taxable year is payable (and paid) on July 1, 2018.
    (ii) The results are the same as Example 2, except that the reduced 
deduction limit of $100,000 is prorated between K and J in proportion to 
the DDR otherwise deductible by them for 2018. Accordingly, $44,444 of 
the remaining deduction limit is allocated to K ($100,000 x ($60,000/
$135,000)), and $55,556 of the remaining deduction limit is allocated to 
J ($100,000 x ($75,000/$135,000)). Because the $60,000 of DDR otherwise 
deductible by K exceeds the $44,444 deduction limit applied to that 
remuneration, K may deduct only $44,444 of the $60,000 payment, and 
$15,556 may not be deducted by K for the 2018 taxable year or any other 
taxable year. Similarly, because the $75,000 of DDR otherwise deductible 
by J exceeds the $55,556 deduction limit applied to that remuneration, J 
may deduct only $55,556 of the $75,000 payment, and $19,444 may not be 
deducted by J for that taxable year or any other taxable year.

    (f) Corporate transactions--(1) Treatment as a covered health 
insurance provider in connection with a corporate transaction. Except as 
otherwise provided in this paragraph (f), a person that participates in 
a corporate transaction is a covered health insurance provider for the 
taxable year in which the corporate transaction occurs (and any other 
taxable year) if it would otherwise be a covered health insurance 
provider under paragraph (b)(4) of this section for that taxable year. 
For example, if a member of an aggregated group that did not previously 
include a health insurance issuer purchases a health insurance issuer 
that is a covered health insurance provider (so that the health 
insurance issuer becomes a member of the aggregated group), each member 
of the acquiring aggregated group will be a covered health insurance 
provider for its full taxable year in which the corporate transaction 
occurs and each subsequent taxable year in which the health insurance 
issuer continues to be a member of the group, if it would otherwise be a 
covered health insurance provider under paragraph (b)(4), except as 
otherwise provided in this paragraph (f). For purposes of this section, 
the term corporate transaction means a merger, acquisition or 
disposition of assets or stock, reorganization, consolidation, 
separation, or any other transaction resulting in a change in the 
composition of an aggregated group.
    (2) Transition period relief for a person becoming a covered health 
insurance provider solely as a result of a corporate transaction--(i) In 
general. Except as provided in paragraph (f)(2)(ii) of this

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section, a person that is not a covered health insurance provider before 
a corporate transaction, but would (except for application of this 
paragraph (f)(2)(i)) become a covered health insurance provider solely 
because it becomes a member of an aggregated group with another person 
that is a health insurance issuer as a result of the corporate 
transaction, is not a covered health insurance provider subject to the 
deduction limitation of section 162(m)(6) for the taxable year of that 
person in which the corporate transaction occurs (the transition period 
relief).
    (ii) Certain applicable individuals. The transition period relief 
described in paragraph (f)(2)(i) of this section does not apply with 
respect to the remuneration of any individual who is an applicable 
individual of a person that would have been a covered health insurance 
provider for the taxable year in which the corporate transaction 
occurred without regard to the occurrence of the corporate transaction 
(for example, the applicable individuals of a health insurance issuer 
and the members of its affiliated group that were covered health 
insurance issuers before the occurrence of a corporate transaction). 
This exception to the transition period relief applies even with respect 
to remuneration attributable to services performed by the applicable 
individual for a person that is eligible for the transition period 
relief described in paragraph (f)(1)(ii)(A) of this section. 
Accordingly, each member of an acquiring aggregated group that would 
become a covered health insurance provider solely as a result of a 
corporate transaction, but is not a covered health insurance provider 
under the transition period relief described in paragraph (f)(1)(ii)(A) 
of this section, is subject to the deduction limitation of section 
162(m)(6) for its taxable year in which the corporate transaction occurs 
with respect to AIR and DDR attributable to services performed by any 
individual who is an applicable individual of the acquired health 
insurance issuer and any member of its aggregated group that would have 
been a covered health insurance provider in the taxable year in which 
the corporate transaction occurred, even if the corporate transaction 
had not occurred.
    (3) Transition relief from the attribution consistency 
requirements--(i) In general. Paragraphs (d)(3)(i), (d)(4)(i) and 
(d)(5)(i)(B) of this section require a covered health insurance provider 
and all members of its aggregated group to use the same method for 
attributing remuneration to services performed by applicable individuals 
consistently for all taxable years (attribution consistency 
requirements). As a result of a corporate transaction, however, a 
covered health insurance provider that uses an attribution method for 
its account balance plans, nonaccount balance plans, or stock options or 
SARs may become a member of an aggregated group with another covered 
health insurance provider that uses a different attribution method for 
those types of plans or arrangements. In that case, neither member of 
the aggregated group will be treated as violating the attribution 
consistency requirements merely because it uses an attribution method 
that is different from the attribution method used by another member of 
its aggregated group to attribute remuneration that becomes otherwise 
deductible in the taxable year in which the corporate transaction 
occurs. However, the attribution consistency requirements apply with 
respect to remuneration that becomes otherwise deductible in all 
subsequent taxable years. Following the date of the corporate 
transaction, any member of the aggregated group may change the 
attribution method that it used before the date of the corporate 
transaction to attribute remuneration under its account balance plans, 
nonaccount balance plans, or stock options or SARs to make its method 
consistent with the method used by any other member of the aggregated 
group. Notwithstanding the foregoing, the Secretary may subject this 
change in attribution method to limitations, or may otherwise modify the 
attribution consistency requirements, pursuant to a notice, revenue 
ruling, or other guidance of general applicability published in the 
Internal Revenue Bulletin.
    (ii) Exception for certain applicable individuals. Notwithstanding 
the transition relief described in paragraphs

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(f)(2)(A) of this section, if a covered health insurance provider has 
attributed remuneration under a method described in paragraphs (d)(3), 
(d)(4), or (d)(5) of this section with respect to an applicable 
individual before a corporate transaction, the covered health insurance 
provider must continue at all times to use that attribution method for 
all other remuneration that becomes otherwise deductible under the same 
type of plan (that is, an account balance plan, a nonaccount balance 
plan, or a stock option or SAR) to which the applicable individual has a 
legally binding right as of the corporate transaction.
    (4) Deduction limitation not prorated for short taxable years. If a 
corporate transaction results in a short taxable year for a covered 
health insurance provider, the $500,000 deduction limit for the short 
taxable year is neither prorated nor reduced. For example, if a 
corporate transaction results in a short taxable year of three months, 
the deduction limit under section 162(m)(6) for that short taxable year 
is $500,000 (and is not reduced to $125,000).
    (5) Effect of a corporate transaction on the application of the de 
minimis exception. If a person becomes or ceases to be a member of an 
aggregated group, only the premiums and gross revenues of that person 
for the portion of its taxable year during which it is a member of the 
aggregated group are taken into account for purposes of determining 
whether the de minimis exception applies.
    (6) Examples. The following examples illustrate the principles of 
this paragraph (f). For purposes of these examples, each corporation has 
a taxable year that is the calendar year unless stated otherwise, and 
none of the corporations qualify for the de minimis exception under 
paragraph (b)(4)(v) of this section.

    Example 1. (i) Corporation J merges with and into corporation H on 
June 30, 2015, such that H is the surviving entity. As a result of the 
merger, J's taxable year ends on June 30, 2015. For its taxable year 
ending June 30, 2015, J is a health insurance issuer that is a covered 
health insurance provider. For all taxable years before the taxable year 
of the merger, H is not a covered health insurance provider.
    (ii) Corporation J is a covered health insurance provider for its 
short taxable year ending June 30, 2015. As a result of the merger, H 
becomes a covered health insurance provider for its 2015 taxable year, 
but Corporation H is not a covered health insurance provider for its 
2015 taxable year by reason of the transition period relief in paragraph 
(f)(1)(ii)(A) of this section. However, applicable individuals of J 
continue to be subject to the deduction limit under section 162(m)(6) 
for amounts that become otherwise deductible in the 2015 taxable year 
and DDR that is attributable to services performed by applicable 
individuals of J, and H is a covered health insurance provider for all 
subsequent taxable years for which it is a covered health insurance 
provider under paragraph (b)(4) of this section.
    Example 2. (i) On January 1, 2016, corporations D, E, and F are 
members of a controlled group within the meaning of section 414(b). F is 
a health insurance issuer that is a covered health insurance provider 
under paragraph (b)(4)(i)(A) of this section. D and E are not health 
insurance issuers (but are covered health insurance providers pursuant 
to paragraphs (b)(4)(i)(C) and (D) of this section). D is the parent 
entity of the DEF aggregated group. F's taxable year ends on September 
30. P is an applicable individual of F for all taxable years. On May 1, 
2016, a controlled group within the meaning of section 414(b) consisting 
of corporations C and B purchases all of the stock of corporation F, 
resulting in a controlled group within the meaning of section 414(b) 
consisting of corporations C, B, and F. The amount of premiums received 
by F from providing minimum essential coverage during the portion of its 
taxable year when it was a member of the DEF aggregated group constitute 
more than two percent of the gross revenues of the aggregated group for 
the taxable year of D (the parent entity) ending on December 31, 2016, 
and the taxable years of E and F ending with or within D's taxable year 
(December 31, 2016 and May 1, 2016 respectively). C and B are not health 
insurance issuers. C is the parent entity of the CBF aggregated group. 
The CBF aggregated group is also a consolidated group within the meaning 
of Sec.  1.1502-1(h). Thus, F's taxable year ends on May 1, 2016 by 
reason of Sec.  1.1502-76(b)(1)(ii)(A)(1), and F becomes part of the CBF 
consolidated group for the taxable year ending December 31, 2016.
    (ii) D and E are covered health insurance providers for the taxable 
year ending December 31, 2016, and the de minimis exception does not 
apply because the amount of premiums received by F from providing 
minimum essential coverage during the short taxable year that it was a 
member of the DEF aggregated group are more than two percent of the 
gross revenues of the aggregated group for the taxable years during

[[Page 278]]

which the members would otherwise be a covered health insurance 
providers under paragraph (b)(4)(i) of this section. Accordingly, D and 
E are subject to the deduction limitation under section 162(m)(6) for 
their taxable years ending December 31, 2016. C and B are not covered 
health insurance providers for their taxable year ending December 31, 
2016, by reason of the transition period relief of paragraph 
(f)(1)(ii)(A) of this section.
    (iii) As a result of leaving the aggregated group, F has a new 
taxable year beginning on May 2, 2016 and ending on December 31, 2016. F 
is a covered health insurance provider within the meaning of paragraph 
(b)(4) of this section for its new taxable year ending on December 31, 
2016 (even though C and B are not covered health insurance providers for 
their taxable years ending December 31, 2016) unless the CBF aggregated 
group qualifies for the de minimis exception for that taxable year.
    (iv) P is an applicable individual whose remuneration from F is 
subject to the deduction limitation under section 162(m)(6) for F's 
short taxable year ending May 1, 2016 and F's taxable year ending 
December 31, 2016. In addition, any remuneration provided to P by C or B 
at any time for services provided by P from May 1, 2016 to December 31, 
2016 is also subject to the deduction limitation under section 
162(m)(6), even though C and B are not covered health insurance 
providers for their taxable years ending December 31, 2016 by reason of 
the transition period relief of paragraph (f)(1)(ii)(A) of this section. 
Remuneration to which P had the legally binding right on or before the 
date of the transaction is subject to the deduction limitation when that 
remuneration becomes otherwise deductible.
    Example 3. (i) The same facts as Example 2, except that E is a 
health insurance issuer that is a covered health insurance provider 
under paragraph (b)(4) of this section and thus receives premiums from 
providing minimum essential coverage (instead of F), and F is not a 
health insurance issuer.
    (ii) F is a covered health insurance provider for its short taxable 
year ending May 1, 2016. However, because F is not a health insurance 
issuer that is a covered health insurance provider and there are no 
other health insurance issuers in the BCF aggregated group, F is not a 
covered health insurance provider for its short, post-acquisition 
taxable year ending December 31, 2016.
    (iii) With respect to P, remuneration to which P had the legally 
binding right on or before the date of the transaction is subject to the 
deduction limitation. However, remuneration to which P obtains the 
legally binding right after the date of the corporate transaction is not 
subject to the deduction limitation.
    Example 4. (i) Corporations N, O, and P are members of an aggregated 
group as described in paragraph (b)(2) of this section. N is a health 
insurance issuer that is a covered health insurance provider pursuant to 
paragraph (b)(4)(i)(A) of this section, but neither O nor P is a health 
insurance issuer. P is the parent entity of the aggregated group. On 
April 1, 2016, O ceases to be a member of the NOP aggregated group as 
the result of a corporate transaction. O's taxable year does not end as 
a result of the corporate transaction.
    (ii) Because O was a member of the NOP aggregated group during a 
portion of its taxable year, O is a covered health insurance provider 
for its taxable year ending December 31, 2016.
    Example 5. (i) Corporations V, W, and X are members of an aggregated 
group as described in paragraph (b)(2) of this section. V is a health 
insurance issuer that is a covered health insurance provider pursuant to 
paragraph (b)(4)(i)(A) of this section, but neither W nor X is a health 
insurance issuer. W is the parent entity of the aggregated group. V's 
taxable year ends on December 31; W's taxable year ends on June 30; and 
X's taxable year ends on September 30. For its taxable year ending June 
30, 2017, W has $100x in gross revenue. For its taxable year ending 
September 30, 2016, X has $60x in gross revenue. For its taxable year 
ending December 31, 2016, V receives $4x of premiums from providing 
minimum essential coverage and has no other revenue. As of September 30, 
2016, V ceases to be a member of the VWX aggregated group. V's taxable 
year does not end on September 30, 2016 as a result of the transaction. 
Of the $4x that that V receives for providing minimum essential coverage 
during its taxable year ending December 31, 2016, $3x is received during 
the period from January 1, 2016 through September 30, 2016. As a result 
of the corporate transaction, V's taxable year ends on September 30, 
2016. The de minimis exception of paragraph (b)(4)(v)(A) of this section 
did not apply to the members of the VWX aggregated group for their 
immediately preceding taxable years ending December 31, 2015, June 30, 
2016, and September 30, 2015, respectively.
    (ii) For purposes of applying the de minimis exception to an 
aggregated group for a taxable year during which a person leaves or 
joins the aggregated group, only the premiums and revenues of the person 
for the portion of its taxable year during which it was a member of the 
aggregated group are taken into account. The premiums from providing 
minimum essential coverage received by the VWX aggregated group for W's 
taxable year ending June 30, 2017 are $3x. The revenues of the V, W, and 
X aggregated group for W's taxable year ending June 30, 2017 are $163x. 
Accordingly, the premiums received by the members of the aggregated 
group from providing minimum essential

[[Page 279]]

coverage are less than two percent of the gross revenues of the 
aggregated group ($3x is less than $3.26x (two percent of $163x)). 
Therefore, V, W and X are not covered health insurance providers for 
their taxable years ending December 31, 2016, June 30, 2017, and 
September 30, 2016, respectively.
    Example 6. (i) The facts are the same as Example 5, except that F 
received $4x of premiums during the period from January 1, 2016 to 
September 30, 2016, and the members of the VWX aggregated group were not 
covered health insurance providers for their taxable years ending 
December 31, 2015, June 30, 2016, and September 30, 2015, respectively 
(their immediately preceding taxable years) solely by reason of the de 
minimis exception of paragraph (b)(4)(v)(A) of this section.
    (ii) The premiums from providing minimum essential coverage received 
by the VWX aggregated group for W's taxable year ending June 30, 2017 
are $4x. The revenues of the VWX aggregated group for W's taxable year 
ending June 30, 2017 are $164x. Accordingly, the premiums received by 
the members of the aggregated group from providing minimum essential 
coverage are greater than two percent of the gross revenues of the 
aggregated group ($4x is greater than $3.28x (two percent of $164x)). 
Therefore, V, W, and X do not qualify for the de minimis exception for 
their taxable years ending December 31, 2016, June 30, 2017, and 
September 30, 2016, respectively. However, V, W, and X are not covered 
health insurance providers for these taxable years by reason of the de 
minimis exception one year transition period described in paragraph 
(b)(4)(v)(B) of this section.
    Example 7. (i) Corporation N is a health insurance issuer that is a 
covered health insurance provider. Corporation O is also a health 
insurance issuer that is a covered health insurance provider. Both N and 
O have taxable years ending December 31. N uses the account balance 
ratio method to attribute remuneration that becomes otherwise deductible 
under its account balance plans. O uses the principal additions method 
to attribute amounts that become otherwise deductible under its account 
balance plans. On June 30, 2016, O purchases all of the stock of N.
    (ii) For the taxable year of N and O ending December 31, 2016, N may 
continue to attribute amounts that become deductible under its account 
balance plans using the account balance ratio method, and O can continue 
to attribute amounts that become otherwise deductible under its account 
balance plan using the principal additions method, even though they are 
members of the same aggregated group, pursuant to the transition period 
relief described in paragraph (f)(2) of this section. In all subsequent 
taxable years, N and O must use the same method to attribute amounts 
that become otherwise deductible under their account balance plans. 
Either N or O may change the method that it uses to attribute amounts 
under its account balance plans to be consistent with the attribution 
method used by the other.
    Example 8. (i) The facts are the same as Example 7. In addition, B 
is an applicable individual of N before the corporate transaction and is 
a participant in an account balance plan of N. On December 31, 2015, N 
made a payment to B, and N used the account balance ratio method 
described in paragraph (d)(3)(ii) of this section to attribute the 
payment to services performed by B in taxable years of N.
    (ii) Because N used the account balance ratio method described in 
paragraph (d)(3)(ii) of this section to attribute an amount that became 
otherwise deductible under the plan before the corporate transaction, N 
must continue to use the account balance ratio method for attributing 
amounts to which B had a legally binding right as of the corporate 
transaction, whenever those amounts become otherwise deductible.

    (g) Coordination--(1) Coordination with section 162(m)(1). If 
section 162(m)(1) and section 162(m)(6) both otherwise would apply with 
respect to the remuneration of an applicable individual, the deduction 
limitation under section 162(m)(6) applies without regard to section 
162(m)(1). For example, if an applicable individual is both a covered 
employee of a publicly held corporation (see sections 162(m)(2) and (3); 
Sec.  1.162-27) and an applicable individual within the meaning of 
paragraph (b)(7) of this section, remuneration earned by the applicable 
individual that is attributable to a disqualified taxable year of a 
covered health insurance provider is subject to the $500,000 deduction 
limitation under section 162(m)(6) with respect to such disqualified 
taxable year, without regard to section 162(m)(1).
    (2) Coordination with disallowed excess parachute payments--(i) In 
general. The $500,000 deduction limitation of section 162(m)(6) is 
reduced (but not below zero) by the amount (if any) that would have been 
included in the AIR or DDR of the applicable individual for a taxable 
year but for the deduction for the AIR or DDR being disallowed by reason 
of section 280G.
    (ii) Example. The following example illustrates the rule of this 
paragraph (g)(2).

    Example. Corporation A, a covered health insurance provider, pays 
$750,000 of AIR to P, an applicable individual, during A's disqualified 
taxable year ending December 31, 2016.

[[Page 280]]

Of the $750,000, $300,000 is an excess parachute payment as defined in 
section 280G(b)(1), the deduction for which is disallowed by reason of 
that section. The excess parachute payment reduces the $500,000 
deduction limit to $200,000 ($500,000 - $300,000). Therefore, A may 
deduct only $200,000 of the $750,000 in AIR, and $250,000 of the payment 
is not deductible by reason of section 162(m)(6).

    (h) Grandfathered amounts attributable to services performed in 
taxable years beginning before January 1, 2010--(1) In general. The 
section 162(m)(6) deduction limitation does not apply to remuneration 
attributable to services performed in taxable years of a covered health 
insurance provider beginning before January 1, 2010 (grandfathered 
amounts). For purposes of this paragraph (h), whether remuneration is 
attributable to services performed in a taxable year beginning before 
January 1, 2010, is determined by applying an attribution method 
described in paragraph (h)(2) of this section.
    (2) Identification of services performed in taxable years beginning 
before January 1, 2010--(i) In general. DDR described in paragraphs 
(d)(2) (legally binding right), (d)(3) (account balance plans), (d)(4) 
(nonaccount balance plans), (d)(6) (involuntary separation pay), (d)(7) 
(reimbursements), and (d)(8) (split dollar life insurance) of this 
section is attributable to services performed in a taxable year 
beginning before January 1, 2010 if it is attributable to services 
performed before that date under the rules of these paragraphs, without 
regard to whether that remuneration is subject to a substantial risk of 
forfeiture on or after that date. Notwithstanding the requirement under 
paragraph (d)(3)(i) of this section that a covered health insurance 
provider must use the same attribution method for its account balance 
plans for all taxable years, a covered health insurance provider that 
uses the account balance ratio method described in paragraph (d)(3)(i) 
of this section to attribute remuneration to services performed in 
taxable years beginning after December 31, 2009 may use the principal 
additions method described in paragraph (d)(3)(ii) of this section to 
attribute remuneration under an account balance plan to services 
performed in a taxable year beginning before January 1, 2010 for 
purposes of determining grandfathered amounts under the plan. (See 
paragraph (d)(3)(ii)(C)(3) of this section for required account balance 
adjustments if a covered health insurance provider generally uses the 
account balance ratio method to attribute amounts otherwise deductible 
under its account balance plans but uses the principal additions method 
to attribute remuneration to services performed in taxable years 
beginning before January 1, 2010.)
    (ii) Equity-based remuneration. For purposes of this section, all 
remuneration resulting from a stock option, stock appreciation right, 
restricted stock, or restricted stock unit and the right to any 
associated dividends or dividend equivalents (together, referred to as 
equity-based remuneration) granted before the first day of the taxable 
year of the covered health insurance provider beginning on or after 
January 1, 2010, is attributable to services performed in taxable years 
beginning before January 1, 2010, regardless of the date on which the 
equity-based remuneration is exercised (in the case of a stock option or 
SAR), the date on which the amounts due under the equity-based 
remuneration are paid or includible in income, or whether the equity-
based remuneration is subject to a substantial risk of forfeiture on or 
after the first day of the taxable year of the covered health insurance 
provider beginning on or after January 1, 2010. For example, 
appreciation in the value of restricted shares granted before the first 
day of the taxable year beginning on or after January 1, 2010 is treated 
as remuneration that is attributable to services performed in taxable 
years beginning before January 1, 2010, regardless of whether the shares 
are vested at that time.
    (i) Transition rules for certain DDR--(1) Transition rule for DDR 
attributable to services performed in taxable years of the covered 
health insurance provider beginning after December 31, 2009 and before 
January 1, 2013. The deduction limitation under section 162(m)(6) 
applies to DDR attributable to services performed in a disqualified 
taxable year of a covered health insurance provider beginning after 
December 31, 2009 and before January 1, 2013, only if that remuneration 
is otherwise deductible in a disqualified taxable year of the covered

[[Page 281]]

health insurance provider beginning after December 31, 2012. However, if 
the deduction limitation applies to DDR attributable to services 
performed by an applicable individual in a disqualified taxable year of 
a covered health insurance provider beginning after December 31, 2009 
and before January 1, 2013, the deduction limitation is calculated as if 
it had been applied to the applicable individual's AIR and DDR 
deductible in those taxable years.
    (2) Examples. The following examples illustrate the principles of 
this paragraph (i). For purposes of these examples, each corporation has 
a taxable year that is the calendar year, and DDR is otherwise 
deductible by the covered health insurance provider in the taxable year 
in which it is paid.

    Example 1. (i) Q is an applicable individual of corporation Z. Z's 
2010, 2011, and 2012 taxable years are disqualified taxable years. Z's 
2013, 2014, and 2015 taxable years are not disqualified taxable years. 
However, Z's 2016 taxable year and all subsequent taxable years are 
disqualified taxable years. Q receives $200,000 of AIR from Z for 2012, 
and becomes entitled to $800,000 of DDR that is attributable to services 
performed by Q in 2012. Z pays Q $350,000 of the DDR in 2015, and the 
remaining $450,000 of the DDR in 2016. These payments are otherwise 
deductible by Z in 2015 and 2016, respectively.
    (ii) DDR attributable to services performed by Q in Z's 2010, 2011, 
and 2012 taxable years that is otherwise deductible in Z's 2013, 2014, 
or 2015 taxable years is not subject to the deduction limitation under 
section 162(m)(6) by reason of the transition rule under paragraph 
(i)(1) of this section. However, DDR attributable to services performed 
in Z's 2010, 2011, and 2012 taxable years that is otherwise deductible 
in a later taxable year that is a disqualified taxable year (in this 
case, Z's 2016 and subsequent taxable years) is subject to the deduction 
limitation under section 162(m)(6). Accordingly, the deduction 
limitation with respect to AIR and DDR attributable to services 
performed by Q in 2012 is determined by reducing the $500,000 deduction 
limit by the $200,000 of AIR paid to Q by Z for 2012 ($500,000 - 
$200,000). Under the transition rule of paragraph (i)(1) of this 
section, no portion of the reduced deduction limit of $300,000 for the 
2012 taxable year is applied against the $350,000 payment made in 2015, 
and accordingly, the deduction limit is not reduced by the amount of 
that payment. The reduced deduction limit is then applied to Q's 
$450,000 of DDR attributable to services performed by Q in 2012 that is 
paid to Q and becomes otherwise deductible in 2016. Because the reduced 
deduction limit of $300,000 is less than the $450,000 otherwise 
deductible by Z in 2016, Z may deduct only $300,000 of the DDR, and 
$150,000 of the $450,000 payment is not deductible by Z in that taxable 
year or any taxable year.
    Example 2. (i) R is an applicable individual of corporation Y, which 
is a covered health insurance provider for all relevant taxable years. 
During 2010, Y pays R $400,000 in salary and grants R a right to 
$200,000 in DDR payable on a fixed schedule in 2011, 2012, and 2013. 
Pursuant to the fixed schedule, Y pays R $50,000 of DDR in 2011, $50,000 
of DDR in 2012, and the remaining $100,000 of DDR in 2013.
    (ii) Because the deduction limitation for DDR under section 
162(m)(6)(A)(ii) is effective for DDR that is attributable to services 
performed by an applicable individual during any disqualified taxable 
year beginning after December 31, 2009 that would otherwise be 
deductible in a taxable year beginning after December 31, 2012, only the 
DDR paid by Y in 2013 is subject to the deduction limitation. However, 
the limitation is applied as if section 162(m)(6) and paragraph (c)(2) 
of this section were effective for taxable years beginning after 
December 31, 2009 and before January 1, 2013. Accordingly, the deduction 
limitation with respect to remuneration for services performed by R in 
2010 is determined by reducing the $500,000 deduction limit by the 
$400,000 of AIR paid to R for 2010 ($500,000 -$400,000). The reduced 
deduction limit of $100,000 is further reduced to zero by the $50,000 of 
DDR attributable to services performed by R in Y's 2010 taxable year 
that is deductible in each of 2011 and 2012 (($100,000 - $50,000 - 
$50,000). Because the deduction limit is reduced to zero, none of the 
$100,000 of DDR attributable to services performed by R in Y's 2010 
taxable year and paid to R in 2013 is deductible.

    (j) Effective/applicability dates. These regulations are effective 
on September 23, 2014. The regulations apply to taxable years beginning 
on or after September 23, 2014.

[T.D, 9694, 79 FR 56904, Sept. 23, 2014]



Sec.  1.162-32  Expenses paid or incurred for lodging when 
not traveling away from home.

    (a) In general. Expenses paid or incurred for lodging of an 
individual who is not traveling away from home (local lodging) generally 
are personal, living, or family expenses that are nondeductible by the 
individual under section 262(a). Under certain circumstances, however, 
local lodging expenses may be

[[Page 282]]

deductible under section 162(a) as ordinary and necessary expenses paid 
or incurred in connection with carrying on a taxpayer's trade or 
business, including a trade or business as an employee. Whether local 
lodging expenses are paid or incurred in carrying on a taxpayer's trade 
or business is determined under all the facts and circumstances. One 
factor is whether the taxpayer incurs an expense because of a bona fide 
condition or requirement of employment imposed by the taxpayer's 
employer. Expenses paid or incurred for local lodging that is lavish or 
extravagant under the circumstances or that primarily provides an 
individual with a social or personal benefit are not incurred in 
carrying on a taxpayer's trade or business.
    (b) Safe harbor for local lodging at business meetings and 
conferences. An individual's local lodging expenses will be treated as 
ordinary and necessary business expenses if--
    (1) The lodging is necessary for the individual to participate fully 
in or be available for a bona fide business meeting, conference, 
training activity, or other business function;
    (2) The lodging is for a period that does not exceed five calendar 
days and does not recur more frequently than once per calendar quarter;
    (3) If the individual is an employee, the employee's employer 
requires the employee to remain at the activity or function overnight; 
and
    (4) The lodging is not lavish or extravagant under the circumstances 
and does not provide any significant element of personal pleasure, 
recreation, or benefit.
    (c) Examples. The provisions of the facts and circumstances test of 
paragraph (a) of this section are illustrated by the following examples. 
In each example the employer and the employees meet all other 
requirements (such as substantiation) for deductibility of the expense 
and for exclusion from income of the value of the lodging as a working 
condition fringe or of reimbursements under an accountable plan.

    Example 1. (i) Employer conducts a seven-day training session for 
its employees at a hotel near Employer's main office. The training is 
directly connected with Employer's trade or business. Some employees 
attending the training are traveling away from home and some employees 
are not traveling away from home. Employer requires all employees 
attending the training to remain at the hotel overnight for the bona 
fide purpose of facilitating the training. Employer pays the costs of 
the lodging at the hotel directly to the hotel and does not treat the 
value as compensation to the employees.
    (ii) Because the training is longer than five calendar days, the 
safe harbor in paragraph (b) of this section does not apply. However, 
the value of the lodging may be excluded from income if the facts and 
circumstances test in paragraph (a) of this section is satisfied.
    (iii) The training is a bona fide condition or requirement of 
employment and Employer has a noncompensatory business purpose for 
paying the lodging expenses. Employer is not paying the expenses 
primarily to provide a social or personal benefit to the employees, and 
the lodging Employer provides is not lavish or extravagant. If the 
employees who are not traveling away from home had paid for their own 
lodging, the expenses would have been deductible by the employees under 
section 162(a) as ordinary and necessary business expenses. Therefore, 
the value of the lodging is excluded from the employees' income as a 
working condition fringe under section 132(a) and (d).
    (iv) Employer may deduct the lodging expenses, including lodging for 
employees who are not traveling away from home, as ordinary and 
necessary business expenses under section a162(a).
    Example 2. (i) The facts are the same as in Example 1, except that 
the employees pay the cost of their lodging at the hotel directly to the 
hotel, Employer reimburses the employees for the cost of the lodging, 
and Employer does not treat the reimbursement as compensation to the 
employees.
    (ii) Because the training is longer than five calendar days, the 
safe harbor in paragraph (b) of this section does not apply. However, 
the reimbursement of the expenses for the lodging may be excluded from 
income if the facts and circumstances test in paragraph (a) of this 
section is satisfied.
    (iii) The training is a bona fide condition or requirement of 
employment and Employer is reimbursing the lodging expenses for a 
noncompensatory business purpose and not primarily to provide a social 
or personal benefit to the employees and the lodging Employer provides 
is not lavish or extravagant. The employees incur the expenses in 
performing services for the employer. If Employer had not reimbursed the 
employees who are not traveling away from home for the cost of the 
lodging, the expenses would have been deductible by the employees under 
section 162(a) as ordinary and necessary business expenses. Therefore, 
the reimbursements to the employees are made under an

[[Page 283]]

accountable plan and are excluded from the employees' gross income.
    (iv) Employer may deduct the lodging expense reimbursements, 
including reimbursements for employees who are not traveling away from 
home, as ordinary and necessary business expenses under section 162(a).
    Example 3. (i) Employer is a professional sports team. Employer 
requires its employees (for example, players and coaches) to stay at a 
local hotel the night before a home game to conduct last minute training 
and ensure the physical preparedness of the players. Employer pays the 
lodging expenses directly to the hotel and does not treat the value as 
compensation to the employees.
    (ii) Because the overnight stays occur more than once per calendar 
quarter, the safe harbor in paragraph (b) of this section does not 
apply. However, the value of the lodging may be excluded from income if 
the facts and circumstances test in paragraph (a) of this section is 
satisfied.
    (iii) The overnight stays are a bona fide condition or requirement 
of employment and Employer has a noncompensatory business purpose for 
paying the lodging expenses. Employer is not paying the lodging expenses 
primarily to provide a social or personal benefit to the employees and 
the lodging Employer provides is not lavish or extravagant. If the 
employees had paid for their own lodging, the expenses would have been 
deductible by the employees under section 162(a) as ordinary and 
necessary business expenses. Therefore, the value of the lodging is 
excluded from the employees' income as a working condition fringe.
    (iv) Employer may deduct the expenses for lodging the employees at 
the hotel as ordinary and necessary business expenses under section 
162(a).
    Example 4. (i) Employer hires Employee, who currently resides 500 
miles from Employer's business premises. Employer pays for temporary 
lodging for Employee near Employer's business premises while Employee 
searches for a residence.
    (ii) Employer is paying the temporary lodging expense primarily to 
provide a personal benefit to Employee by providing housing while 
Employee searches for a residence. Employer incurs the expense only as 
additional compensation and not for a noncompensatory business purpose. 
If Employee paid the temporary lodging expense, the expense would not be 
an ordinary and necessary employee business expense under section 162(a) 
because the lodging primarily provides a personal benefit to Employee. 
Therefore, the value of the lodging is includible in Employee's gross 
income as additional compensation.
    (iii) Employer may deduct the lodging expenses as ordinary and 
necessary business expenses under section 162(a) and Sec.  1.162-25T.
    Example 5. (i) Employee normally travels two hours each way between 
her home and her office. Employee is working on a project that requires 
Employee to work late hours. Employer provides Employee with lodging at 
a hotel near the office.
    (ii) Employer is paying the temporary lodging expense primarily to 
provide a personal benefit to Employee by relieving her of the daily 
commute to her residence. Employer incurs the expense only as additional 
compensation and not for a noncompensatory business purpose. If Employee 
paid the temporary lodging expense, the expense would not be an ordinary 
and necessary business expense under section 162(a) because the lodging 
primarily provides a personal benefit to Employee. Therefore, the value 
of the lodging is includible in Employee's gross income as additional 
compensation.
    (iii) Employer may deduct the lodging expenses as ordinary and 
necessary business expenses under section 162(a) and Sec.  1.162-25T.
    Example 6. (i) Employer requires an employee to be ``on duty'' each 
night to respond quickly to emergencies that may occur outside of normal 
working hours. Employees who work daytime hours each serve a ``duty 
shift'' once each month in addition to their normal work schedule. 
Emergencies that require the duty shift employee to respond occur 
regularly. Employer has no sleeping facilities on its business premises 
and pays for a hotel room nearby where the duty shift employee stays 
until called to respond to an emergency.
    (ii) Because an employee's expenses for lodging while on the duty 
shift occur more frequently than once per calendar quarter, the safe 
harbor in paragraph (b) of this section does not apply. However, the 
value of the lodging may be excluded from income if the facts and 
circumstances test in paragraph (a) of this section is satisfied.
    (iii) The duty shift is a bona fide condition or requirement of 
employment and Employer has a noncompensatory business purpose for 
paying the lodging expenses. Employer is not providing the lodging to 
duty shift employees primarily to provide a social or personal benefit 
to the employees and the lodging Employer provides is not lavish or 
extravagant. If the employees had paid for their lodging, the expenses 
would have been deductible by the employees under section 162(a) as 
ordinary and necessary business expenses. Therefore, the value of the 
lodging is excluded from the employees' income as a working condition 
fringe.
    (iv) Employer may deduct the lodging expenses as ordinary and 
necessary business expenses under section 162(a).


[[Page 284]]


    (d) Effective/applicability date. This section applies to expenses 
paid or incurred on or after October 1, 2014. However, taxpayers may 
apply these regulations to local lodging expenses that are paid or 
incurred in taxable years for which the period of limitation on credit 
or refund under section 6511 has not expired.

[T.D. 9696, 79 FR 59113, Oct. 1, 2014]



Sec.  1.162(k)-1  Disallowance of deduction for reacquisition payments.

    (a) In general. Except as provided in paragraph (b) of this section, 
no deduction otherwise allowable is allowed under Chapter 1 of the 
Internal Revenue Code for any amount paid or incurred by a corporation 
in connection with the reacquisition of its stock or the stock of any 
related person (as defined in section 465(b)(3)(C)). Amounts paid or 
incurred in connection with the reacquisition of stock include amounts 
paid by a corporation to reacquire its stock from an ESOP that are used 
in a manner described in section 404(k)(2)(A). See Sec.  1.404(k)-3.
    (b) Exceptions. Paragraph (a) of this section does not apply to 
any--
    (1) Deduction allowable under section 163 (relating to interest);
    (2) Deduction for amounts that are properly allocable to 
indebtedness and amortized over the term of such indebtedness;
    (3) Deduction for dividends paid (within the meaning of section 
561); or
    (4) Amount paid or incurred in connection with the redemption of any 
stock in a regulated investment company that issues only stock which is 
redeemable upon the demand of the shareholder.
    (c) Effective date. This section applies with respect to amounts 
paid or incurred on or after August 30, 2006.

[T.D. 9282, 71 FR 51473, Aug. 30, 2006]



Sec.  1.162(l)-0  Table of Contents.

    This section lists the table of contents for Sec.  1.162(l)-1.

 Sec.  1.162(l)-1 Deduction for health insurance costs of self-employed 
                              individuals.

(a) Coordination of section 162(l) deduction for taxpayers subject to 
section 36B.
(1) In general.
(2) Specified premiums.
(3) Specified premiums not paid through advance credit payments.
(b) Additional guidance.
(c) Applicability date.

[T.D. 9822, 82 FR 34610, July 26, 2017]



Sec.  1.162(l)-1  Deduction for health insurance costs 
of self-employed individuals.

    (a) Coordination of section 162(l) deduction for taxpayers subject 
to section 36B--(1) In general. A taxpayer is allowed a deduction under 
section 162(l) for specified premiums, as defined in paragraph (a)(2) of 
this section, not to exceed an amount equal to the lesser of--
    (i) The specified premiums less the premium tax credit attributable 
to the specified premiums; and
    (ii) The sum of the specified premiums not paid through advance 
credit payments, as described in paragraph (a)(3) of this section, and 
the additional tax (if any) imposed under section 36B(f)(2)(A) and Sec.  
1.36B-4(a)(1) with respect to the specified premiums after application 
of the limitation on additional tax in section 36B(f)(2)(B) and Sec.  
1.36B-4(a)(3).
    (2) Specified premiums. For purposes of paragraph (a)(1) of this 
section, specified premiums means premiums for a specified qualified 
health plan or plans for which the taxpayer may otherwise claim a 
deduction under section 162(l). For purposes of this paragraph (a)(2), a 
specified qualified health plan is a qualified health plan, as defined 
in Sec.  1.36B-1(c), covering the taxpayer, the taxpayer's spouse, or a 
dependent of the taxpayer (enrolled family member) for a month that is a 
coverage month within the meaning of Sec.  1.36B-3(c) for the enrolled 
family member. If a specified qualified health plan covers individuals 
other than enrolled family members, the specified premiums include only 
the portion of the premiums for the specified qualified health plan that 
is allocable to the enrolled family members under rules similar to Sec.  
1.36B-3(h), which provides rules for determining the amount under Sec.  
1.36B-3(d)(1) when two families are enrolled in the same qualified 
health plan.
    (3) Specified premiums not paid through advance credit payments. For 
purposes of paragraph (a)(1)(ii) of this section, specified premiums not 
paid through

[[Page 285]]

advance credit payments equal the amount of the specified premiums minus 
the advance credit payments attributable to the specified premiums.
    (b) Additional guidance. The Secretary may provide by publication in 
the Federal Register or in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2) of this chapter) additional guidance on coordinating the 
deduction allowed under section 162(l) and the credit provided under 
section 36B.
    (c) Applicability date. This section applies for taxable years 
beginning after December 31, 2013.

[T.D. 9822, 82 FR 34610, July 26, 2017]



Sec.  1.163-1  Interest deduction in general.

    (a) Except as otherwise provided in sections 264 to 267, inclusive, 
interest paid or accrued within the taxable year on indebtedness shall 
be allowed as a deduction in computing taxable income. For rules 
relating to interest on certain deferred payments, see section 483 and 
the regulations thereunder.
    (b) Interest paid by the taxpayer on a mortgage upon real estate of 
which he is the legal or equitable owner, even though the taxpayer is 
not directly liable upon the bond or note secured by such mortgage, may 
be deducted as interest on his indebtedness. Pursuant to the provisions 
of section 163(c), any annual or periodic rental payment made by a 
taxpayer on or after January 1, 1962, under a redeemable ground rent, as 
defined in section 1055(c) and paragraph (b) of Sec.  1.1055-1, is 
required to be treated as interest on an indebtedness secured by a 
mortgage and, accordingly, may be deducted by the taxpayer as interest 
on his indebtedness. Section 163(c) has no application in respect of any 
annual or periodic rental payment made prior to January 1, 1962, or 
pursuant to an arrangement which does not constitute a ``redeemable 
ground rent'' as defined in section 1055(c) and paragraph (b) of Sec.  
1.1055-1. Accordingly, annual or periodic payments of Pennsylvania 
ground rents made before, on, or after January 1, 1962, are deductible 
as interest if the ground rent is redeemable. An annual or periodic 
rental payment under a Maryland redeemable ground rent made prior to 
January 1, 1962, is deductible in accordance with the rules and 
regulations applicable at the time such payment was made. Any annual or 
periodic rental payment under a Maryland redeemable ground rent made by 
the taxpayer on or after January 1, 1962, is, pursuant to the provisions 
of section 163(c), treated as interest on an indebtedness secured by a 
mortgage and, accordingly, is deductible by the taxpayer as interest on 
his indebtedness. In any case where the ground rent is irredeemable, any 
annual or periodic ground rent payment shall be treated as rent and 
shall be deductible only to the extent that the payment constitutes a 
proper business expense. Amounts paid in redemption of a ground rent 
shall not be treated as interest. For treatment of redeemable ground 
rents and real property held subject to liabilities under redeemable 
ground rents, see section 1055 and the regulations thereunder.
    (c) Interest calculated for costkeeping or other purposes on account 
of capital or surplus invested in the business which does not represent 
a charge arising under an interest-bearing obligation, is not an 
allowable deduction from gross income. Interest paid by a corporation on 
scrip dividends is an allowable deduction. So-called interest on 
preferred stock, which is in reality a dividend thereon, cannot be 
deducted in computing taxable income. (See, however, section 583.) In 
the case of banks and loan or trust companies, interest paid within the 
year on deposits, such as interest paid on moneys received for 
investment and secured by interest-bearing certificates of indebtedness 
issued by such bank or loan or trust company, may be deducted from gross 
income.
    (d) To the extent of assistance payments made in respect of an 
indebtedness of the taxpayer during the taxable year by the Department 
of Housing and Urban Development under section 235 of the National 
Housing Act (12 U.S.C. 1715z), as amended, no deduction shall be allowed 
under section 163 and this section for interest paid or accrued with 
respect to such indebtedness. However, such payments shall not affect 
the amount of any deduction under

[[Page 286]]

any section of the Code other than section 163. The provisions of this 
paragraph shall apply to taxable years beginning after December 31, 
1974.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6821, 30 FR 
6216, May 4, 1965; T.D. 6873, 31 FR 941, Jan. 25, 1966; T.D. 7408, 41 FR 
9547, Mar. 5, 1976]



Sec.  1.163-2  Installment purchases where interest charge 
is not separately stated.

    (a) In general. (1) Whenever there is a contract with a seller for 
the purchase of personal property providing for payment of part or all 
of the purchase price in installments and there is a separately stated 
carrying charge (including a finance charge, service charge, and the 
like) but the actual interest charge cannot be ascertained, a portion of 
the payments made during the taxable year under the contract shall be 
treated as interest and is deductible under section 163 and this 
section. Section 163(b) contains a formula, described in paragraph (b) 
of this section, in accordance with which the amount of interest 
deductible in the taxable year must be computed. This formula is 
designed to operate automatically in the case of any installment 
purchase, without regard to whether payments under the contract are made 
when due or are in default. For applicable limitations when an 
obligation to pay is terminated, see paragraph (c) of this section.
    (2) Whenever there is a contract with an educational institution for 
the purchase of educational services providing for payment of part or 
all of the purchase price in installments and there is a separately 
stated carrying charge (including a finance charge, service charge, and 
the like) but the actual interest charge cannot be ascertained, a 
portion of the payments made during the taxable year under the contract 
shall be treated as interest and is deductible under section 163 and 
this section. See paragraphs (b) and (c) of this section for the 
applicable computation and limitations rules. For purposes of section 
163(b) and this section, the term ``educational services'' means any 
service (including lodging) which is purchased from an educational 
institution (as defined in section 151(e)(4) and paragraph (c) of Sec.  
1.151-3) and which is provided for a student of such institution.
    (3) Section 163(b) and this section do not apply to a contract for 
the loan of money, even if the loan is to be repaid in installments and 
even if the borrowed amount is used to purchase personal property or 
educational services. In cases to which the preceding sentence applies, 
the portion of the installment payment which constitutes interest (as 
distinguished from payments of principal and charges such as payments 
for credit life insurance) is deductible under section 163(a) and Sec.  
1.163-1.
    (b) Computation. The portion of any such payments to be treated as 
interest shall be equal to 6 percent of the average unpaid balance under 
the contract during the taxable year. For purposes of this computation, 
the average unpaid balance under the contract is the sum of the unpaid 
balance outstanding on the first day of each month beginning during the 
taxable year, divided by 12.
    (c) Limitations. The amount treated as interest under section 163(b) 
and this section for any taxable year shall not exceed the amount of the 
payments made under the contract during the taxable year nor the 
aggregate carrying charges properly attributable to each contract for 
such taxable year. In computing the amount to be treated as interest if 
the obligation to pay is terminated as, for example, in the case of a 
repossession of the property, the unpaid balance on the first day of the 
month during which the obligation is terminated shall be zero.
    (d) Illustrations. The provisions of this section may be illustrated 
by the following examples:

    Example 1. On January 20, 1955, A purchased a television set for 
$400, including a stated carrying charge of $25. The down payment was 
$50, and the balance was paid in 14 monthly installments of $25 each, on 
the 20th day of each month commencing with February. Assuming that A is 
a cash method, calendar year taxpayer and that no other installment 
purchases were made, the amount to be treated as interest in 1955 is 
$12.38, computed as follows:

[[Page 287]]



                                Year 1955
------------------------------------------------------------------------
                                                                Unpaid
                        First day of                           balance
                                                             outstanding
------------------------------------------------------------------------
January....................................................           0
February...................................................        $350
March......................................................         325
April......................................................         300
May........................................................         275
June.......................................................         250
July.......................................................         225
August.....................................................         200
September..................................................         175
October....................................................         150
November...................................................         125
December...................................................         100
                                                            ------------
                                                                  2,475
------------------------------------------------------------------------

    Sum of unpaid balances $2,475 / 12 = $206.25; 6 percent thereof = 
$12.38.
    Example 2. On November 20, 1955, B purchased a furniture set for 
$1,250, including a stated carrying charge of $48. The down payment was 
$50 and the balance was payable in 12 monthly installments of $100 each, 
on the first day of each month commencing with December 1955. Assume 
that B is a cash method, calendar year taxpayer and that no other 
installment purchases were made. Assume further that B made the first 
payment when due, but made only one other payment on June 1, 1956. The 
amount to be treated as interest in 1955 is $4, and the amount to be 
treated as interest in 1956 is $33, computed as follows:

                                Year 1955
------------------------------------------------------------------------
                                                                Unpaid
                        First day of                           balance
                                                             outstanding
------------------------------------------------------------------------
December...................................................      $1,200
------------------------------------------------------------------------

    Sum of unpaid balances $1,200 / 12 = $100; 6 percent thereof = $6.
    Carrying charges attributable to 1955 = $4.

                                Year 1956
------------------------------------------------------------------------
                                                                Unpaid
                        First day of                           balance
                                                             outstanding
------------------------------------------------------------------------
January....................................................      $1,100
February...................................................       1,000
March......................................................         900
April......................................................         800
May........................................................         700
June.......................................................         600
July.......................................................         500
August.....................................................         400
September..................................................         300
October....................................................         200
November...................................................         100
                                                            ------------
                                                                  6,600
------------------------------------------------------------------------

    Sum of unpaid balances $6,600 / 12 = $550; 6 percent thereof = $33.
    Carrying charges attributable to 1956 = $44 ($4 x 11).
    Example 3. Assume the same facts as in example (2), except that the 
furniture was repossessed and B's obligation to pay terminated as of 
July 15, 1956. The amount to be treated as interest in 1955 is $4, 
computed as in example (2) above. The amount to be treated as interest 
in 1956 is $25.50, computed as follows:

                                Year 1956
------------------------------------------------------------------------
                                                                Unpaid
                        First day of                           balance
                                                             outstanding
------------------------------------------------------------------------
January....................................................      $1,100
February...................................................       1,000
March......................................................         900
April......................................................         800
May........................................................         700
June.......................................................         600
July-November..............................................           0
                                                            ------------
                                                                  5,100
------------------------------------------------------------------------

    Sum of unpaid balances $5,100 / 12 = $425. 6 percent thereof = 
$25.50.
    Carrying charges attributable to 1956 = $44 ($4 x 11).
    Example 4. (i) On September 15, 1968, C registered at X University 
for the 1968-69 academic year. C entered into an agreement with the X 
University for the purchase during such academic year of educational 
services (including lodging and tuition) for a total fee of $1,000, 
including a separately stated carrying charge of $50. Under the terms of 
the agreement, an initial payment of $200 was to be made by C on 
September 15, 1968, and the balance was to be paid in 8 monthly 
installments of $100 each, on the 15th day of each month commencing with 
October 1968. C made all of the required 1968 payments. Assuming that C 
is a cash method, calendar year taxpayer and that no other installment 
purchases of services or property were made, the amount to be treated as 
interest in 1968 is $10.50, computed as follows:

                                Year 1968
------------------------------------------------------------------------
                                                                Unpaid
                        First day of                           balance
                                                             outstanding
------------------------------------------------------------------------
January-September..........................................           0
October....................................................        $800
November...................................................         700
December...................................................         600
                                                            ------------
    Total..................................................       2,100
------------------------------------------------------------------------


The sum of unpaid balances ($2,100) divided by 12 is $175; 6 percent 
thereof is $10.50. The carrying charges attributable to 1968 are

[[Page 288]]

$18.75 (i.e., the total carrying charges ($50), divided by the total 
number of payments (8), multiplied by the number of payments made in 
1968 (3)). Since the amount to be treated as interest in 1968 ($10.50) 
does not exceed the carrying charges attributable to 1968 ($18.75), the 
limitation set forth in paragraph (c) of this section is not applicable.
    (ii) The result in this example would be the same even if the X 
University assigned the agreement to a bank or other financial 
institution and C made his payments directly to the bank or other 
financial institution.
    Example 5. On September 15, 1968, D registered at Y University for 
the 1968-69 academic year. The tuition for such year was $1,500. In 
order to pay his tuition, D borrowed $1,500 from the M Corporation, a 
lending institution, and remitted that sum to the Y University. The loan 
agreement between M Corporation and D provided that D was to repay the 
loan, plus a service charge, in 10 equal monthly installments, on the 
first day of each month commencing with October 1968. The service charge 
consisted of interest and the cost of credit life insurance on D's life. 
Since section 163(b) and this section do not apply to a contract for the 
loan of money, D is not entitled to compute his interest deduction with 
respect to his loan from M Corporation under such sections. D may deduct 
that portion of each installment payment which constitutes interest (as 
distinguished from payments of principal and the charge for credit life 
insurance) under section 163(a) and Sec.  1.163-1, provided that the 
amount of such interest can be ascertained.

    (e) Effective date. Except in the case of payments made under a 
contract for educational services, the rule provided in section 163(b) 
and this section applies to payments made during taxable years beginning 
after December 31, 1953, and ending after August 16, 1954, regardless of 
when the contract of sale was made. In the case of payments made under a 
contract for educational services, the rule provided in section 163(b) 
and this section applies to payments made during taxable years beginning 
after December 31, 1963, regardless of when the contract for educational 
services was made.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6991, 34 FR 
742, Jan. 17, 1969]



Sec.  1.163-3  Deduction for discount on bond issued on or before May 27, 1969.

    (a) Discount upon issuance. (1) If bonds are issued by a corporation 
at a discount, the net amount of such discount is deductible and should 
be prorated or amortized over the life of the bonds. For purposes of 
this section, the amortizable bond discount equals the excess of the 
amount payable at maturity (or, in the case of a callable bond, at the 
earlier call date) over the issue price of the bond (as defined in 
paragraph (b)(2) of Sec.  1.1232-3).
    (2) In the case of a bond issued by a corporation after December 31, 
1954, as part of an investment unit consisting of an obligation and an 
option, the issue price of the bond is determined by allocating the 
amount received for the investment unit to the individual elements of 
the unit in the manner set forth in subdivision (ii)(a) of Sec.  1.1232-
3(b)(2). Discount with respect to bonds issued by a corporation as part 
of investment units consisting of obligations and options after December 
31, 1954, and before Dec. 24, 1968--
    (i) Increased by any amount treated as bond premium which has been 
included in gross income with respect to such bonds prior to Dec. 24, 
1968, or
    (ii) Decreased by any amount which has been deducted by the issuer 
as discount attributable to such bonds prior to Dec. 24, 1968, and
    (iii) Decreased by any amount which has been deducted by the issuer 
prior to Dec. 24, 1968 upon the exercise or sale by investors of options 
issued in investment units with such bonds,

should be amortized, starting with the first taxable year ending on or 
after Dec. 24, 1968 over the remaining life of such bonds.
    (b) Examples. The rules in paragraph (a) of this section are 
illustrated by the following examples:

    Example 1. M Corporation, on January 1, 1960, the beginning of its 
taxable year issued for $95,000, 3 percent bonds, maturing 10 years from 
the date of issue, with a stated redemption price at maturity of 
$100,000. M Corporation should treat $5,000 ($100,000-$95,000) as the 
total amount to be amortized over the life of the bonds.
    Example 2. Assume the same facts as example (1), except that the 
bonds are convertible into common stock of M Corporation. Since the 
issue price of the bonds includes any amount attributable to the 
conversion privilege, the result is the same as in example (1).
    Example 3. Assume the same facts as example (1), except that the 
bonds are issued as part of an investment unit consisting of an 
obligation and an option. Assume further

[[Page 289]]

that the issue price of the bonds as determined under the rules of 
allocation set forth in subdivision (ii)(a) of Sec.  1.1232-3(b)(2) is 
$94,000. Accordingly, M Corporation should treat $6,000 ($100,000-
$94,000) as the total amount to be amortized over the life of the bonds.
    Example 4. Assume in example (3), that prior to Dec. 24, 1968, M 
Corporation had only treated $5,000 as the bond discount to be amortized 
and deducted only $4,000 of this amount. Starting with the first taxable 
year ending on or after Dec. 24, 1968, M Corporation should amortize 
$2,000 ($6,000 discount, less $4,000 previously deducted) over the 
remaining life of the bonds.
    Example 5. N Corporation, on January 1, 1956, for a consideration of 
$102,000, issued 20-year bonds in the face amount of $100,000, together 
with options to purchase stock of N Corporation. The issue price of the 
bonds as determined under the rules of allocation set forth in 
subdivision (ii)(a) of Sec.  1.1232-3(b)(2) is $99,000. Until Dec. 24, 
1968, N Corporation has treated as bond premium, $2,000, representing 
the excess of the consideration received for the bond-option investment 
units over the maturity value of the bonds, and has accordingly prorated 
and included in income $1,200 of such amount. Starting with the first 
taxable year beginning on or after Dec. 24, 1968, N Corporation may 
amortize as a deduction over the remaining life of the bonds the amount 
of $2,200 ($1,000 discount, plus $1,200 previously included in income).
    Example 6. O Corporation, on January 1, 1956, for a consideration of 
$100,000, issued 20-year bonds with a $100,000 face value, together with 
options to purchase stock of O Corporation, which could be exercised at 
any time up to 5 years from the date of issue. The issue price of the 
bonds as determined under the rules of allocation set forth in 
subdivision (ii)(a) of Sec.  1.1232-3(b)(2) is $98,000. O Corporation, 
upon the exercise of the options prior to Dec. 24, 1968, had deducted 
from income their fair market value at the time of exercise, which is 
assumed for purposes of this example to have been $3,000. Even though 
the bonds are considered to have been issued at a discount under 
paragraph (a)(1) of this section, O Corporation would have no deduction 
over the remaining life of the bonds, inasmuch as O Corporation, in 
computing the amount of such deduction, is required under paragraph 
(a)(2)(iii) of this section to reduce the amount which would otherwise 
be treated as bond discount, $2,000 ($100,000-$98,000), by the amount 
deducted from income upon the exercise of the options, in this case, 
$3,000.

    (c) Deduction upon repurchase. (1) Except as provided in 
subparagraphs (2) and (3) of this paragraph, if bonds are issued by a 
corporation and are subsequently repurchased by the corporation at a 
price in excess of the issue price plus any amount of discount deducted 
prior to repurchase, or (in the case of bonds issued subsequent to Feb. 
28, 1913) minus any amount of premium returned as income prior to 
repurchase, the excess of the purchase price over the issue price 
adjusted for amortized premium or discount is a deductible expense for 
the taxable year.
    (2) In the case of a convertible bond (except a bond which the 
corporation, before Sept. 5, 1968, has obligated itself to repurchase at 
a specified price), the deduction allowable under subparagraph (1) of 
this paragraph may not exceed an amount equal to 1 year's interest at 
the rate specified in the bond, except to the extent that the 
corporation can demonstrate to the satisfaction of the Commissioner or 
his delegate that an amount in excess of 1 year's interest does not 
include any amount attributable to the conversion feature.
    (3) No deduction shall be allowed under subparagraph (1) of this 
paragraph to the extent a deduction is disallowed under subparagraph (2) 
of this paragraph or to the extent a deduction is disallowed by section 
249 (relating to limitation on deduction of bond premium on repurchase 
of convertible obligation) and the regulations thereunder. See paragraph 
(f) of Sec.  1.249-1 for effective date limitation on section 249.
    (d) Definition. For purposes of this section, a debenture, note, 
certificate other evidence of indebtedness, issued by a corporation and 
bearing interest shall be given the same treatment as a bond.
    (e) Effective date. The provisions of this section shall not apply 
in respect of a bond issued after May 27, 1969, unless issued pursuant 
to a written commitment which was binding on that date and at all times 
thereafter.

[T.D. 6984, 33 FR 19175, Dec. 24, 1968, as amended by T.D. 7154, 36 FR 
24996, Dec. 28, 1971; T.D. 7259, 38 FR 4253, Feb. 12, 1973]



Sec.  1.163-4  Deduction for original issue discount on certain obligations 
issued after May 27, 1969.

    (a) In general. (1) If an obligation is issued by a corporation with 
original issue discount, the amount of such discount is deductible as 
interest and

[[Page 290]]

shall be prorated or amortized over the life of the obligation. For 
purposes of this section the term ``obligation'' shall have the same 
meaning as in Sec.  1.1232-1 (without regard to whether the obligation 
is a capital asset in the hands of the holder) and the term ``original 
issue discount'' shall have the same meaning as in section 1232(b)(1) 
(without regard to the one-fourth of 1 percent limitation in the second 
sentence thereof). Thus, in general, the amount of original issue 
discount equals the excess of the amount payable at maturity over the 
issue price of the bond (as defined in paragraph (b)(2) of Sec.  1.1232-
3), regardless of whether that amount is less than one-fourth of 1 
percent of the redemption price at maturity multiplied by the number of 
complete years to maturity. For the rule as to whether there is original 
issue discount in the case of an obligation issued in an exchange for 
property other than money, and the amount thereof, see paragraph 
(b)(2)(iii) of Sec.  1.1232-3. In any case in which original issue 
discount is carried over from one corporation to another corporation 
under section 381(c)(9) or from an obligation exchanged to an obligation 
received in any exchange under paragraph (b)(1)(iv) of Sec.  1.1232-3, 
such discount shall be carried over for purposes of this section. The 
amount of original issue discount carried over in an exchange of 
obligations under the preceding sentence shall be prorated or amortized 
over the life of the obligation issued in such exchange. For computation 
of issue price and the amount of original issue discount in the case of 
serial obligations, see paragraph (b)(2)(iv) of Sec.  1.1232-3.
    (2) In the case of an obligation issued by a corporation as part of 
an investment unit (as defined in paragraph (b)(2)(ii)(a) of Sec.  
1.1232-3) consisting of an obligation and other property, the issue 
price of the obligation is determined by allocating the amount received 
for the investment unit to the individual elements of the unit in the 
manner set forth in paragraph (b)(2)(ii) of Sec.  1.1232-3.
    (3) Recovery or retention of amounts previously deducted. In any 
taxable year in which an amount of original issue discount which was 
deducted as interest under this section is retained or recovered by the 
taxpayer, such as, for example, by reason of a fine, penalty, 
forfeiture, or other withdrawal fee, such amount shall be includible in 
the gross income of such taxpayer for such taxable year.
    (b) Examples. The rules in paragraph (a) of this section are 
illustrated by the following examples:

    Example 1. N Corporation, which uses the calendar year as its 
taxable year, on January 1, 1970, issued for $99,000, 9 percent bonds 
maturing 10 years from the date of issue, with a stated redemption price 
at maturity of $100,000. The original issue discount on each bond (as 
determined under section 1232(b)(1) without regard to the one-fourth-of-
1-percent limitation in the second sentence thereof) is $1,000, i.e., 
redemption price, $100,000, minus issue price, $99,000. N shall treat 
$1,000 as the total amount to be amortized over the life of the bonds.
    Example 2. Assume the same facts as example (1), except that the 
bonds are convertible into common stock of N Corporation. Since the 
issue price of the bonds includes any amount attributable to the 
conversion privilege, the result is the same as in example (1).
    Example 3. Assume the same facts as example (1), except that the 
bonds are issued as part of an investment unit consisting of an 
obligation and an option. Assume further that the issue price of the 
bonds as determined under the rules of allocation set forth in paragraph 
(b)(2)(ii) of Sec.  1.1232-3 is $94,000. The original issue discount on 
the bond (as determined under section 1232(b)(1) without regard to the 
one-fourth-of-1-percent limitation in the second sentence thereof) is 
$6,000, i.e., redemption price, $100,000, minus issue price, $94,000. N 
shall treat $6,000 as the total amount to be amortized over the life of 
the bonds.
    Example 4. On January 1, 1971, a commercial bank which uses the 
calendar year as its taxable year, issued a certificate of deposit for 
$10,000. The certificate of deposit is not redeemable until December 31, 
1975, except in an emergency as defined in, and subject to the 
qualifications provided by Regulations Q of the Board of Governors of 
the Federal Reserve. See 12 CFR Sec.  217.4(d). The stated redemption 
price at maturity is $13,382.26. The certificate is an obligation to 
which section 1232(a)(3)(A) applies (see paragraph (d) of Sec.  1.1232-
1), and the original issue discount with respect to the certificate (as 
determined under section 1232(b)(1) without regard to the one-fourth-of-
1-percent limitation in the second sentence thereof) is $3,382.26 (i.e., 
redemption price, $13,382.26, minus issued price, $10,000). Y shall 
treat $3,382.26 as the total amount to be amortized over the life of the 
certificate.


[[Page 291]]


    (c) Deduction upon repurchase. (1) Except as provided in 
subparagraph (2) of this paragraph, if bonds are issued by a corporation 
and are subsequently repurchased by the corporation at a price in excess 
of the issue price plus any amount of original issue discount deducted 
prior to repurchase, or minus any amount of premium returned as income 
prior to repurchase, the excess of the repurchase price over the issue 
price adjusted for amortized premium or deducted discount is deductible 
as interest for the taxable year.
    (2) The provisions of subparagraph (1) of this paragraph shall not 
apply to the extent a deduction is disallowed by section 249 (relating 
to limitation on deduction of bond premium or repurchase of convertible 
obligation) and the regulations thereunder.
    (d) Effective date. The provisions of this section shall apply in 
respect of obligations issued after May 27, 1969, other than--
    (1) Obligations issued pursuant to a written commitment which was 
binding on May 27, 1969, and at all times thereafter, and
    (2) Deposits made before January 1, 1971, in the case of 
certificates of deposit, time deposits, bonus plans, and other deposit 
arrangements with banks, domestic building and loan associations, and 
similar financial institutions.

[36 FR 24996, Dec. 28, 1971, as amended by T.D. 7213, 37 FR 21991, Oct. 
18, 1972; T.D. 7259, 38 FR 4253, Feb. 12, 1973]



Sec.  1.163-5  Denial of interest deduction on certain obligations 
issued after December 31, 1982, unless issued in registered form.

    (a)-(b) [Reserved]
    (c) Obligations issued to foreign persons after September 21, 1984--
(1) In general. A determination of whether an obligation satisfies each 
of the requirements of this paragraph shall be made on an obligation-by-
obligation basis. An obligation issued directly (or through affiliated 
entities) in bearer form by, or guaranteed by, a United States 
Government-owned agency or a United States Government-sponsored 
enterprise, such as the Federal National Mortgage Association, the 
Federal Home Loan Banks, the Federal Loan Mortgage Corporation, the Farm 
Credit Administration, and the Student Loan Marketing Association, may 
not satisfy this paragraph (c). An obligation issued after September 21, 
1984 is described in this paragraph if--
    (i) There are arrangements reasonably designed to ensure that such 
obligation will be sold (or resold in connection with its original 
issuance) only to a person who is not a United States person or who is a 
United States person that is a financial institution (as defined in 
Sec.  1.165-12(c)(1)(v)) purchasing for its own account or for the 
account of a customer and that agrees to comply with the requirements of 
section 165(j)(3) (A), (B), or (C) and the regulations thereunder, and
    (ii) In the case of an obligation which is not in registered form--
    (A) Interest on such obligation is payable only outside the United 
States and its possessions, and
    (B) Unless the obligation is described in subparagraph (2)(i)(C) of 
this paragraph or is a temporary global security, the following 
statement in English either appears on the face of the obligation and on 
any interest coupons which may be detached therefrom or, if the 
obligation is evidenced by a book entry, appears in the book or record 
in which the book entry is made: ``Any United States person who holds 
this obligation will be subject to limitations under the United States 
income tax laws, including the limitations provided in sections 165(j) 
and 1287(a) of the Internal Revenue Code.'' For purposes of this 
paragraph, the term ``temporary global security'' means a security which 
is held for the benefit of the purchasers of the obligations of the 
issuer and interests in which are exchangeable for securities in 
definitive registered or bearer form prior to its stated maturity.
    (2) Rules for the application of this paragraph--(i) Arrangements 
reasonably designed to ensure sale to non-United States persons. An 
obligation will be considered to satisfy paragraph (c)(1)(i) of this 
section if the conditions of paragraph (c)(2)(i) (A), (B), (C), or (D) 
of this section are met in connection with the original issuance of the 
obligation. An exchange of one obligation for another is considered an 
original issuance

[[Page 292]]

if and only if the exchange constitutes a disposition of property for 
purposes of section 1001 of the Code. However, an exchange of one 
obligation for another will not be considered a new issuance if the 
obligation received is identical in all respects to the obligation 
surrendered in exchange therefor, except that the obligor of the 
obligation received need not be the same obligor as the obligor of the 
obligation surrendered. Obligations that meet the conditions of 
paragraph (c)(2)(i) (A), (B), (C) or (D) of this section may be issued 
in a single public offering. The preceding sentence does not apply to 
certificates of deposit issued under the conditions of paragraph 
(c)(2)(i)(C) of this section by a United States person or by a 
controlled foreign corporation within the meaning of section 957(a) that 
is engaged in the active conduct of a banking business within the 
meaning of section 954(c)(3)(B) as in effect prior to the Tax Reform Act 
of 1986, and the regulations thereunder. A temporary global security 
need not satisfy the conditions of paragraph (c)(2)(i) (A), (B) or (C) 
of this section, but must satisfy the applicable requirements of 
paragraph (c)(2)(i)(D) of this section.
    (A) In connection with the original issuance of an obligation, the 
obligation is offered for sale or resale only outside of the United 
States and its possessions, is delivered only outside the United States 
and its possessions and is not registered under the Securities Act of 
1933 because it is intended for distribution to persons who are not 
United States persons. An obligation will not be considered to be 
required to be registered under the Securities Act of 1933 if the 
issuer, in reliance on the written opinion of counsel received prior to 
the issuance thereof, determines in good faith that the obligation need 
not be registered under the Securities Act of 1933 for the reason that 
it is intended for distribution to persons who are not United States 
persons. Solely for purposes of this subdivision (i)(A), the term 
``United States person'' has the same meaning as it has for purposes of 
determining whether an obligation is intended for distribution to 
persons under the Securities Act of 1933. Except as provided in 
paragraph (c)(3) of this section, this paragraph (c)(2)(i)(A) applies 
only to obligations issued on or before September 7, 1990.
    (B) The obligation is registered under the Securities Act of 1933, 
is exempt from registration by reason of section 3 or section 4 of such 
Act, or does not qualify as a security under the Securities Act of 1933; 
all of the conditions set forth in paragraph (c)(2)(i)(B) (1), (2), (3), 
(4), and (5) of this section are met with respect to such obligations; 
and, except as provided in paragraph (c)(3) of this section, the 
obligation is issued on or before September 7, 1990.
    (1) In connection with the original issuance of an obligation in 
bearer form, the obligation is offered for sale or resale only outside 
the United States and its possessions.
    (2) The issuer does not, and each underwriter and each member of the 
selling group, if any, covenants that it will not, in connection with 
the original issuance of the obligation, offer to sell or resell the 
obligation in bearer form to any person inside the United States or to a 
United States person unless such United States person is a financial 
institution as defined in Sec.  1.165-12(c)(v) purchasing for its own 
account or for the account of a customer, which financial institution, 
as a condition of the purchase, agrees to provide on delivery of the 
obligation (or on issuance, if the obligation is not in definitive form) 
the certificate required under paragraph (c)(2)(i)(B)(4).
    (3) In connection with its sale or resale during the original 
issuance of the obligation in bearer form, each underwriter and each 
member of the selling group, if any, or the issuer, if there is no 
underwriter or selling group, sends a confirmation to the purchaser of 
the bearer obligation stating that the purchaser represents that it is 
not a United States person or, if it is a United States person, it is a 
financial institution as defined in Sec.  1.165-12(c)(v) purchasing for 
its own account or for the account of a customer and that the financial 
institution will comply with the requirements of section 165(j)(3) (A), 
(B), or (C) and the regulations thereunder. The confirmation must also 
state that, if the purchaser is a dealer, it will send similar 
confirmations to whomever purchases from it.

[[Page 293]]

    (4) In connection with the original issuance of the obligation in 
bearer form it is delivered in definitive form (or issued, if the 
obligation is not in definitive form) to the person entitled to physical 
delivery thereof only outside the United States and its possessions and 
only upon presentation of a certificate signed by such person to the 
issuer, underwriter, or member of the selling group, which certificate 
states that the obligation is not being acquired by or on behalf of a 
United States person, or for offer to resell or for resale to a United 
States person or any person inside the United States, or, if a 
beneficial interest in the obligation is being acquired by a United 
States person, that such person is a financial institution as defined in 
Sec.  1.165.12(c)(1)(v) or is acquiring through a financial institution 
and that the obligation is held by a financial institution that has 
agreed to comply with the requirements of section 165(j)(3) (A), (B), or 
(C) and the regulations thereunder and that is not purchasing for offer 
to resell or for resale inside the United States. When a certificate is 
provided by a clearing organization, it must be based on statements 
provided to it by its member organizations. A clearing organization is 
an entity which is in the business of holding obligations for member 
organizations and transferring obligations among such members by credit 
or debit to the account of a member without the necessity of physical 
delivery of the obligation. For purposes of paragraph (c)(2)(i)(B), the 
term ``delivery'' does not include the delivery of an obligation to an 
underwriter or member of the selling group, if any.
    (5) The issuer, underwriter, or member of the selling group does not 
have actual knowledge that the certificate described in paragraph 
(c)(2)(i)(B)(4) of this section is false. The issuer, underwriter, or 
member of the selling group shall be deemed to have actual knowledge 
that the certificate described in paragraph (c)(2)(i)(B)(4) of this 
section is false if the issuer, underwriter, or member of the selling 
group has a United States address for the beneficial owner (other than a 
financial institution as defined in Sec.  1.165-12(c)(v) that represents 
that it will comply with the requirements of section 165(j)(3) (A), (B), 
or (C) and the regulations thereunder) and does not have documentary 
evidence as described in Sec.  1.6049-5(c)(1) that the beneficial owner 
is not a United States person.
    (C) The obligation is issued only outside the United States and its 
possessions by an issuer that does not significantly engage in 
interstate commerce with respect to the issuance of such obligation 
either directly or through its agent, an underwriter, or a member of the 
selling group. In the case of an issuer that is a United States person, 
such issuer may only satisfy the test set forth in this paragraph 
(c)(2)(i)(C) if--
    (1) It is engaged through a branch in the active conduct of a 
banking business, within the meaning of section 954(c)(3)(B) as in 
effect before the Tax Reform Act of 1986, and the regulations 
thereunder, outside the United States;
    (2) The obligation is issued outside of the United States by the 
branch in connection with that trade or business;
    (3) The obligation that is so issued is sold directly to the public 
and is not issued as a part of a larger issuance made by means of a 
public offering; and
    (4) The issuer either maintains documentary evidence as described in 
subdivision (iii) of A-5 of Sec.  35a.9999-4T that the purchaser is not 
a United States person (provided that the issuer has no actual knowledge 
that the documentary evidence is false) or on delivery of the obligation 
the issuer receives a statement signed by the person entitled to 
physical delivery thereof and stating either that the obligation is not 
being acquired by or on behalf of a United States person or that, if a 
beneficial interest in the obligation is being acquired by a United 
States person, such person is a financial institution as defined in 
Sec.  1.165-12(c)(v) or is acquiring through a financial institution and 
the obligation is held by a financial institution that has agreed to 
comply with the requirements of 165(j)(3) (A), (B) or (C) and the 
regulations thereunder and that it is not purchasing for offer to resell 
or for resale inside the United States (provided that the issuer has no 
actual knowledge that the statement is false).

[[Page 294]]


In addition, an issuer that is a controlled foreign corporation within 
the meaning of section 957 (a) that is engaged in the active conduct of 
a banking business outside the United States within the meaning of 
section 954(c)(3)(B) as in effect before the Tax Reform Act of 1986, and 
the regulations thereunder, can only satisfy the provisions of this 
paragraph (c)(2)(i)(C), if it meets the requirements of this paragraph 
(c)(2)(i)(C)(2), (3) and (4).
    (D) The obligation is issued after September 7, 1990, and all of the 
conditions set forth in this paragraph (c)(2)(i)(D) are met with respect 
to such obligation.
    (1) Offers and sales--(i) Issuer. The issuer does not offer or sell 
the obligation during the restricted period to a person who is within 
the United States or its possessions or to a United States person.
    (ii) Distributors. (A) The distributor of the obligation does not 
offer or sell the obligation during the restricted period to a person 
who is within the United States or its possessions or to a United States 
person.
    (B) The distributor of the obligation will be deemed to satisfy the 
requirements of paragraph (c)(2)(i)(D)(1)(ii)(A) of this section if the 
distributor of the obligation convenants that it will not offer or sell 
the obligation during the restricted period to a person who is within 
the United States or its possessions or to a United States person; and 
the distributor of the obligation has in effect, in connection with the 
offer and sale of the obligation during the restricted period, 
procedures reasonably designed to ensure that its employees or agents 
who are directly engaged in selling the obligation are aware that the 
obligation cannot be offered or sold during the restricted period to a 
person who is within the United States or its possessions or is a United 
States person.
    (iii) Certain rules. For purposes of paragraph (c)(2)(i)(D)(1) (i) 
and (ii) of this section:
    (A) An offer or sale will be considered to be made to a person who 
is within the United States or its possessions if the offeror or seller 
of the obligation has an address within the United States or its 
possessions for the offeree or buyer of the obligation with respect to 
the offer or sale.
    (B) An offer or sale of an obligation will not be treated as made to 
a person within the United States or its possessions or to a United 
States person if the person to whom the offer or sale is made is: An 
exempt distributor, as defined in paragraph (c)(2)(i)(D)(5) of this 
section; An international organization as defined in section 7701(a)(18) 
and the regulations thereunder, or a foreign central bank as defined in 
section 895 and the regulations thereunder; or The foreign branch of a 
United States financial institution as described in paragraph 
(c)(2)(i)(D)(6)(i) of this section.

Paragraph (c)(2)(i)(D)(1)(iii)(B) regarding an exempt distributor will 
only apply to an offer to the United States office of an exempt 
distributor, and paragraph (c)(2)(i)(D)(1)(iii)(B) regarding an 
international organization or foreign central bank will only apply to an 
offer to an international organization or foreign central bank, if such 
offer is made directly and specifically to the United States office, 
organization or bank.
    (C) A sale of an obligation will not be treated as made to a person 
within the United States or its possessions or to a United States person 
if the person to whom the sale is made is a person described in 
paragraph (c)(2)(i)(D)(6)(ii) of this section.
    (2) Delivery. In connection with the sale of the obligation during 
the restricted period, neither the issuer nor any distributor delivers 
the obligation in definitive form within the United States or it 
possessions.
    (3) Certification--(i) In general. On the earlier of the date of the 
first actual payment of interest by the issuer on the obligation or the 
date of delivery by the issuer of the obligation in definitive form, a 
certificate is provided to the issuer of the obligation stating that on 
such date:
    (A) The obligation is owned by a person that is not a United States 
person:
    (B) The obligation is owned by a United States person described in 
paragraph (c)(2)(i)(D)(6) of this section; or
    (C) The obligation is owned by a financial institution for purposes 
of resale during the restricted period, and

[[Page 295]]

such financial institution certifies in addition that it has not 
acquired the obligation for purposes of resale directly or indirectly to 
a United States person or to a person within the United States or its 
possessions.

A certificate described in paragraph (c)(2)(i)(D)(3)(i) (A) or (B) of 
this section may not be given with respect to an obligation that is 
owned by a financial institution for purposes of resale during the 
restricted period. For purposes of paragraph (c)(2)(i)(D) (2) and (3) of 
this section, a temporary global security (as defined in Sec.  1.163-5 
(c)(1)(ii)(B)) is not considered to be an obligation in definitive form. 
If the issuer does not make the obligation available for delivery in 
definitive form within a reasonable period of time after the end of the 
restricted period, then the obligation shall be treated as not 
satisfying the requirements of this paragraph (c)(2)(i)(D)(3). The 
certificate must be signed (or sent, as provided in paragraph 
(c)(2)(i)(D)(3)(ii) of this section) either by the owner of the 
obligation or by a financial institution or clearing organization 
through which the owner holds the obligation, directly or indirectly. 
For purposes of this paragraph (c)(2)(i)(D)(3), the term ``financial 
institution'' means a financial institution described in Sec.  1.165-
12(c)(i)(v). When a certificate is provided by a clearing organization, 
the certificate must be based on statements provided to it by its member 
organizations. The requirement of this paragraph (c)(1)(D)(3) shall be 
deemed not to be satisfied with respect to an obligation if the issuer 
knows or has reason to know that the certificate with respect to such 
obligation is false. The certificate must be retained by the issuer (and 
statements by member organizations must be retained by the clearing 
organization, in the case of certificates based on such statements) for 
a period of four calendar years following the year in which the 
certificate is received.
    (ii) Electronic certification. The certificate required by paragraph 
(c)(2)(i)(D)(3)(i) of this section (including a statement provided to a 
clearing organization by a member organization) may be provided 
electronically, but only if the person receiving such electronic 
certificate maintains adequate records, for the retention period 
described in paragraph (c)(2)(i)(D)(3)(i) of this section, establishing 
that such certificate was received in respect of the subject obligation, 
and only if there is a written agreement entered into prior to the time 
of certification (including the written membership rules of a clearing 
organization) to which the sender and recipient are subject, providing 
that the electronic certificate shall have the effect of a signed 
certificate described in paragraph (c)(2)(i)(D)(3)(i) of this section.
    (iii) Exception for certain obligations. This paragraph 
(c)(2)(i)(D)(3) shall not apply, and no certificate shall be required, 
in the case of an obligation that is sold during the restricted period 
and that satisfies all of the following requirements:
    (A) The interest and principal with respect to the obligation are 
denominated only in the currency of a single foreign country.
    (B) The interest and principal with respect to the obligation are 
payable only within that foreign country (according to rules similar to 
those set forth in Sec.  1.163-5(c)(2)(v)).
    (C) The obligation is offered and sold in accordance with practices 
and documentation customary in that foreign country.
    (D) The distributor covenants to use reasonable efforts to sell the 
obligation within that foreign country.
    (E) The obligation is not listed, or the subject of an application 
for listing, on an exchange located outside that foreign country.
    (F) The Commissioner has designated that foreign country as a 
foreign country in which certification under paragraph 
(c)(2)(i)(D)(3)(i) of this section is not permissible.
    (G) The issuance of the obligation is subject to guidelines or 
restrictions imposed by governmental, banking or securities authorities 
in that foreign country.
    (H) More than 80 percent by value of the obligations included in the 
offering of which the obligation is a part are offered and sold to non-
distributors by distributors maintaining an office located in that 
foreign country. Foreign currency denominated obligations that

[[Page 296]]

are convertible into U.S. dollar denominated obligations or that by 
their terms are linked to the U.S. dollar in a way which effectively 
converts the obligations to U.S. dollar denominated obligations do not 
satisfy the requirements of this paragraph (c)(2)(i)(D)(3)(iii). A 
foreign currency denominated obligation will not be treated as linked, 
by its terms, to the U.S. dollar solely because the obligation is the 
subject of a swap transaction.
    (4) Distributor. For purposes of this paragraph (c)(2)(i)(D), the 
term ``distributor'' means:
    (i) A person that offers or sells the obligation during the 
restricted period pursuant to a written contract with the issuer;
    (ii) Any person that offers or sells the obligation during the 
restricted period pursuant to a written contract with a person described 
in paragraph (c)(2)(i)(D) (4) (i); and
    (iii) Any affiliate that acquires the obligation from another member 
of its affiliated group for the purpose of offering or selling the 
obligation during the restricted period, but only if the transferor 
member of the group is the issuer or a person described in paragraph 
(c)(2)(i)(D) (4)(i) or (ii) of this section. The terms ``affiliate'' and 
``affiliated group'' have the same meanings as in section 1504(a) of the 
Code, but without regard to the exceptions contained in section 1504(b) 
and substituting ``50 percent'' for ``80 percent'' each time it appears.

For purposes of this paragraph (c)(2)(i)(D)(4), a written contract does 
not include a confirmation or other notice of the transaction.
    (5) Exempt distributor. For purposes of this paragraph (c)(2)(i)(D), 
the term ``exempt distributor'' means a distributor that convenants in 
its contract with the issuer or with a distributor described in 
paragraph (c)(2)(i)(D)(4)(i) that it is buying the obligation for the 
purpose of resale in connection with the original issuance of the 
obligation, and that if it retains the obligation for its own account, 
it will only do so in accordance with the requirements of paragraph 
(c)(2)(i)(D)(6) of this section. In the latter case, the convenant will 
constitute the certificate required under paragraph (c)(2)(i)(D)(6). The 
provisions of paragraph (c)(2)(i)(D)(7) governing the restricted period 
for unsold allotments or subscriptions shall apply to any obligation 
retained for investment by an exempt distributor.
    (6) Certain United States persons. A person is described in this 
paragraph (c)(2)(i)(D)(6) if the requirements of this paragraph are 
satisfied and the person is:
    (i) The foreign branch of a United States financial institution 
purchasing for its own account or for resale, or
    (ii) A United States person who acquired the obligation through the 
foreign branch of a United States financial institution and who, for 
purposes of the certification required in paragraph (c)(2)(i)(D)(3) of 
this section, holds the obligation through such financial institution on 
the date of certification.

For purposes of paragraph (c)(2)(i)(D)(6)(ii) of this section, a United 
States person will be considered to acquire and hold an obligation 
through the foreign branch of a United States financial institution if 
the United States person has an account with the United States office of 
a financial institution, and the transaction is executed by a foreign 
office of that financial institution, or by the foreign office of 
another financial institution acting on behalf of that financial 
institution. This paragraph (c)(2)(i)(D)(6) will apply, however, only if 
the United States financial institution (or the United States office of 
a foreign financial institution) holding the obligation provides a 
certificate to the issuer or distributor selling the obligation within a 
reasonable time stating that it agrees to comply with the requirements 
of section 165(j)(3)(A), (B), or (C) and the regulations thereunder. For 
purposes of this paragraph (c)(2)(i)(D)(6), the term ``financial 
institution'' means a financial institution as defined in Sec.  1.165-
12(c)(1)(v). As an alternative to the certification required above, a 
financial institution may provide a blanket certificate to the issuer or 
distributor selling the obligation stating that the financial 
institution will comply with the requirements of section 165(j)(3)(A), 
(B) or (C) and the

[[Page 297]]

regulations thereunder. A blanket certificate must be received by the 
issuer or the distributor in the year of the issuance of the obligation 
or in either of the preceding two calendar years, and must be retained 
by the issuer or distributor for at least four years after the end of 
the last calendar year to which it relates.
    (7) Restricted period. For purposes of this paragraph (c)(2)(i)(D), 
the restricted period with respect to an obligation begins on the 
earlier of the closing date (or the date on which the issuer receives 
the loan proceeds, if there is no closing with respect to the 
obligation), or the first date on which the obligation is offered to 
persons other than a distributor. The restricted period with respect to 
an obligation ends on the expiration of the forty day period beginning 
on the closing date (or the date on which the issuer receives the loan 
proceeds, if there is no closing with respect to the obligation). 
Notwithstanding the preceding sentence, any offer or sale of the 
obligation by the issuer or a distributor shall be deemed to be during 
the restricted period if the issuer or distributor holds the obligation 
as part of an unsold allotment or subscription.
    (8) Clearing organization. For purposes of this paragraph 
(c)(2)(i)(D), a ``clearing organization'' is an entity which is in the 
business of holding obligations for member organizations and 
transferring obligations among such members by credit or debit to the 
account of a member without the necessity of physical delivery of the 
obligation.
    (ii) Special rules. An obligation shall not be considered to be 
described in paragraph (c)(2)(i)(C) of this section if it is--
    (A) Guaranteed by a United States shareholder of the issuer;
    (B) Convertible into a debt or equity interest in a United States 
shareholder of the issuer; or
    (C) Substantially identical to an obligation issued by a United 
States shareholder of the issuer.

For purposes of this paragraph (c)(2)(ii), the term ``United States 
shareholder'' is defined as it is defined in section 951 (b) and the 
regulations thereunder. For purposes of this paragraph (c)(2)(ii)(C), 
obligations are substantially identical if the face amount, interest 
rate, term of the issue, due dates for payments, and maturity date of 
each is substantially identical to the other.
    (iii) Interstate commerce. For purposes of this paragraph, the term 
``interstate commerce'' means trade or commerce in obligations or any 
transportation or communication relating thereto between any foreign 
country and the United States or its possessions.
    (A) An issuer will not be considered to engage significantly in 
interstate commerce with respect to the issuance of an obligation if the 
only activities with respect to which the issuer uses the means or 
instrumentalities of interstate commerce are activities of a preparatory 
or auxiliary character that do not involve communication between a 
prospective purchaser and an issuer, its agent, an underwriter, or 
member of the selling group if either is inside the United States or its 
possessions. Activities of a preparatory or auxiliary character include, 
but are not limited to, the following activities:
    (1) Establishment or participation in establishment of policies 
concerning the issuance of obligations and the allocation of funding by 
a United States shareholder with respect to obligations issued by a 
foreign corporation or by a United States office with respect to 
obligations issued by a foreign branch;
    (2) Negotiation between the issuer and underwriters as to the terms 
and pricing of an issue;
    (3) Transfer of funds to an office of an issuer in the United States 
or its possessions by a foreign branch or to a United States shareholder 
by a foreign corporation;
    (4) Consultation by an issuer with accountants and lawyers or other 
financial advisors in the United States or its possessions regarding the 
issuance of an obligation;
    (5) Document drafting and printing; and
    (6) Provision of payment or delivery instructions to members of the 
selling group by an issuer's office or agent that is located in the 
United States or its possessions.
    (B) Activities that will not be considered to be of a preparatory or 
auxiliary

[[Page 298]]

character include, but are not limited to, any of the following 
activities:
    (1) Negotiation or communication between a prospective purchaser and 
an issuer, its agent, an underwriter, or a member of the selling group 
concerning the sale of an obligation if either is inside the United 
States or its possessions;
    (2) Involvement of an issuer's office, its agent, an underwriter, or 
a member of the selling group in the United States or its possessions in 
the offer or sale of a particular obligation, either directly with the 
prospective purchaser, or through the issuer in a foreign country;
    (3) Delivery of an obligation in the United States or its 
possessions; or
    (4) Advertising or otherwise promoting an obligation in the United 
States or its possessions.
    (C) The following examples illustrate the application of this 
subdivision (iii) of Sec.  1.163-5(c)(2).

    Example 1. Foreign corporation A, a corporation organized in and 
doing business in foreign country Z, and not a controlled foreign 
corporation within the meaning of section 957(a) that is engaged in the 
conduct of a banking business within the meaning of section 954(c)(3)(B) 
as in effect before the Tax Reform Act of 1986, issues its debentures 
outside the United States. The debentures are not guaranteed by a United 
States shareholder of A, nor are they convertible into a debt or equity 
interest of a United States shareholder of A, nor are they substantially 
identical to an obligation issued by a United States shareholder of A. A 
consults its accountants and lawyers in the United States for certain 
securities and tax advice regarding the debt offering. The underwriting 
and selling group in respect to A's offering is composed entirely of 
foreign securities firms, some of which are foreign subsidiaries of 
United States securities firms. A U.S. affiliate of the foreign 
underwriter communicates payment and delivery instructions to the 
selling group. All offering circulars for the offering are mailed and 
delivered outside the United States and its possessions. All debentures 
are delivered and paid for outside the United States and its 
possessions. No office located in the United States or in a United 
States possession is involved in the sale of debentures. Interest on the 
debentures is payable only outside the United States and its 
possessions. A is not significantly engaged in interstate commerce with 
respect to the offering.
    Example 2. B, a United States bank, does business in foreign country 
X through a branch located in X. The branch is a staffed and operating 
unit engaged in the active conduct of a banking business consisting of 
one or more of the activities set forth in Sec.  1.954-2(d)(2)(ii). As 
part of its ongoing business, the branch in X issues negotiable 
certificates of deposit with a maturity in excess of one year to 
customers upon request. The certificates of deposit are not guaranteed 
by a United States shareholder of B, nor are they convertible into a 
debt or equity interest of a United States shareholder of B, nor are 
they substantially identical to an obligation issued by a United States 
shareholder of B. Policies regarding the issuance of negotiable 
certificates of deposit and funding allocations for foreign branches are 
set in the United States at B's main office. Branch personnel decide 
whether to issue a negotiable certificate of deposit based on the 
guidelines established by the United States offices of B, but without 
communicating with the United States offices of B with respect to the 
issuance of a particular obligation. Negotiable certificates of deposits 
are delivered and paid for outside the United States and its 
possessions. Interest on the negotiable certificates of deposit is 
payable only outside the United States and its possessions. B maintains 
documentary evidence described in Sec.  1.163-5(c)(2)(i)(C)(4). After 
the issuance of negotiable certificates of deposit by the foreign branch 
of B, the foreign branch sends the funds to a United States branch of B 
for use in domestic operations. B is not significantly engaged in 
interstate commerce with respect to the issuance of such obligation.
    Example 3. The facts in Example (2) apply except that the foreign 
branch of B consulted, by telephone, the main office in the United 
States to request approval of the issuance of the certificate of deposit 
at a particular rate of interest. The main office granted permission to 
issue the negotiable certificate of deposit to the customer by a telex 
sent from the main office of B to the branch in X. B is significantly 
engaged in interstate commerce with respect to the issuance of the 
obligation as a result of involvement of B's United States office in the 
issuance of the obligation.
    Example 4. The facts in Example (2) apply with the additional fact 
that a customer contacted the foreign branch of B through a telex 
originating in the United States or its possessions. Subsequent to the 
telex, the foreign branch issued the negotiable certificate of deposit 
and recorded it on the books. B is significantly engaged in interstate 
commerce with respect to the issuance of the obligation as a result of 
its communication by telex with a customer in the United States.


[[Page 299]]


    (iv) Possessions. For purposes of this section, the term 
``possessions'' includes Puerto Rico, the U.S. Virgin Islands, Guam, 
American Samoa, Wake Island, and Northern Mariana Islands.
    (v) Interest payable outside of the United States. Interest will be 
considered payable only outside the United States and its possessions if 
payment of such interest can be made only upon presentation of a coupon, 
or upon making of any other demand for payment, outside of the United 
States and its possessions to the issuer or a paying agent. The fact 
that payment is made by a draft drawn on a United States bank account or 
by a wire or other electronic transfer from a United States account does 
not affect this result. Interest payments will be considered to be made 
within the United States if the payments are made by a transfer of funds 
into an account maintained by the payee in the United States or mailed 
to an address in the United States, if--
    (A) The interest is paid on an obligation issued by either a United 
States person, a controlled foreign corporation as defined in section 
957 (a), or a foreign corporation if 50 percent or more of the gross 
income of the foreign corporation from all sources of the 3-year period 
ending with the close of its taxable year preceding the original 
issuance of the obligation (or for such part of the period that the 
foreign corporation has been in existence) was effectively connected 
with the conduct of a trade or business within the United States; and
    (B) The interest is paid to a person other than--
    (1) A person who may satisfy the requirements of section 165 (j)(3) 
(A), (B), or (C) and the regulations thereunder; and
    (2) A financial institution as a step in the clearance of funds and 
such interest is promptly credited to an account maintained outside the 
United States for such financial institution or for persons for which 
the financial institution has collected such interest.

Interest is considered to be paid within the United States and its 
possessions if a coupon is presented, or a demand for payment is 
otherwise made, to the issuer or a paying agent (whether a United States 
or foreign person) in the United States and its possessions even if the 
funds paid are credited to an account maintained by the payee outside 
the United States and its possessions. Interest will be considered 
payable only outside the United States and its possessions 
notwithstanding that such interest may become payable at the office of 
the issuer or its United States paying agent under the following 
conditions: the issuer has appointed paying agents located outside the 
United States and its possessions with the reasonable expectation that 
such paying agents will be able to pay the interest in United States 
dollars, and the full amount of such payment at the offices of all such 
paying agents is illegal or effectively precluded because of the 
imposition of exchange controls or other similar restrictions on the 
full payment or receipt of interest in United States dollars. A lawsuit 
brought in the United States or its possessions for payment of the 
obligation or interest thereon as a result of a default shall not be 
considered to be a demand for payment. For purposes of this subdivision 
(v), interest includes original issue discount as defined in section 
1273(a). Therefore, an amount equal to the original issue discount as 
defined in section 1273(a) is payable only outside the United States and 
its possessions. The amount of market discount as defined in section 
1278(a) does not affect the amount of interest to be considered payable 
only outside the United States and its possessions.
    (vi) Rules relating to obligations issued after December 31, 1982 
and on or before September 21, 1984. Whether an obligation originally 
issued after December 31, 1982 and on or before September 21, 1984, or 
an obligation originally issued after September 21, 1984 pursuant to the 
exercise of a warrant or the conversion of a convertible obligation, 
which warrant or obligation (including conversion privilege) was issued 
after December 31, 1982 and on or before September 21, 1984, is 
described in section 163(f)(2)(B) shall be determined under the rules 
provided in Sec.  5f.163-1(c) as in effect prior to its removal. 
Notwithstanding the preceding sentence, an issuer will be considered to 
satisfy the requirements of section 163(f)(2)(B)

[[Page 300]]

with respect to an obligation issued after December 31, 1982 and on or 
before September 21, 1984 or after September 21, 1984 pursuant to the 
exercise of a warrant or the conversion of a convertible obligation, 
which warrant or obligation (including conversion privilege) was issued 
after December 31, 1982 and on or before September 21, 1984, if the 
issuer substantially complied with the proposed regulations provided in 
Sec.  1.163-5(c), which were published in the Federal Register on 
September 2, 1983 (48 FR 39953) and superseded by temporary regulations 
published in the Federal Register on August 22, 1984 (49 FR 33228).
    (3) Effective date--(i) In general. These regulations apply 
generally to obligations issued after January 20, 1987. A taxpayer may 
choose to apply the rules of Sec.  1.163-5(c) with respect to an 
obligation issued after December 31, 1982 and on or before January 20, 
1987. If this choice is made, the rules of Sec.  1.163-5(c) will apply 
in lieu of Sec.  1.163-5T(c) except that the legend requirement under 
Sec.  1.163-5(c)(l)(ii)(B) does not apply with respect to a bearer 
obligation evidenced exclusively by a book entry and that the 
certification requirement under Sec.  1.163-5T(c)(2)(B)(4) applies in 
lieu of the certification under Sec.  1.163-5(c)(2)(i)(B)(4).
    (ii) Special rules. If an obligation is originally issued after 
September 7, 1990 pursuant to the exercise of a warrant or the 
conversion of a convertible obligation, which warrant or obligation 
(including conversion privilege) was issued on or before May 10, 1990, 
then the issuer may choose to apply either the rules of Sec.  1.163-
5(c)(2)(i)(A) or Sec.  1.163-5(c)(2)(i)(B), or the rules of Sec.  1.163-
5(c)(2)(i)(D). The issuer of an obligation may choose to apply either 
the rules of Sec.  1.163-5(c)(2)(i) (A) or (B), or the rules of Sec.  
1.163-5(c)(2)(i)(D), to an obligation that is originally issued after 
May 10, 1990, and on or before September 7, 1990. However, any issuer 
choosing to apply the rules of Sec.  1.163-5(c)(2)(i)(A) must apply the 
definition of United States person used for such purposes on December 
31, 1989, and must obtain any certificates that would have been required 
under applicable law on December 31, 1989.

[T.D. 8110, 51 FR 45456, Dec. 19, 1986, as amended by T.D. 8203, 53 FR 
17926, May 19, 1988; T.D. 8300, 55 FR 19624, May 10, 1990; T.D. 8734, 62 
FR 53416, Oct. 14, 1997]



Sec.  1.163-5T  Denial of interest deduction on certain obligations 
issued after December 31, 1982, unless issued in registered form (temporary).

    (a)-(c) [Reserved]
    (d) Pass-through certificates. (1) A pass-through or participation 
certificate evidencing an interest in a pool of mortgage loans which 
under subpart E of subchapter J of the Code is treated as a trust of 
which the grantor is the owner (or similar evidence of interest in a 
similar pooled fund or pooled trust treated as a grantor trust) (``pass-
through certificate'') is considered to be a ``registration-required 
obligation'' under section 163(f)(2)(A) and Sec.  1.163-5(c) if the 
pass-through certificate is described in section 163(f)(2)(A) and Sec.  
1.163-5(c) without regard to whether any obligation held by the fund or 
trust to which the pass-through certificate relates is described in 
section 163(f)(2)(A) and Sec.  1.163-5(c). A pass-through certificate is 
considered to be described in section 163(f)(2)(B) and Sec.  1.163-5(c) 
if the pass-through certificate is described in section 163(f)(2)(B) and 
Sec.  1.163-5(c) without regard to whether any obligation held by the 
fund or trust to which the pass-through certificate relates is described 
in section 163(f)(2)(B) and Sec.  1.163-5(c).
    (2) An obligation held by a fund or trust in which ownership 
interests are represented by pass-through certificates is considered to 
be in registered form under section 149(a) and the regulations 
thereunder or to be described in section 163(f)(2) (A) or (B), if the 
obligation held by the fund or trust is in registered form under section 
149(a) and the regulations thereunder or is described in section 
163(f)(2) (A) or (B), respectively, without regard to whether the pass-
through certificates are so considered.
    (3) For purposes of section 4701, a pass-through certificate is 
considered to be issued solely by the recipient of the proceeds from the 
issuance of the pass-through certificate (hereinafter

[[Page 301]]

the ``sponsor''). The sponsor is therefore liable for any excise tax 
under section 4701 that may be imposed with reference to the principal 
amount of the pass-through certificate.
    (4) In order to implement the purpose of section 163, Sec.  1.163-
5(c) and this section, the Commissioner may characterize a certificate 
or other evidence of interest in a fund or trust which under subpart E 
of subchapter J of the Code is treated as a trust of which the grantor 
is the owner and any obligation held by such fund or trust in accordance 
with the substance of the arrangement they represent and may impose the 
penalties provided under sections 163(f)(1) and 4701 in the appropriate 
amounts and on the appropriate persons. This provision may be applied, 
for example, where a corporation issues obligations purportedly in 
registered form, contributes them to a grantor trust as its only assets, 
and arranges for the sale to investors of bearer certificates of 
interest in the trust which do not meet the requirements of section 
163(f)(2)(B). If this provision is applied, the obligations held by the 
fund or trust will not be considered to be issued in registered form or 
to meet the requirements of section 163(f)(2)(B). The corporation will 
not be allowed a deduction for the payment of interest on the 
obligations held by the trust, and the excise tax under section 4701, 
calculated with reference to the principal amount of the obligations 
held by the trust will be imposed on the corporation may be collected 
from the corporation and its agents. This paragraph (d)(4) will not be 
applied so as to alter the tax consequences of transactions as to which 
rulings have been issued by the Internal Revenue Service prior to 
September 19, 1985.
    (5) The rules set forth in this paragraph (d) apply solely for 
purposes of sections 4701, 163(f)(2)(A), 163(f)(2)(B), Sec.  1.163-5(c), 
and any other section that refers to this section for the definition of 
the term ``registration-required obligation'' (such as the regulations 
under sections 871(h) and 881(c)). The treatment of obligations 
described in this paragraph (d) for purposes of section 163(f)(2) (A) 
and (B) does not affect the determination of whether bearer obligations 
that are issued or guaranteed by the United States Government, a United 
States Government-owned agency, a United States Government sponsored 
enterprise (within the meaning of Sec.  1.163-5(c)(1)) or that are 
backed (as described in the Treasury Department News Release R-2835 of 
September 10, 1984 and Treasury Department News Release R-2847 of 
September 14, 1984) by obligations issued by the United States 
Government, a United States Government-owned agency, or a United States 
Government sponsored enterprise comply with the requirements of section 
163(f)(2)(B) and the regulations thereunder.
    (6) The provisions of paragraphs (d) (1) through (5) may be 
illustrated by the following example:

    Commercial Bank K forms a pool of 1000 residential mortgage loans, 
each made to a different individual homeowner, by assigning them to 
Commercial Bank L, an unrelated entity serving as trustee of the pool. 
Commercial Bank L immediately sells in a public offering certificates of 
interest in the trust of a maturity of 10 years in registered form. 
Commercial Bank L transfers the cash proceeds of the offering to 
Commercial Bank K. The certificates of interest in the trust are of a 
type offered to the public and are not described in section 
163(f)(2)(B). Pursuant to paragraph (d)(1), the certificates of interest 
in the pool are registration-required obligations without regard to the 
fact that the obligations held by the trust are not registration-
required obligations.

    (e) Regular interests in REMICS. (1) A regular interest in a REMIC, 
as defined in sections 860D and 860G and the regulations thereunder, is 
considered to be a ``registration-required obligation'' under section 
163(f)(2)(A) and Sec.  1.163-5(c) if the regular interest is described 
in section 163(f)(2)(A) and Sec.  1.163-5(c), without regard to whether 
any obligation held by the REMIC to which the regular interest relates 
is described in section 163(f)(2)(A) and Sec.  1.163-5(c). A regular 
interest in a REMIC is considered to be described in section 
163(f)(2)(B) and Sec.  1.163-5(c), if the regular interest is described 
in section 163(f)(2)(B) and Sec.  1.163(c), without regard to whether 
any obligation held by the REMIC to which the regular interest relates 
is described in section 163(f)(2)(B) and Sec.  1.163-5(c).
    (2) An obligation held by a REMIC is considered to be described in 
section

[[Page 302]]

163(f)(2) (A) or (B) if such obligation is described in section 
163(f)(2) (A) or (B), respectively, without regard to whether the 
regular interests in the REMIC are so considered.
    (3) For purposes of section 4701, a regular interest is considered 
to be issued solely by the recipient of the proceeds from the issuance 
of the regular interest (hereinafter the ``sponsor''). The sponsor is 
therefore liable for any excise tax under section 4701 that may be 
imposed with reference to the principal amount of the regular interest.
    (4) In order to implement the purpose of section 163, Sec.  1.163-
5(c), and this section, the Commissioner may characterize a regular 
interest in a REMIC and any obligation held by such REMIC in accordance 
with the substance of the arrangement they represent and may impose the 
penalties provided under sections 163(f)(1) and 4701 in the appropriate 
amounts and on the appropriate persons. This provision may be applied, 
for example, where a corporation issues an obligation that is 
purportedly in registered form and that will qualify as a ``qualified 
mortgage'' within the meaning of section 860G(a)(3) in the hands of a 
REMIC, contributes the obligation to a REMIC as its only asset, and 
arranges for the sale to investors of regular interests in the REMIC in 
bearer form that do not meet the requirements of section 163(f)(2)(B). 
If this provision is applied, the obligation held by the REMIC will not 
be considered to be issued in registered form or to meet the 
requirements of section 163(f)(2)(B). The corporation will not be 
allowed a deduction for the payment of interest on the obligation held 
by the REMIC, and the excise tax under section 4701, calculated with 
reference to the principal amount of the obligation held by the REMIC, 
will be imposed on the corporation and may be collected from the 
corporation and its agents.

[T.D. 8202, 53 FR 17928, May 19, 1988, as amended by T.D. 8300, 55 FR 
19626, May 10, 1990]



Sec.  1.163-6T  Reduction of deduction where section 25 credit taken 
(temporary).

    (a) In general. The amount of the deduction under section 163 for 
interest paid or accrued during any taxable year on a certified 
indebtedness amount with respect to a mortgage credit certificate which 
has been issued under section 25 shall be reduced by the amount of the 
credit allowable with respect to such interest under section 25 
(determined without regard to section 26).
    (b) Cross reference. See Sec. Sec.  1.25-1T through 1.25-8T with 
respect to rules relating to mortgage credit certificates.

[T.D. 8023, 50 FR 19355, May 8, 1985]



Sec.  1.163-7  Deduction for OID on certain debt instruments.

    (a) General rule. Except as otherwise provided in paragraph (b) of 
this section, an issuer (including a transferee) determines the amount 
of OID that is deductible each year under section 163(e)(1) by using the 
constant yield method described in Sec.  1.1272-1(b). This 
determination, however, is made without regard to section 1272(a)(7) 
(relating to acquisition premium) and Sec.  1.1273-1(d) (relating to de 
minimis OID). An issuer is permitted a deduction under section 163(e)(1) 
only to the extent the issuer is primarily liable on the debt 
instrument. For certain limitations on the deductibility of OID, see 
sections 163(e) and 1275(b)(2). To determine the amount of interest 
(OID) that is deductible each year on a debt instrument that provides 
for contingent payments, see Sec.  1.1275-4.
    (b) Special rules for de minimis OID--(1) Stated interest. If a debt 
instrument has a de minimis amount of OID (within the meaning of Sec.  
1.1273-1(d)), the issuer treats all stated interest on the debt 
instrument as qualified stated interest. See Sec. Sec.  1.446-2(b) and 
1.461-1 for the treatment of qualified stated interest.
    (2) Deduction of de minimis OID on other than a constant yield 
basis. In lieu of deducting de minimis OID under the general rule of 
paragraph (a) of this section, an issuer of a debt instrument with a de 
minimis amount of OID (other than a de minimis amount treated as 
qualified stated interest under paragraph (b)(1) of this section) may 
choose to deduct the OID at maturity, on a straight-line basis over the 
term of the debt instrument, or in proportion to stated interest 
payments. The issuer makes this choice by reporting

[[Page 303]]

the de minimis OID in a manner consistent with the method chosen on the 
issuer's timely filed Federal income tax return for the taxable year in 
which the debt instrument is issued.
    (c) Deduction upon repurchase. Except to the extent disallowed by 
any other section of the Internal Revenue Code (e.g., section 249) or 
this paragraph (c), if a debt instrument is repurchased by the issuer 
for a price in excess of its adjusted issue price (as defined in Sec.  
1.1275-1(b)), the excess (repurchase premium) is deductible as interest 
for the taxable year in which the repurchase occurs. If the issuer 
repurchases a debt instrument in a debt-for-debt exchange, the 
repurchase price is the issue price of the newly issued debt instrument 
(reduced by any unstated interest within the meaning of section 483). 
However, if the issue price of the newly issued debt instrument is 
determined under either section 1273(b)(4) or section 1274, any 
repurchase premium is not deductible in the year of the repurchase, but 
is amortized over the term of the newly issued debt instrument in the 
same manner as if it were OID.
    (d) Choice of accrual periods to determine whether a debt instrument 
is an applicable high yield discount obligation (AHYDO). Section 
163(e)(5) affects an issuer's OID deductions for certain high yield debt 
instruments that have significant OID. For purposes of section 
163(i)(2), which defines significant OID, the issuer's choice of accrual 
periods to determine OID accruals is used to determine whether a debt 
instrument has significant OID. See Sec.  1.1275-2(e) for rules relating 
to the issuer's obligation to disclose certain information to holders.
    (e) Qualified reopening--(1) In general. In a qualified reopening of 
an issue of debt instruments, if a holder pays more or less than the 
adjusted issue price of the original debt instruments to acquire an 
additional debt instrument, the issuer treats this difference as an 
adjustment to the issuer's interest expense for the original and 
additional debt instruments. As provided by paragraphs (e)(2) through 
(5) of this section, the adjustment is taken into account over the term 
of the instrument using constant yield principles.
    (2) Positive adjustment. If the difference is positive (that is, the 
holder pays more than the adjusted issue price of the original debt 
instrument), then, with respect to the issuer but not the holder, the 
difference increases the aggregate adjusted issue prices of all of the 
debt instruments in the issue, both original and additional.
    (3) Negative adjustment. If the difference is negative (that is, the 
holder pays less than the adjusted issue price of the original debt 
instrument), then, with respect to the issuer but not the holder, the 
difference reduces the aggregate adjusted issue prices of all of the 
debt instruments in the issue, both original and additional.
    (4) Determination of issuer's interest accruals. As of the reopening 
date, the issuer must redetermine the yield of the debt instruments in 
the issue for purposes of applying the constant yield method described 
in Sec.  1.1272-1(b) to determine the issuer's accruals of interest 
expense over the remaining term of the debt instruments in the issue. 
This redetermined yield is based on the aggregate adjusted issue prices 
of the debt instruments in the issue (as determined under this paragraph 
(e)) and the remaining payment schedule of the debt instruments in the 
issue. If the aggregate adjusted issue prices of the debt instruments in 
the issue (as determined under this paragraph (e)) are less than the 
aggregate stated redemption price at maturity of the instruments 
(determined as of the reopening date) by a de minimis amount (within the 
meaning of Sec.  1.1273-1(d)), the issuer may use the rules in paragraph 
(b) of this section to determine the issuer's accruals of interest 
expense.
    (5) Effect of adjustments on issuer's adjusted issue price. The 
adjustments made under this paragraph (e) are taken into account for 
purposes of determining the issuer's adjusted issue price under Sec.  
1.1275-1(b).
    (6) Definitions. The terms additional debt instrument, original debt 
instrument, qualified reopening, and reopening date have the same 
meanings as in Sec.  1.1275-2(k).
    (f) Effective dates. This section (other than paragraph (e) of this 
section) applies to debt instruments issued on or after April 4, 1994. 
Taxpayers, however,

[[Page 304]]

may rely on this section (other than paragraph (e) of this section) for 
debt instruments issued after December 21, 1992, and before April 4, 
1994. Paragraph (e) of this section applies to qualified reopenings 
where the reopening date is on or after March 13, 2001.

[T.D. 8517, 59 FR 4804, Feb. 2, 1994, as amended by T.D. 8674, 61 FR 
30138, June 14, 1996; T.D. 8934, 66 FR 2815, Jan. 12, 2001]



Sec.  1.163-8T  Allocation of interest expense among expenditures (temporary).

    (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.


[[Page 305]]


    (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.


[[Page 306]]


    (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 x .055) is allocated to the investment expenditure. The 
remaining $55 of interest expense for the period from July 1 through 
December 31 ($1,000 x .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 x $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 Sec.  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.

[[Page 307]]

 
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  .........................
----------------------------------------------------------------------------------------------------------------

    (3) 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):


[[Page 308]]


    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 
unborrowed 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.

[[Page 309]]

    (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

[[Page 310]]

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 
x $30,000/$60,000), $1,000 to the passive activity expenditure ($3,000 x 
$20,000/$60,000), and $500 ($3,000 x $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 expenditure 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

[[Page 311]]

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 x $40,000/$80,000) to the personal expenditure, $1,250 
($5,000 x $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

[[Page 312]]

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

[[Page 313]]

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)

[[Page 314]]

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).

[[Page 315]]

    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

[[Page 316]]

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 Sec.  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

[[Page 317]]

amended return) for the first taxable year beginning after December 31, 
1986, a statement to that effect, prominently identified as as election 
out under Sec.  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.

[T.D. 8145, 52 FR 24999, July 2, 1987, as amended by T.D. 8145, 62 FR 
40270, July 28, 1997]



Sec.  1.163-9T  Personal interest (temporary).

    (a) In general. No deduction under any provision of Chapter 1 of the 
Internal Revenue Code shall be allowed for personal interest paid or 
accrued during the taxable year by a taxpayer other than a corporation.
    (b) Personal interest--(1) Definition. For purposes of this section, 
personal interest is any interest expense other than--
    (i) Interest paid or accrued on indebtedness properly allocable 
(within the meaning of Sec.  1.163-8T) to the conduct of trade or 
business (other than the trade or business of performing services as an 
employee),
    (ii) Any investment interest (within the meaning of section 
163(d)(3)),
    (iii) Any interest that is taken into account under section 469 in 
computing income or loss from a passive activity of the taxpayer,
    (iv) Any qualified residence interest (within the meaning of section 
163(h)(3) and Sec.  1.163-10T), and
    (v) Any interest payable under section 6601 with respect to the 
unpaid portion of the tax imposed by section 2001 for the period during 
which an extension of time for payment of such tax is in effect under 
section 6163, 6166, or 6166A (as in effect before its repeal by the 
Economic Recovery Tax Act of 1981).
    (2) Interest relating to taxes--(i) In general. Except as provided 
in paragraph (b)(2)(iii) of this section, personal interest includes 
interest--
    (A) Paid on underpayments of individual Federal, State or local 
income taxes and on indebtedness used to pay such taxes (within the 
meaning of Sec.  1.163-8T), regardless of the source of the income 
generating the tax liability;
    (B) Paid under section 453(e)(4)(B) (interest on deferred tax 
resulting from certain installment sales) and section 1291(c) (interest 
on deferred tax attributable to passive foreign investment companies); 
or
    (C) Paid by a trust, S corporation, or other pass-through entity on 
underpayments of State or local income taxes and on indebtedness used to 
pay such taxes.
    (ii) Example. A, an individual, owns stock of an S corporation. On 
its return for 1987, the corporation underreports its taxable income. 
Consequently, A underreports A's share of that income on A's tax return. 
In 1989, A pays the resulting deficiency plus interest to the Internal 
Revenue Service. The interest paid by A in 1989 on the tax deficiency is 
personal interest, notwithstanding the fact that the additional tax 
liability may have arisen out of income from a trade or business. The 
result would be the same if A's business had been operated as a sole 
proprietorship.
    (iii) Certain other taxes. Personal interest does not include 
interest--
    (A) Paid with respect to sales, excise and similar taxes that are 
incurred in connection with a trade or business or an investment 
activity;
    (B) Paid by an S corporation with respect to an underpayment of 
income tax from a year in which the S corporation was a C corporation or 
with respect to an underpayment of the taxes imposed by sections 1374 or 
1375, or similar provision of State law; or
    (C) Paid by a transferee under section 6901 (tax liability resulting 
from transferred assets), or a similar provision of State law, with 
respect to a C corporation's underpayment of income tax.
    (3) Cross references. See Sec.  1.163-8T for rules for determining 
the allocation of interest expense to various activities. See Sec.  
1.163-10T for rules concerning qualified residence interest.

[[Page 318]]

    (c) Effective date--(1) In general. The provisions of this section 
are effective for taxable years beginning after December 31, 1986. In 
the case of any taxable year beginning in calendar years 1987 through 
1990, the amount of personal interest that is nondeductible under this 
section is limited to the applicable percentage of such amount.
    (2) Applicable percentages. The applicable percentage for taxable 
years beginning in 1987 through 1990 are as follows:

1987: 35 percent
1988: 60 percent
1989: 80 percent
1990: 90 percent

[T.D. 8168, 52 FR 48409, Dec. 22, 1987; 68 FR 13226, Mar. 19, 2003]



Sec.  1.163-10T  Qualified residence interest (temporary).

    (a) Table of contents. This paragraph (a) lists the major paragraphs 
that appear in this Sec.  1.163-10T.

    (a) Table of contents.
    (b) Treatment of qualified residence interest.
    (c) Determination of qualified residence interest when secured debt 
does not exceed the adjusted purchase price.
    (1) In general.
    (2) Examples.
    (d) Determination of qualified residence interest when secured debt 
exceeds adjusted purchase price--Simplified method.
    (1) In general.
    (2) Treatment of interest paid or accrued on secured debt that is 
not qualified residence interest.
    (3) Example.
    (e) Determination of qualified residence interest when secured debt 
exceeds adjusted purchase price--Exact method.
    (1) In general.
    (2) Determination of applicable debt limit.
    (3) Example.
    (4) Treatment of interest paid or accrued with respect to secured 
debt that is not qualified residence interest.
    (i) In general.
    (ii) Example.
    (iii) Special rule of debt is allocated to more than one 
expenditure.
    (iv) Example.
    (f) Special rules.
    (1) Special rules for personal property.
    (i) In general.
    (ii) Example.
    (2) Special rule for real property.
    (i) In general.
    (ii) Example.
    (g) Selection of method.
    (h) Average balance.
    (1) Average balance defined.
    (2) Average balance reported by lender.
    (3) Average balance computed on a daily basis.
    (i) In general.
    (ii) Example.
    (4) Average balance computed using the interest rate.
    (i) In general.
    (ii) Points and prepaid interest.
    (iii) Examples.
    (5) Average balance computed using average of beginning and ending 
balance.
    (i) In general.
    (ii) Example.
    (6) Highest principal balance.
    (7) Other methods provided by the Commissioner.
    (8) Anti-abuse rule.
    (i) [Reserved]
    (j) Determination of interest paid or accrued during the taxable 
year.
    (1) In general.
    (2) Special rules for cash-basis taxpayers.
    (i) Points deductible in year paid under section 461(g)(2).
    (ii) Points and other prepaid interest described in section 
461(g)(1).
    (3) Examples.
    (k) Determination of adjusted purchase price and fair market value.
    (1) Adjusted purchase price.
    (i) In general.
    (ii) Adjusted purchase price of a qualified residence acquired 
incident to divorce.
    (iii) Examples.
    (2) Fair market value.
    (i) In general.
    (ii) Examples.
    (3) Allocation of adjusted purchase price and fair market value.
    (l) [Reserved]
    (m) Grandfathered amount.
    (1) Substitution for adjusted purchase price.
    (2) Determination of grandfathered amount.
    (i) In general.
    (ii) Special rule for lines of credit and certain other debt.
    (iii) Fair market value limitation.
    (iv) Examples.
    (3) Refinancing of grandfathered debt.
    (i) In general.
    (ii) Determination of grandfathered amount.
    (4) Limitation on terms of grandfathered debt.
    (i) In general.
    (ii) Special rule for nonamortizing debt.
    (iii) Example.
    (n) Qualified indebtedness (secured debt used for medical and 
educational purposes).
    (1) In general.
    (i) Treatment of qualified indebtedness.

[[Page 319]]

    (ii) Determination of amount of qualified indebtedness.
    (iii) Determination of amount of qualified indebtedness for mixed-
use debt.
    (iv) Example.
    (v) Prevention of double counting in year of refinancing.
    (vi) Special rule for principal payments in excess of qualified 
expenses.
    (2) Debt used to pay for qualified medical or educational expenses.
    (i) In general.
    (ii) Special rule for refinancing.
    (iii) Other special rules.
    (iv) Examples.
    (3) Qualified medical expenses.
    (4) Qualified educational expenses.
    (o) Secured debt.
    (1) In general.
    (2) Special rule for debt in certain States.
    (3) Time at which debt is treated as secured.
    (4) Partially secured debt.
    (i) In general.
    (ii) Example.
    (5) Election to treat debt as not secured by a qualified residence.
    (i) In general.
    (ii) Example.
    (iii) Allocation of debt secured by two qualified residences.
    (p) Definition of qualified residence.
    (1) In general.
    (2) Principal residence.
    (3) Second residence.
    (i) In general.
    (ii) Definition of residence.
    (iii) Use as a residence.
    (iv) Election of second residence.
    (4) Allocations between residence and other property.
    (i) In general.
    (ii) Special rule for rental of residence.
    (iii) Examples.
    (5) Residence under construction.
    (i) In general.
    (ii) Example.
    (6) Special rule for the time-sharing arrangements.
    (q) Special rules for tenant-stockholders in cooperative housing 
corporations.
    (1) In general.
    (2) Special rule where stock may not be used to secure debt.
    (3) Treatment of interest expense of the cooperative described in 
section 216(a)(2).
    (4) Special rule to prevent tax avoidance.
    (5) Other definitions.
    (r) Effective date.

    (b) Treatment of qualified residence interest. Except as provided 
below, qualified residence interest is deductible under section 163(a). 
Qualified residence interest is not subject to limitation or otherwise 
taken into account under section 163(d) (limitation on investment 
interest), section 163(h)(1) (disallowance of deduction for personal 
interest), section 263A (capitalization and inclusion in inventory costs 
of certain expenses) or section 469 (limitations on losses from passive 
activities). Qualified residence interest is subject to the limitation 
imposed by section 263(g) (certain interest in the case of straddles), 
section 264(a) (2) and (4) (interest paid in connection with certain 
insurance), section 265(a)(2) (interest relating to tax-exempt income), 
section 266 (carrying charges), section 267(a)(2) (interest with respect 
to transactions between related taxpayers) section 465 (deductions 
limited to amount at risk), section 1277 (deferral of interest deduction 
allocable to accrued market discount), and section 1282 (deferral of 
interest deduction allocable to accrued discount).
    (c) Determination of qualified residence interest when secured debt 
does not exceed adjusted purchase price--(1) In general. If the sum of 
the average balances for the taxable year of all secured debts on a 
qualified residence does not exceed the adjusted purchase price 
(determined as of the end of the taxable year) of the qualified 
residence, all of the interest paid or accrued during the taxable year 
with respect to the secured debts is qualified residence interest. If 
the sum of the average balances for the taxable year of all secured 
debts exceeds the adjusted purchase price of the qualified residences 
(determined as of the end of the taxable year), the taxpayer must use 
either the simplified method (see paragraph (d) of this section) or the 
exact method (see paragraph (e) of this section) to determine the amount 
of interest that is qualified residence interest.
    (2) Examples.

    Example 1. T purchases a qualified residence in 1987 for $65,000. T 
pays $6,500 in cash and finances the remainder of the purchase with a 
mortgage of $58,500. In 1988, the average balance of the mortgage is 
$58,000. Because the average balance of the mortgage is less than the 
adjusted purchase price of the residence ($65,000), all of the interest 
paid or accrued during 1988 on the mortgage is qualified residence 
interest.
    Example 2. The facts are the same as in example (1), except that T 
incurs a second mortgage on January 1, 1988, with an initial

[[Page 320]]

principal balance of $2,000. The average balance of the second mortgage 
in 1988 is $1,900. Because the sum of the average balance of the first 
and second mortgages ($59,900) is less than the adjusted purchase price 
of the residence ($65,000), all of the interest paid or accrued during 
1988 on both the first and second mortgages is qualified residence 
interest.
    Example 3. P borrows $50,000 on January 1, 1988 and secures the debt 
by a qualified residence. P pays the interest on the debt monthly, but 
makes no principal payments in 1988. There are no other debts secured by 
the residence during 1988. On December 31, 1988, the adjusted purchase 
price of the residence is $40,000. The average balance of the debt in 
1988 is $50,000. Because the average balance of the debt exceeds the 
adjusted purchase price ($10,000), some of the interest on the debt is 
not qualified residence interest. The portion of the total interest that 
is qualified residence interest must be determined in accordance with 
the rules of paragraph (d) or paragraph (e) of this section.

    (d) Determination of qualified residence interest when secured debt 
exceeds adjusted purchase price--Simplified method--(1) In general. 
Under the simplified method, the amount of qualified residence interest 
for the taxable year is equal to the total interest paid or accrued 
during the taxable year with respect to all secured debts multiplied by 
a fraction (not in excess of one), the numerator of which is the 
adjusted purchase price (determined as of the end of the taxable year) 
of the qualified residence and the denominator of which is the sum of 
the average balances of all secured debts.
    (2) Treatment of interest paid or accrued on secured debt that is 
not qualified residence interest. Under the simplified method, the 
excess of the total interest paid or accrued during the taxable year 
with respect to all secured debts over the amount of qualified residence 
interest is personal interest.
    (3) Example.

    Example. R's principal residence has an adjusted purchase price on 
December 31, 1988, of $105,000. R has two debts secured by the 
residence, with the following average balances and interest payments:

------------------------------------------------------------------------
       Debt            Date secured     Average balance      Interest
------------------------------------------------------------------------
        Debt 1           June 1983           $80,000          $8,000
        Debt 2            May 1987            40,000           4,800
                                       ---------------------------------
         Total      ..................       120,000          12,800
------------------------------------------------------------------------


The amount of qualified residence interest is determined under the 
simplified method by multiplying the total interest ($12,800) by a 
fraction (expressed as a decimal amount) equal to the adjusted purchase 
price ($105,000) of the residence divided by the combined average 
balances ($120,000). For 1988, this fraction is equal to 0.875 
($105,000/$120,000). Therefore, $11,200 ($12,800 x 0.875) of the total 
interest is qualified residence interest. The remaining $1,600 in 
interest ($12,800 - $11,200) is personal interest, even if (under the 
rules of Sec.  1.163-8T) such remaining interest would be allocated to 
some other category of interest.

    (e) Determination of qualified residence interest when secured debt 
exceeds adjusted purchase price--Exact method--(1) In general. Under the 
exact method, the amount of qualified residence interest for the taxable 
year is determined on a debt-by-debt basis by computing the applicable 
debt limit for each secured debt and comparing each such applicable debt 
limit to the average balance of the corresponding debt. If, for the 
taxable year, the average balance of a secured debt does not exceed the 
applicable debt limit for that debt, all of the interest paid or accrued 
during the taxable year with respect to the debt is qualified residence 
interest. If the average balance of the secured debt exceeds the 
applicable debt limit for that debt, the amount of qualified residence 
interest with respect to the debt is determined by multiplying the 
interest paid or accrued with respect to the debt by a fraction, the 
numerator of which is the applicable debt limit for that debt and the 
denominator of which is the average balance of the debt.
    (2) Determination of applicable debt limit. For each secured debt, 
the applicable debt limit for the taxable year is equal to
    (i) The lesser of--
    (A) The fair market value of the qualified residence as of the date 
the debt is first secured, and
    (B) The adjusted purchase price of the qualified residence as of the 
end of the taxable year,
    (ii) Reduced by the average balance of each debt previously secured 
by the qualified residence.


For purposes of paragraph (e)(2)(ii) of this section, the average 
balance of a debt shall be treated as not exceeding

[[Page 321]]

the applicable debt limit of such debt. See paragraph (n)(1)(i) of this 
section for the rule that increases the adjusted purchase price in 
paragraph (e)(2)(i)(B) of this section by the amount of any qualified 
indebtedness (certain medical and educational debt). See paragraph (f) 
of this section for special rules relating to the determination of the 
fair market value of the qualified residence.
    (3) Example. (i) R's principal residence has an adjusted purchase 
price on December 31, 1988, of $105,000. R has two debts secured by the 
residence. The average balances and interest payments on each debt 
during 1988 and fair market value of the residence on the date each debt 
was secured are as follows:

------------------------------------------------------------------------
                                Fair market      Average
     Debt       Date secured       value         balance      Interest
------------------------------------------------------------------------
      Debt 1       June 1983       $100,000       $80,000        $8,000
      Debt 2        May 1987        140,000        40,000         4,800
                                             ---------------------------
       Total   ..............  .............      120,000        12,800
------------------------------------------------------------------------

    (ii) The amount of qualified residence interest for 1988 under the 
exact method is determined as follows. Because there are no debts 
previously secured by the residence, the applicable debt limit for Debt 
1 is $100,000 (the lesser of the adjusted purchase price as of the end 
of the taxable year and the fair market value of the residence at the 
time the debt was secured). Because the average balance of Debt 1 
($80,000) does not exceed its applicable debt limit ($100,000), all of 
the interest paid on the debt during 1988 ($8,000) is qualified 
residence interest.
    (iii) The applicable debt limit for Debt 2 is $25,000 ($105,000 (the 
lesser of $140,000 fair market value and $105,000 adjusted purchase 
price) reduced by $80,000 (the average balance of Debt 1)). Because the 
average balance of Debt 2 ($40,000) exceeds its applicable debt limit, 
the amount of qualified residence interest on Debt 2 is determined by 
multiplying the amount of interest paid on the debt during the year 
($4,800) by a fraction equal to its applicable debt limit divided by its 
average balance ($25,000/$40,000 = 0.625). Accordingly, $3,000 ($4,800 x 
0.625) of the interest paid in 1988 on Debt 2 is qualified residence 
interest. The character of the remaining $1,800 of interest paid on Debt 
2 is determined under the rules of paragraph (e)(4) of this section.
    (4) Treatment of interest paid or accrued with respect to secured 
debt that is not qualified residence interest--(i) In general. Under the 
exact method, the excess of the interest paid or accrued during the 
taxable year with respect to a secured debt over the amount of qualified 
residence interest with respect to the debt is allocated under the rules 
of Sec.  1.163-8T.
    (ii) Example. T borrows $20,000 and the entire proceeds of the debt 
are disbursed by the lender to T's broker to purchase securities held 
for investment. T secures the debt with T's principal residence. In 
1990, T pays $2,000 of interest on the debt. Assume that under the rules 
of paragraph (e) of this section, $1,500 of the interest is qualified 
residence interest. The remaining $500 in interest expense would be 
allocated under the rules of Sec.  1.163-8T. Section 1.163-8T generally 
allocates debt (and the associated interest expense) by tracing 
disbursements of the debt proceeds to specific expenditures. 
Accordingly, the $500 interest expense on the debt that is not qualified 
residence interest is investment interest subject to section 163(d).
    (iii) Special rule if debt is allocated to more than one 
expenditure. If--
    (A) The average balance of a secured debt exceeds the applicable 
debt limit for that debt, and
    (B) Under the rules of Sec.  1.163-8T, interest paid or accrued with 
respect to such debt is allocated to more than one expenditure,

the interest expense that is not qualified residence interest may be 
allocated among such expenditures, to the extent of such expenditures, 
in any manner selected by the taxpayer.

[[Page 322]]

    (iv) Example. (i) C borrows $60,000 secured by a qualified 
residence. C uses (within the meaning of Sec.  1.163-8T) $20,000 of the 
proceeds in C's trade or business, $20,000 to purchase stock held for 
investment and $20,000 for personal purposes. In 1990, C pays $6,000 in 
interest on the debt and, under the rules of Sec.  1.163-8T, $2,000 in 
interest is allocable to trade or business expenses, $2,000 to 
investment expenses and $2,000 to personal expenses. Assume that under 
paragraph (e) of this section, $2,500 of the interest is qualified 
residence interest and $3,500 of the interest is not qualified residence 
interest.
    (ii) Under paragraph (e)(4)(iii) of this section, C may allocate up 
to $2,000 of the interest that is not qualified residence interest to 
any of the three categories of expenditures up to a total of $3,500 for 
all three categories. Therefore, for example, C may allocate $2,000 of 
such interest to C's trade or business and $1,500 of such interest to 
the purchase of stock.
    (f) Special rules--(1) Special rules for personal property--(i) In 
general. If a qualified residence is personal property under State law 
(e.g., a boat or motorized vehicle)--
    (A) For purposes of paragraphs (c)(1) and (d)(1) of this section, if 
the fair market value of the residence as of the date that any secured 
debt (outstanding during the taxable year) is first secured by the 
residence is less than the adjusted purchase price as of the end of the 
taxable year, the lowest such fair market value shall be substituted for 
the adjusted purchase price.
    (B) For purposes of paragraphs (e)(2)(i)(A) and (f)(1)(i)(A) of this 
section, the fair market value of the residence as of the date the debt 
is first secured by the residence shall not exceed the fair market value 
as of any date on which the taxpayer borrows any additional amount with 
respect to the debt.
    (ii) Example. D owns a recreational vehicle that is a qualified 
residence under paragraph (p)(4) of this section. The adjusted purchase 
price and fair market value of the recreational vehicle is $20,000 in 
1989. In 1989, D establishes a line of credit secured by the 
recreational vehicle. As of June 1, 1992, the fair market value of the 
vehicle has decreased to $10,000. On that day, D borrows an additional 
amount on the debt by using the line of credit. Although under 
paragraphs (e)(2)(i) and (f)(1)(i)(A) of this section, fair market value 
is determined at the time the debt is first secured, under paragraph 
(f)(1)(i)(B) of this section, the fair market value is the lesser of 
that amount or the fair market value on the most recent date that D 
borrows any additional amount with respect to the line of credit. 
Therefore, the fair market value with respect to the debt is $10,000.
    (2) Special rule for real property--(i) In general. For purposes of 
paragraph (e)(2)(i)(A) of this section, the fair market value of a 
qualified residence that is real property under State law is presumed 
irrebuttably to be not less than the adjusted purchase price of the 
residence as of the last day of the taxable year.
    (ii) Example. (i) C purchases a residence on August 11, 1987, for 
$50,000, incurring a first mortgage. The residence is real property 
under State law. During 1987, C makes $10,000 in home improvements. 
Accordingly, the adjusted purchase price of the residence as of December 
31, 1988, is $60,000. C incurs a second mortgage on May 19, 1988, as of 
which time the fair market value of the residence is $55,000.
    (ii) For purposes of determining the applicable debt limit for each 
debt, the fair market value of the residence is generally determined as 
of the time the debt is first secured. Accordingly, the fair market 
value would be $50,000 and $55,000 with respect to the first and second 
mortgage, respectively. Under the special rule of paragraph (f)(2)(i) of 
this section, however, the fair market value with respect to both debts 
in 1988 is $60,000, the adjusted purchase price on December 31, 1988.
    (g) Selection of method. For any taxable year, a taxpayer may use 
the simplified method (described in paragraph (d) of this section) or 
the exact method (described in paragraph (e) of this section) by 
completing the appropriate portion of Form 8598. A taxpayer with two 
qualified residences may use the simplified method for one residence and 
the exact method for the other residence.

[[Page 323]]

    (h) Average balance--(1) Average balance defined. For purposes of 
this section, the term ``average balance'' means the amount determined 
under this paragraph (h). A taxpayer is not required to use the same 
method to determine the average balance of all secured debts during a 
taxable year or of any particular secured debt from one year to the 
next.
    (2) Average balance reported by lender. If a lender that is subject 
to section 6050H (returns relating to mortgage interest received in 
trade or business from individuals) reports the average balance of a 
secured debt on Form 1098, the taxpayer may use the average balance so 
reported.
    (3) Average balance computed on a daily basis--(i) In general. The 
average balance may be determined by--
    (A) Adding the outstanding balance of a debt on each day during the 
taxable year that the debt is secured by a qualified residence, and
    (B) Dividing the sum by the number of days during the taxable year 
that the residence is a qualified residence.
    (ii) Example. Taxpayer A incurs a debt of $10,000 on September 1, 
1989, securing the debt with A's principal residence. The residence is 
A's principal residence during the entire taxable year. A pays current 
interest on the debt monthly, but makes no principal payments. The debt 
is, therefore, outstanding for 122 days with a balance each day of 
$10,000. The residence is a qualified residence for 365 days. The 
average balance of the debt for 1989 is $3,342 (122 x $10,000/365).
    (4) Average balance computed using the interest rate--(i) In 
general. If all accrued interest on a secured debt is paid at least 
monthly, the average balance of the secured debt may be determined by 
dividing the interest paid or accrued during the taxable year while the 
debt is secured by a qualified residence by the annual interest rate on 
the debt. If the interest rate on a debt varies during the taxable year, 
the lowest annual interest rate that applies to the debt during the 
taxable year must be used for purposes of this paragraph (h)(4). If the 
residence securing the debt is a qualified residence for less than the 
entire taxable year, the average balance of any secured debt may be 
determined by dividing the average balance determined under the 
preceding sentence by the percentage of the taxable year that the debt 
is secured by a qualified residence.
    (ii) Points and prepaid interest. For purposes of paragraph 
(h)(4)(i) of this section, the amount of interest paid during the 
taxable year does not include any amount paid as points and includes 
prepaid interest only in the year accrued.
    (iii) Examples.

    Example 1. B has a line of credit secured by a qualified residence 
for the entire taxable year. The interest rate on the debt is 10 percent 
throughout the taxable year. The principal balance on the debt changes 
throughout the year. B pays the accrued interest on the debt monthly. B 
pays $2,500 in interest on the debt during the taxable year. The average 
balance of the debt ($25,000) may be computed by dividing the total 
interest paid by the interest rate ($25,000 = $2,500/0.10).
    Example 2. Assume the same facts as in example 1, except that the 
residence is a qualified residence, and the debt is outstanding, for 
only one-half of the taxable year and B pays only $1,250 in interest on 
the debt during the taxable year. The average balance of the debt may be 
computed by first dividing the total interest paid by the interest rate 
($12,500 = $1,250/0.10). Second, because the residence is not a 
qualified residence for the entire taxable year, the average balance 
must be determined by dividing this amount ($12,500) by the portion of 
the year that the residence is qualified (0.50). The average balance is 
therefore $25,000 ($12,500/0.50).

    (5) Average balance computed using average of beginning and ending 
balances--(i) In general. If--
    (A) A debt requires level payments at fixed equal intervals (e.g., 
monthly, quarterly) no less often than semi-annually during the taxable 
year,
    (B) The taxpayer prepays no more than one month's principal on the 
debt during the taxable year, and
    (C) No new amounts are borrowed on the debt during the taxable year,

the average balance of the debt may be determined by adding the 
principal balance as of the first day of the taxable year that the debt 
is secured by the qualified residence and the principal balance as of 
the last day of the taxable year that the debt is secured by the 
qualified residence and dividing the sum by 2. If the debt is secured by 
a

[[Page 324]]

qualified residence for less than the entire period during the taxable 
year that the residence is a qualified residence, the average balance 
may be determined by multiplying the average balance determined under 
the preceding sentence by a fraction, the numerator of which is the 
number of days during the taxable year that the debt is secured by the 
qualified residence and the denominator of which is the number of days 
during the taxable year that the residence is a qualified residence. For 
purposes of this paragraph (h)(5)(i), the determination of whether 
payments are level shall disregard the fact that the amount of the 
payments may be adjusted from time to time to take into account changes 
in the applicable interest rate.
    (ii) Example. C borrows $10,000 in 1988, securing the debt with a 
second mortgage on a principal residence. The terms of the loan require 
C to make equal monthly payments of principal and interest so as to 
amortize the entire loan balance over 20 years. The balance of the debt 
is $9,652 on January 1, 1990, and is $9,450 on December 31, 1990. The 
average balance of the debt during 1990 may be computed as follows:

Balance on first day of the year: $9,652
Balance on last day of the year: $9,450
[GRAPHIC] [TIFF OMITTED] TC14NO91.175

    (6) Highest principal balance. The average balance of a debt may be 
determined by taking the highest principal balance of the debt during 
the taxable year.
    (7) Other methods provided by the Commissioner. The average balance 
may be determined using any other method provided by the Commissioner by 
form, publication, revenue ruling, or revenue procedure. Such methods 
may include methods similar to (but with restrictions different from) 
those provided in paragraph (h) of this section.
    (8) Anti-abuse rule. If, as a result of the determination of the 
average balance of a debt using any of the methods specified in 
paragraphs (h) (4), (5), or (6) of this section, there is a significant 
overstatement of the amount of qualified residence interest and a 
principal purpose of the pattern of payments and borrowing on the debt 
is to cause the amount of such qualified residence interest to be 
overstated, the district director may redetermine the average balance 
using the method specified under paragraph (h)(3) of this section.
    (i) [Reserved]
    (j) Determination of interest paid or accrued during the taxable 
year--(1) In general. For purposes of determining the amount of 
qualified residence interest with respect to a secured debt, the amount 
of interest paid or accrued during the taxable year includes only 
interest paid or accrued while the debt is secured by a qualified 
residence.
    (2) Special rules for cash-basis taxpayers--(i) Points deductible in 
year paid under section 461(g)(2). If points described in section 
461(g)(2) (certain points paid in respect of debt incurred in connection 
with the purchase or improvement of a principal residence) are paid with 
respect to a debt, the amount of such points is qualified residence 
interest.
    (ii) Points and other prepaid interest described in section 
461(g)(1). The amount of points or other prepaid interest charged to 
capital account under section 461(g)(1) (prepaid interest) that is 
qualified residence interest shall be determined under the rules of 
paragraphs (c) through (e) of this section in the same manner as any 
other interest paid with respect to the debt in the taxable year to 
which such payments are allocable under section 461(g)(1).
    (3) Examples.

    Example 1. T designates a vacation home as a qualified residence as 
of October 1, 1987. The home is encumbered by a mortgage during the 
entire taxable year. For purposes of determining the amount of qualified 
residence interest for 1987, T may take into account the interest paid 
or accrued on the secured debt from October 1, 1987, through December 
31, 1987.
    Example 2. R purchases a principal residence on June 17, 1987. As 
part of the purchase price, R obtains a conventional 30-year mortgage, 
secured by the residence. At closing, R pays 2\1/2\ points on the 
mortgage and interest on the mortgage for the period June 17, 1987 
through June 30, 1987. The points are actually paid by R and are not 
merely withheld from the loan proceeds. R incurs no additional secured 
debt during 1987. Assuming that the points satisfy the requirements of 
section 461(g) (2), the entire amount of points

[[Page 325]]

and the interest paid at closing are qualified residence interest.
    Example 3. (i) On July 1, 1987, W borrows $120,000 to purchase a 
residence to use as a vacation home. W secures the debt with the 
residence. W pays 2 points, or $2,400. The debt has a term of 10 years 
and requires monthly payments of principal and interest. W is permitted 
to amortize the points at the rate of $20 per month over 120 months. W 
elects to treat the residence as a second residence. W has no other debt 
secured by the residence. The average balance of the debt in each 
taxable year is less than the adjusted purchase price of the residence. 
W sells the residence on June 30, 1990, and pays off the remaining 
balance of the debt.
    (ii) W is entitled to treat the following amounts of the points as 
interest paid on a debt secured by a qualified residence--

------------------------------------------------------------------------
 
------------------------------------------------------------------------
1987......................................  $120 = $20 x 6 months;
1988......................................  $240 = $20 x 12 months;
1989......................................  $120 = $20 x 6 months.
Total.....................................  $480
------------------------------------------------------------------------

    All of the interest paid on the debt, including the allocable 
points, is qualified residence interest. Upon repaying the debt, the 
remaining $1,920 ($2,400-$480) in unamortized points is treated as 
interest paid in 1990 and, because the average balance of the secured 
debt in 1990 is less than the adjusted purchase price, is also qualified 
residence interest.

    (k) Determination of adjusted purchase price and fair market value--
(1) Adjusted purchase price--(i) In general. For purposes of this 
section, the adjusted purchase price of a qualified residence is equal 
to the taxpayer's basis in the residence as initially determined under 
section 1012 or other applicable sections of the Internal Revenue Code, 
increased by the cost of any improvements to the residence that have 
been added to the taxpayer's basis in the residence under section 
1016(a)(1). Any other adjustments to basis, including those required 
under section 1033(b) (involuntary conversions), and 1034(e) (rollover 
of gain or sale of principal residence) are disregarded in determining 
the taxpayer's adjusted purchase price. If, for example, a taxpayer's 
second residence is rented for a portion of the year and its basis is 
reduced by depreciation allowed in connection with the rental use of the 
property, the amount of the taxpayer's adjusted purchase price in the 
residence is not reduced. See paragraph (m) of this section for a rule 
that treats the sum of the grandfathered amounts of all secured debts as 
the adjusted purchase price of the residence.
    (ii) Adjusted purchase price of a qualified residence acquired 
incident to divorce. [Reserved]
    (iii) Examples.

    Example 1. X purchases a residence for $120,000. X's basis, as 
determined under section 1012, is the cost of the property, or $120,000. 
Accordingly, the adjusted purchase price of the residence is initially 
$120,000.
    Example 2. Y owns a principal residence that has a basis of $30,000. 
Y sells the residence for $100,000 and purchases a new principal 
residence for $120,000. Under section 1034, Y does not recognize gain on 
the sale of the former residence. Under section 1034(e), Y's basis in 
the new residence is reduced by the amount of gain not recognized. 
Therefore, under section 1034(e), Y's basis in the new residence is 
$50,000 ($120,000-$70,000). For purposes of section 163(h), however, the 
adjusted purchase price of the residence is not adjusted under section 
1034(e). Therefore, the adjusted purchase price of the residence is 
initially $120,000.
    Example 3. Z acquires a residence by gift. The donor's basis in the 
residence was $30,000. Z's basis in the residence, determined under 
section 1015, is $30,000. Accordingly, the adjusted purchase price of 
the residence is initially $30,000.

    (2) Fair market value--(i) In general. For purposes of this section, 
the fair market value of a qualified residence on any date is the fair 
market value of the taxpayer's interest in the residence on such date. 
In addition, the fair market value determined under this paragraph 
(k)(2)(i) shall be determined by taking into account the cost of 
improvements to the residence reasonably expected to be made with the 
proceeds of the debt.
    (ii) Example. In 1988, the adjusted purchase price of P's second 
residence is $65,000 and the fair market value of the residence is 
$70,000. At that time, P incurs an additional debt of $10,000, the 
proceeds of which P reasonably expects to use to add two bedrooms to the 
residence. Because the fair market value is determined by taking into 
account the cost of improvements to the residence that are reasonably 
expected to be made with the proceeds of the debt, the fair market value 
of the residence with respect to the debt incurred in 1988 is $80,000 
($70,000 + $10,000).

[[Page 326]]

    (3) Allocation of adjusted purchase price and fair market value. If 
a property includes both a qualified residence and other property, the 
adjusted purchase price and the fair market value of such property must 
be allocated between the qualified residence and the other property. See 
paragraph (p)(4) of this section for rules governing such an allocation.
    (l) [Reserved]
    (m) Grandfathered amount--(1) Substitution for adjusted purchase 
price. If, for the taxable year, the sum of the grandfathered amounts, 
if any, of all secured debts exceeds the adjusted purchase price of the 
qualified residence, such sum may be treated as the adjusted purchase 
price of the residence under paragraphs (c), (d) and (e) of this 
section.
    (2) Determination of grandfathered amount--(i) In general. For any 
taxable year, the grandfathered amount of any secured debt that was 
incurred on or before August 16, 1986, and was secured by the residence 
continuously from August 16, 1986, through the end of the taxable year, 
is the average balance of the debt for the taxable year. A secured debt 
that was not incurred and secured on or before August 16, 1986, has no 
grandfathered amount.
    (ii) Special rule for lines of credit and certain other debt. If, 
with respect to a debt described in paragraph (m)(2)(i) of this section, 
a taxpayer has borrowed any additional amounts after August 16, 1986, 
the grandfathered amount of such debt is equal to the lesser of--
    (A) The average balance of the debt for the taxable year, or
    (B) The principal balance of the debt as of August 16, 1986, reduced 
(but not below zero) by all principal payments after August 16, 1986, 
and before the first day of the current taxable year.

For purposes of this paragraph (m)(2)(ii), a taxpayer shall not be 
considered to have borrowed any additional amount with respect to a debt 
merely because accrued interest is added to the principal balance of the 
debt, so long as such accrued interest is paid by the taxpayer no less 
often than quarterly.
    (iii) Fair market value limitation. The grandfathered amount of any 
debt for any taxable year may not exceed the fair market value of the 
residence on August 16, 1986, reduced by the principal balance on that 
day of all previously secured debt.
    (iv) Examples.

    Example 1. As of August 16, 1986, T has one debt secured by T's 
principal residence. The debt is a conventional self-amortizing mortgage 
and, on August 16, 1986, it has an outstanding principal balance of 
$75,000. In 1987, the average balance of the mortgage is $73,000. The 
adjusted purchase price of the residence as of the end of 1987 is 
$50,000. Because the mortgage was incurred and secured on or before 
August 16, 1986 and T has not borrowed any additional amounts with 
respect to the mortgage, the grandfathered amount is the average 
balance, $73,000. Because the grandfathered amount exceeds the adjusted 
purchase price ($50,000), T may treat the grandfathered amount as the 
adjusted purchase price in determining the amount of qualified residence 
interest.
    Example 2. (i) The facts are the same as in example (1), except that 
in May 1986, T also obtains a home equity line of credit that, on August 
16, 1986, has a principal balance of $40,000. In November 1986, T 
borrows an additional $10,000 on the home equity line, increasing the 
balance to $50,000. In December 1986, T repays $5,000 of principal on 
the home equity line. The average balance of the home equity line in 
1987 is $45,000.
    (ii) Because T has borrowed additional amounts on the line of credit 
after August 16, 1986, the grandfathered amount for that debt must be 
determined under the rules of paragraph (m)(2)(ii) of this section. 
Accordingly, the grandfathered amount for the line of credit is equal to 
the lesser of $45,000, the average balance of the debt in 1987, and 
$35,000, the principal balance on August 16, 1986, reduced by all 
principal payments between August 17, 1986, and December 31, 1986 
($40,000-$5,000). The sum of the grandfathered amounts with respect to 
the residence is $108,000 ($73,000 + $35,000). Because the sum of the 
grandfathered amounts exceeds the adjusted purchase price ($50,000), T 
may treat the sum as the adjusted purchase price in determining the 
qualified residence interest for 1987.

    (3) Refinancing of grandfathered debt--(i) In general. A debt 
incurred and secured on or before August 16, 1986, is refinanced if some 
or all of the outstanding balance of such a debt (the ``original debt'') 
is repaid out of the proceeds of a second debt secured by the same 
qualified residence (the ``replacement debt''). In the case of a 
refinancing, the replacement debt is treated as a debt incurred and 
secured on or

[[Page 327]]

before August 16, 1986, and the grandfathered amount of such debt is the 
amount (but not less than zero) determined pursuant to paragraph 
(m)(3)(ii) of this section.
    (ii) Determination of grandfathered amount--(A) Exact refinancing. 
If--
    (1) The entire proceeds of a replacement debt are used to refinance 
one or more original debts, and
    (2) The taxpayer has not borrowed any additional amounts after 
August 16, 1986, with respect to the original debt or debts,

the grandfathered amount of the replacement debt is the average balance 
of the replacement debt. For purposes of the preceding sentence, the 
fact that proceeds of a replacement debt are used to pay costs of 
obtaining the replacement debt (including points or other closing costs) 
shall be disregarded in determining whether the entire proceeds of the 
replacement debt have been used to refinance one or more original debts.
    (B) Refinancing other than exact refinancings--(1) Year of 
refinancing. In the taxable year in which an original debt is 
refinanced, the grandfathered amount of the original and replacement 
debts is equal to the lesser of--
    (i) The sum of the average balances of the original debt and the 
replacement debt, and
    (ii) The principal balance of the original debt as of August 16, 
1986, reduced by all principal payments on the original debt after 
August 16, 1986, and before the first day of the current taxable year.
    (2) In subsequent years. In any taxable year after the taxable year 
in which an original debt is refinanced, the grandfathered amount of the 
replacement debt is equal to the least of--
    (i) The average balance of the replacement debt for the taxable 
year,
    (ii) The amount of the replacement debt used to repay the principal 
balance of the original debt, reduced by all principal payments on the 
replacement debt after the date of the refinancing and before the first 
day of the current taxable year, or
    (iii) The principal balance of the original debt on August 16, 1986, 
reduced by all principal payments on the original debt after August 16, 
1986, and before the date of the refinancing, and further reduced by all 
principal payments on the replacement debt after the date of the 
refinancing and before the first day of the current taxable year.
    (C) Example. (i) Facts. On August 16, 1986, T has a single debt 
secured by a principal residence with a balance of $150,000. On July 1, 
1988, T refinances the debt, which still has a principal balance of 
$150,000, with a new secured debt. The principal balance of the 
replacement debt throughout 1988 and 1989 is $150,000. The adjusted 
purchase price of the residence is $100,000 throughout 1987, 1988 and 
1989. The average balance of the original debt was $150,000 in 1987 and 
$75,000 in 1988. The average balance of the replacement debt is $75,000 
in 1988 and $150,000 in 1989.
    (ii) Grandfathered amount in 1987. The original debt was incurred 
and secured on or before August 16, 1986 and T has not borrowed any 
additional amounts with respect to the debt. Therefore, its 
grandfathered amount in 1987 is its average balance ($150,000). This 
amount is treated as the adjusted purchase price for 1987 and all of the 
interest paid on the debt is qualified residence interest.
    (iii) Grandfathered amount in 1988. Because the replacement debt was 
used to refinance a debt incurred and secured on or before August 16, 
1986, the replacement debt is treated as a grandfathered debt. Because 
all of the proceeds of the replacement debt were used in the refinancing 
and because no amounts have been borrowed after August 16, 1986, on the 
original debt, the grandfathered amount for the original debt is its 
average balance ($75,000) and the grandfathered amount for the 
replacement debt is its average balance ($75,000). Since the sum of the 
grandfathered amounts ($150,000) exceeds the adjusted purchase price of 
the residence, the sum of the grandfathered amounts may be substituted 
for the adjusted purchase price for 1988 and all of the interest paid on 
the debt is qualified residence interest.
    (iv) Grandfathered amount in 1989. The grandfathered amount for the 
placement debt is its average balance ($150,000). This amount is treated 
as the adjusted purchase price for 1989 and all

[[Page 328]]

of the interest paid on the mortgage is qualified residence interest.
    (4) Limitation on term of grandfathered debt--(i) In general. An 
original debt or replacement debt shall not have any grandfathered 
amount in any taxable year that begins after the date, as determined on 
August 16, 1986, that the original debt was required to be repaid in 
full (the ``maturity date''). If a replacement debt is used to refinance 
more than one original debt, the maturity date is determined by 
reference to the original debt that, as of August 16, 1986, had the 
latest maturity date.
    (ii) Special rule for nonamortizing debt. If an original debt was 
actually incurred and secured on or before August 16, 1986, and if as of 
such date the terms of such debt did not require the amortization of its 
principal over its original term, the maturity date of the replacement 
debt is the earlier of the maturity date of the replacement debt or the 
date 30 years after the date the original debt is first refinanced.
    (iii) Example. C incurs a debt on May 10, 1986, the final payment of 
which is due May 1, 2006. C incurs a second debt on August 11, 1990, 
with a term of 20 years and uses the proceeds of the second debt to 
refinance the first debt. Because, under paragraph (m)(4)(i) of this 
section, a replacement debt will not have any grandfathered amount in 
any taxable year that begins after the maturity date of the original 
debt (May 1, 2006), the second debt has no grandfathered amount in any 
taxable year after 2006.
    (n) Qualified indebtedness (secured debt used for medical and 
educational purposes)--(1) In general--(i) Treatment of qualified 
indebtedness. The amount of any qualified indebtedness resulting from a 
secured debt may be added to the adjusted purchase price under paragraph 
(e)(2)(i)(B) of this section to determine the applicable debt limit for 
that secured debt and any other debt subsequently secured by the 
qualified residence.
    (ii) Determination of amount of qualified indebtedness. If, as of 
the end of the taxable year (or the last day in the taxable year that 
the debt is secured), at least 90 percent of the proceeds of a secured 
debt are used (within the meaning of paragraph (n)(2) of this section) 
to pay for qualified medical and educational expenses (within the 
meaning of paragraphs (n)(3) and (n)(4) of this section), the amount of 
qualified indebtedness resulting from that debt for the taxable year is 
equal to the average balance of such debt for the taxable year.
    (iii) Determination of amount of qualified indebtedness for mixed-
use debt. If, as of the end of the taxable year (or the last day in the 
taxable year that the debt is secured), more than ten percent of the 
proceeds of a secured debt are used to pay for expenses other than 
qualified medical and educational expenses, the amount of qualified 
indebtedness resulting from that debt for the taxable year shall equal 
the lesser of--
    (A) The average balance of the debt, or
    (B) The amount of the proceeds of the debt used to pay for qualified 
medical and educational expenses through the end of the taxable year, 
reduced by any principal payments on the debt before the first day of 
the current taxable year.
    (iv) Example. (i) C incurs a $10,000 debt on April 20, 1987, which 
is secured on that date by C's principal residence. C immediately uses 
(within the meaning of paragraph (n)(2) of this section) $4,000 of the 
proceeds of the debt to pay for a qualified medical expense. C makes no 
principal payments on the debt during 1987. During 1988 and 1989, C 
makes principal payments of $1,000 per year. The average balance of the 
debt during 1988 is $9,500 and the average balance during 1989 is 
$8,500.
    (ii) Under paragraph (n)(1)(iii) of this section, C determines the 
amount of qualified indebtedness for 1988 as follows:

Average balance.......................................  .......   $9,500
  Amount of debt used to pay for qualified medical       $4,000
   expenses...........................................
  Less payments of principal before 1988..............       $0
                                                       ---------
Net qualified expenses................................  .......   $4,000
 


The amount of qualified indebtedness for 1988 is, therefore, $4,000 
(lesser of $9,500 average balance or $4,000 net qualified expenses). 
This amount may be added to the adjusted purchase price of C's principal 
residence under paragraph (e)(2)(i)(B) of this section for purposes of 
computing the applicable debt

[[Page 329]]

limit for this debt and any other debt subsequently secured by the 
principal residence.
    (iii) C determines the amount of qualified indebtedness for 1989 as 
follows:

Average balance.......................................  .......   $8,500
  Amount of debt used to pay for qualified medical       $4,000
   expenses...........................................
  Less payments of principal before 1988..............   $1,000
                                                       ---------
Net qualified expenses................................  .......   $3,000
 


The amount of qualified indebtedness for 1989 is, therefore, $3,000 
(lesser of $8,500 average balance or $3,000 net qualified expenses).
    (v) Prevention of double counting in year of refinancing--(A) In 
general. A debt used to pay for qualified medical or educational 
expenses is refinanced if some or all of the outstanding balance of the 
debt (the ``original debt'') is repaid out of the proceeds of a second 
debt (the ``replacement debt''). If, in the year of a refinancing, the 
combined qualified indebtedness of the original debt and the replacement 
debt exceeds the combined qualified expenses of such debts, the amount 
of qualified indebtedness for each such debt shall be determined by 
multiplying the amount of qualified indebtedness for each such debt by a 
fraction, the numerator of which is the combined qualified expenses and 
the denominator of which is the combined qualified indebtedness.
    (B) Definitions. For purposes of paragraph (n)(1)(v)(A) of this 
section--
    (1) The term ``combined qualified indebtedness'' means the sum of 
the qualified indebtedness (determined without regard to paragraph 
(n)(1)(v) of this section) for the original debt and the replacement 
debt.
    (2) The term ``combined qualified expenses'' means the amount of the 
proceeds of the original debt used to pay for qualified medical and 
educational expenses through the end of the current taxable year, 
reduced by any principal payments on the debt before the first day of 
the current taxable year, and increased by the amount, if any, of the 
proceeds of the replacement debt used to pay such expenses through the 
end of the current taxable year other than as part of the refinancing.
    (C) Example. (i) On August 11, 1987, C incurs a $8,000 debt secured 
by a principal residence. C uses (within the meaning of paragraph 
(n)(2)(i) of this section) $5,000 of the proceeds of the debt to pay for 
qualified educational expenses. C makes no principal payments on the 
debt. On July 1, 1988, C incurs a new debt in the amount of $8,000 
secured by C's principal residence and uses all of the proceeds of the 
new debt to repay the original debt. Under paragraph (n)(2)(ii) of this 
section $5,000 of the new debt is treated as being used to pay for 
qualified educational expenses. C makes no principal payments (other 
than the refinancing) during 1987 or 1988 on either debt and pays all 
accrued interest monthly. The average balance of each debt in 1988 is 
$4,000.
    (ii) Under paragraph (n)(1)(iii) of this section, the amount of 
qualified indebtedness for 1988 with respect to the original debt is 
$4,000 (the lesser of its average balance ($4,000) and the amount of the 
debt used to pay for qualified medical and educational expenses 
($5,000)). Similarly, the amount of qualified indebtedness for 1988 with 
respect to the replacement debt is also $4,000. Both debts, however, are 
subject in 1988 to the limitation in paragraph (n)(1)(v)(A) of this 
section. The combined qualified indebtedness, determined without regard 
to the limitation, is $8,000 ($4,000 of qualified indebtedness from each 
debt). The combined qualified expenses are $5,000 ($5,000 from the 
original debt and $0 from the replacement debt). The amount of qualified 
indebtedness from each debt must, therefore, be reduced by a fraction, 
the numerator of which is $5,000 (the combined qualified expenses) and 
the denominator of which is $8,000 (the combined qualified 
indebtedness). After application of the limitation, the amount of 
qualified indebtedness for the original debt is $2,500 ($4,000 x x \5/
8\). Similarly, the amount of qualified indebtedness for the replacement 
debt is $2,500. Note that the total qualified indebtedness for both the 
original and the replacement debt is $5,000 ($2,500 + $2,500). 
Therefore, C is entitled to the same amount of qualified indebtedness as 
C would have been entitled to if C had not refinanced the debt.

[[Page 330]]

    (vi) Special rule for principal payments in excess of qualified 
expenses. For purposes of paragraph (n)(1)(iii)(B), (n)(1)(v)(B)(2) and 
(n)(2)(ii) of this section, a principal payment is taken into account 
only to the extent that the payment, when added to all prior payments, 
does not exceed the amount used on or before the date of the payment to 
pay for qualified medical and educational expenses.
    (2) Debt used to pay for qualified medical or educational expenses--
(i) In general. For purposes of this section, the proceeds of a debt are 
used to pay for qualified medical or educational expenses to the extent 
that--
    (A) The taxpayer pays qualified medical or educational expenses 
within 90 days before or after the date that amounts are actually 
borrowed with respect to the debt, the proceeds of the debt are not 
directly allocable to another expense under Sec.  1.163-8T(c)(3) 
(allocation of debt; proceeds not disbursed to borrower) and the 
proceeds of any other debt are not allocable to the medical or 
educational expenses under Sec.  1.163-8T(c)(3), or
    (B) The proceeds of the debt are otherwise allocated to such 
expenditures under Sec.  1.163-8T.
    (ii) Special rule for refinancings. For purposes of this section, 
the proceeds of a debt are used to pay for qualified medical and 
educational expenses to the extent that the proceeds of the debt are 
allocated under Sec.  1.163-8T to the repayment of another debt (the 
``original debt''), but only to the extent of the amount of the original 
debt used to pay for qualified medical and educational expenses, reduced 
by any principal payments on such debt up to the time of the 
refinancing.
    (iii) Other special rules. The following special rules apply for 
purposes of this section.
    (A) Proceeds of a debt are used to pay for qualified medical or 
educational expenses as of the later of the taxable year in which such 
proceeds are borrowed or the taxable year in which such expenses are 
paid.
    (B) The amount of debt which may be treated as being used to pay for 
qualified medical or educational expenses may not exceed the amount of 
such expenses.
    (C) Proceeds of a debt may not be treated as being used to pay for 
qualified medical or educational expenses to the extent that:
    (1) The proceeds have been repaid as of the time the expense is 
paid;
    (2) The proceeds are actually borrowed before August 17, 1986; or
    (3) The medical or educational expenses are paid before August 17, 
1986.
    (iv) Examples--

    Example 1. A pays a $5,000 qualified educational expense from a 
checking account that A maintains at Bank 1 on November 9, 1987. On 
January 1, 1988, A incurs a $20,000 debt that is secured by A's 
residence and places the proceeds of the debt in a savings account that 
A also maintains at Bank 1. A pays another $5,000 qualified educations 
expense on March 15 from a checking account that A maintains at Bank 2. 
Under paragraph (n)(2) of this section, the debt proceeds are used to 
pay for both educational expenses, regardless of other deposits to, or 
expenditures from, the accounts, because both expenditures are made 
within 90 days before or after the debt was incurred.
    Example 2. B pays a $5,000 qualified educational expense from a 
checking account on November 1, 1987. On November 30, 1987, B incurs a 
debt secured by B's residence, and the lender disburses the debt 
proceeds directly to a person who sells B a new car. Although the 
educational expense is paid within 90 days of the date the debt is 
incurred, the proceeds of the debt are not used to pay for the 
educational expense because the proceeds are directly allocable to the 
purchase of the new car under Sec.  1.163-8T(c)(3).
    Example 3. On November 1, 1987, C borrows $5,000 from C's college. 
The proceeds of this debt are not disbursed to C, but rather are used to 
pay tuition fees for C's attendance at the college. On November 30, 
1987, C incurs a second debt and secures the debt by C's residence. 
Although the $5,000 educational expense is paid within 90 days before 
the second debt is incurred, the proceeds of the second debt are not 
used to pay for the educational expense, because the proceeds of the 
first debt are directly allocable to the educational expense under Sec.  
1.163-8T(c)(3).
    Example 4. On January 1, 1988, D incurs a $20,000 debt secured by a 
qualified residence. D places the proceeds of the debt in a separate 
account (i.e., the proceeds of the debt are the only deposit in the 
account). D makes payments of $5,000 each for qualified educational 
expenses on September 1, 1988, September 1, 1989, September 1, 1990, and 
September 1, 1991. Because the debt proceeds are allocated to 
educational expenses as of the date the expenses are paid, under the 
rules of Sec.  1.163-8T(c)(4), the following amounts of the debt 
proceeds are used to pay

[[Page 331]]

for qualified educational expenses as of the end of each year:


1988: $5,000
1989: $10,000
1990: $15,000
1991: $20,000

    Example 5. During 1987 E incurs a $10,000 debt secured by a 
principal residence. E uses (within the meaning of paragraph (n)(2)(i) 
of this section) all of the proceeds of the debt to pay for qualified 
educational expenses. On August 20, 1988, at which time the balance of 
the debt is $9,500, E incurs a new debt in the amount of $9,500 secured 
by E's principal residence and uses all of the proceeds of the new debt 
to repay the original debt. Under paragraph (n)(2)(ii) of this section, 
all of the proceeds of the new debt are used to pay for qualified 
educational expenses.

    (3) Qualified medical expenses. Qualified medical expenses are 
amounts that are paid for medical care (within the meaning of section 
213(d)(1) (A) and (B)) for the taxpayer, the taxpayer's spouse, or a 
dependent of the taxpayer (within the meaning of section 152), and that 
are not compensated for by insurance or otherwise.
    (4) Qualified educational expenses. Qualified educational expenses 
are amounts that are paid for tuition, fees, books, supplies and 
equipment required for enrollment, attendance or courses of instruction 
at an educational organization described in section 170(b) (1)(A)(ii) 
and for any reasonable living expenses while away from home while in 
attendance at such an institution, for the taxpayer, the taxpayer's 
spouse or a dependent of the taxpayer (within the meaning of section 
152) and that are not reimbursed by scholarship or otherwise.
    (o) Secured debt--(1) In general. For purposes of this section, the 
term ``secured debt'' means a debt that is on the security of any 
instrument (such as a mortgage, deed of trust, or land contract)--
    (i) That makes the interest of the debtor in the qualified residence 
specific security for the payment of the debt,
    (ii) Under which, in the event of default, the residence could be 
subjected to the satisfaction of the debt with the same priority as a 
mortgage or deed of trust in the jurisdiction in which the property is 
situated, and
    (iii) That is recorded, where permitted, or is otherwise perfected 
in accordance with applicable State law.

A debt will not be considered to be secured by a qualified residence if 
it is secured solely by virtue of a lien upon the general assets of the 
taxpayer or by a security interest, such as a mechanic's lien or 
judgment lien, that attaches to the property without the consent of the 
debtor.
    (2) Special rule for debt in certain States. Debt will not fail to 
be treated as secured solely because, under an applicable State or local 
homestead law or other debtor protection law in effect on August 16, 
1986, the security interest is ineffective or the enforceability of the 
security interest is restricted.
    (3) Times at which debt is treated as secured. For purposes of this 
section, a debt is treated as secured as of the date on which each of 
the requirements of paragraph (o)(1) of this section are satisfied, 
regardless of when amounts are actually borrowed with respect to the 
debt. For purposes of this paragraph (o)(3), if the instrument is 
recorded within a commercially reasonable time after the security 
interest is granted, the instrument will be treated as recorded on the 
date that the security interest was granted.
    (4) Partially secured debt--(i) In general. If the security interest 
is limited to a prescribed maximum amount or portion of the residence, 
and the average balance of the debt exceeds such amount or the value of 
such portion, such excess shall not be treated as secured debt for 
purposes of this section.
    (ii) Example. T borrows $80,000 on January 1, 1991. T secures the 
debt with a principal residence. The security in the residence for the 
debt, however, is limited to $20,000. T pays $8,000 in interest on the 
debt in 1991 and the average balance of the debt in that year is 
$80,000. Because the average balance of the debt exceeds the maximum 
amount of the security interest, such excess is not treated as secured 
debt. Therefore, for purposes of applying the limitation on qualified 
residence interest, the average balance of the secured debt is $20,000 
(the maximum amount of the security interest) and the interest paid or 
accrued on the secured debt is $2,000 (the total interest paid on the 
debt

[[Page 332]]

multiplied by the ratio of the average balance of the secured debt 
($20,000) and the average balance of the total debt ($80,000)).
    (5) Election to treat debt as not secured by a qualified residence--
(i) In general. For purposes of this section, a taxpayer may elect to 
treat any debt that is secured by a qualified residence as not secured 
by the qualified residence. An election made under this paragraph shall 
be effective for the taxable year for which the election is made and for 
all subsequent taxable years unless revoked with the consent of the 
Commissioner.
    (ii) Example. T owns a principal residence with a fair market value 
of $75,000 and an adjusted purchase price of $40,000. In 1988, debt A, 
the proceeds of which were used to purchase the residence, has an 
average balance of $15,000. The proceeds of debt B, which is secured by 
a second mortgage on the property, are allocable to T's trade or 
business under Sec.  1.163-8T and has an average balance of $25,000. In 
1988, T incurs debt C, which is also secured by T's principal residence 
and which has an average balance in 1988 of $5,000. In the absence of an 
election to treat debt B as unsecured, the applicable debt limit for 
debt C in 1988 under paragraph (e) of this section would be zero dollars 
($40,000-$15,000-$25,000) and none of the interest paid on debt C would 
be qualified residence interest. If, however, T makes or has previously 
made an election pursuant to paragraph (o)(5)(i) of this section to 
treat debt B as not secured by the residence, the applicable debt limit 
for debt C would be $25,000 ($40,000-$15,000), and all of the interest 
paid on debt C during the taxable year would be qualified residence 
interest. Since the proceeds of debt B are allocable to T's trade or 
business under Sec.  1.163-8T, interest on debt B may be deductible 
under other sections of the Internal Revenue Code.
    (iii) Allocation of debt secured by two qualified residences. 
[Reserved]
    (p) Definition of qualified residence--(1) In general. The term 
``qualified residence'' means the taxpayer's principal residence (as 
defined in paragraph (p)(2) of this section), or the taxpayer's second 
residence (as defined in paragraph (p)(3) of this section).
    (2) Principal residence. The term ``principal residence'' means the 
taxpayer's principal residence within the meaning of section 1034. For 
purposes of this section, a taxpayer cannot have more than one principal 
residence at any one time.
    (3) Second residence--(i) In general. The term ``second residence'' 
means--
    (A) A residence within the meaning of paragraph (p)(3)(ii) of this 
section,
    (B) That the taxpayer uses as a residence within the meaning of 
paragraph (p)(3)(iii) of this section, and
    (C) That the taxpayer elects to treat as a second residence pursuant 
to paragraph (p)(3)(iv) of this section.

A taxpayer cannot have more than one second residence at any time.
    (ii) Definition of residence. Whether property is a residence shall 
be determined based on all the facts and circumstances, including the 
good faith of the taxpayer. A residence generally includes a house, 
condominium, mobile home, boat, or house trailer, that contains sleeping 
space and toilet and cooking facilities. A residence does not include 
personal property, such as furniture or a television, that, in 
accordance with the applicable local law, is not a fixture.
    (iii) Use as a residence. If a residence is rented at any time 
during the taxable year, it is considered to be used as a residence only 
if the taxpayer uses it during the taxable year as a residence within 
the meaning of section 280A(d). If a residence is not rented at any time 
during the taxable year, it shall be considered to be used as a 
residence. For purposes of the preceding sentence, a residence will be 
deemed to be rented during any period that the taxpayer holds the 
residence out for rental or resale or repairs or renovates the residence 
with the intention of holding it out for rental or resale.
    (iv) Election of second residence. A taxpayer may elect a different 
residence (other than the taxpayer's principal residence) to be the 
taxpayer's second residence for each taxable year. A taxpayer may not 
elect different residences as second residences at different times of 
the same taxable year except as provided below--
    (A) If the taxpayer acquires a new residence during the taxable 
year, the

[[Page 333]]

taxpayer may elect the new residence as a taxpayer's second residence as 
of the date acquired;
    (B) If property that was the taxpayer's principal residence during 
the taxable year ceases to qualify as the taxpayer's principal 
residence, the taxpayer may elect that property as the taxpayer's second 
residence as of the date that the property ceases to be the taxpayer's 
principal residence; or
    (C) If property that was the taxpayer's second residence is sold 
during the taxable year or becomes the taxpayer's principal residence, 
the taxpayer may elect a new second residence as of such day.
    (4) Allocations between residence and other property--(i) In 
general. For purposes of this section, the adjusted purchase price and 
fair market value of property must be allocated between the portion of 
the property that is a qualified residence and the portion that is not a 
qualified residence. Neither the average balance of the secured debt nor 
the interest paid or accrued on secured debt is so allocated. Property 
that is not used for residential purposes does not qualify as a 
residence. For example, if a portion of the property is used as an 
office in the taxpayer's trade or business, that portion of the property 
does not qualify as a residence.
    (ii) Special rule for rental of residence. If a taxpayer rents a 
portion of his or her principal or second residence to another person (a 
``tenant''), such portion may be treated as used by the taxpayer for 
residential purposes if, but only if--
    (A) Such rented portion is used by the tenant primarily for 
residential purposes,
    (B) The rented portion is not a self-contained residential unit 
containing separate sleeping space and toilet and cooking facilities, 
and
    (C) The total number of tenants renting (directly or by sublease) 
the same or different portions of the residence at any time during the 
taxable year does not exceed two. For this purpose, if two persons (and 
the dependents, as defined by section 152, of either of them) share the 
same sleeping quarters, they shall be treated as a single tenant.
    (iii) Examples.

    Example 1. D, a dentist, uses a room in D's principal residence as 
an office which qualifies under section 280A(c)(1)(B) as a portion of 
the dwelling unit used exclusively on a regular basis as a place of 
business for meeting with patients in the normal course of D's trade or 
business. D's adjusted purchase price of the property is $65,000; 
$10,000 of which is allocable under paragraph (o)(4)(i) of this section 
to the room used as an office. For purposes of this section, D's 
residence does not include the room used as an office. The adjusted 
purchase price of the residence is, accordingly, $55,000. Similarly, the 
fair market value of D's residence must be allocated between the office 
and the remainder of the property.
    Example 2. J rents out the basement of property that is otherwise 
used as J's principal residence. The basement is a self-contained 
residential unit, with sleeping space and toilet and cooking facilities. 
The adjusted purchase price of the property is $100,000; $15,000 of 
which is allocable under paragraph (o)(4)(i) of this section to the 
basement. For purposes of this section, J's residence does not include 
the basement and the adjusted purchase price of the residence is 
$85,000. Similarly, the fair market value of the residence must be 
allocated between the basement unit and the remainder of the property.

    (5) Residence under construction--(i) In general. A taxpayer may 
treat a residence under construction as a qualified residence for a 
period of up to 24 months, but only if the residence becomes a qualified 
residence, without regard to this paragraph (p)(5)(i), as of the time 
that the residence is ready for occupancy.
    (ii) Example. X owns a residential lot suitable for the construction 
of a vacation home. On April 20, 1987, X obtains a mortgage secured by 
the lot and any property to be constructed on the lot. On August 9, 
1987, X begins construction of a residence on the lot. The residence is 
ready for occupancy on November 9, 1989. The residence is used as a 
residence within the meaning of paragraph (p)(3)(iii) of this section 
during 1989 and X elects to treat the residence as his second residence 
for the period November 9, 1989, through December 31, 1989. Since the 
residence under construction is a qualified residence as of the first 
day that the residence is ready for occupancy (November 9, 1987), X may 
treat the residence as his second residence under paragraph (p)(5)(i) of 
this section for up to 24 months of the period during which the 
residence is under construction, commencing on or

[[Page 334]]

after the date that construction is begun (August 9, 1987). If X treats 
the residence under construction as X's second residence beginning on 
August 9, 1987, the residence under construction would cease to qualify 
as a qualified residence under paragraph (p)(5)(i) on August 8, 1989. 
The residence's status as a qualified residence for future periods would 
be determined without regard to paragraph (p)(5)(i) of this section.
    (6) Special rule for time-sharing arrangements. Property that is 
otherwise a qualified residence will not fail to qualify as such solely 
because the taxpayer's interest in or right to use the property is 
restricted by an arrangement whereby two or more persons with interests 
in the property agree to exercise control over the property for 
different periods during the taxable year. For purposes of determining 
the use of a residence under paragraph (p)(3)(iii) of this section, a 
taxpayer will not be considered to have used or rented a residence 
during any period that the taxpayer does not have the right to use the 
property or to receive any benefits from the rental of the property.
    (q) Special rules for tenant-stockholders in cooperative housing 
corporations--(1) In general. For purposes of this section, a residence 
includes stock in a cooperative housing corporation owned by a tenant-
stockholder if the house or apartment which the tenant-stockholder is 
entitled to occupy by virtue of owning such stock is a residence within 
the meaning of paragraph (p)(3)(ii) of this section.
    (2) Special rule where stock may not be used to secure debt. For 
purposes of this section, if stock described in paragraph (q)(1) of this 
section may not be used to secure debt because of restrictions under 
local or State law or because of restrictions in the cooperative 
agreement (other than restrictions the principal purpose of which is to 
permit the tenant-stockholder to treat unsecured debt as secured debt 
under this paragraph (q)(2)), debt may be treated as secured by such 
stock to the extent that the proceeds of the debt are allocated to the 
purchase of the stock under the rules of Sec.  1.163-8T. For purposes of 
this paragraph (q)(2), proceeds of debt incurred prior to January 1, 
1987, may be treated as allocated to the purchase of such stock to the 
extent that the tenant-stockholder has properly and consistently 
deducted interest expense on such debt as home mortgage interest 
attributable to such stock on Schedule A of Form 1040 in determining his 
taxable income for taxable years beginning before January 1, 1987. For 
purposes of this paragraph (q)(2), amended returns filed after December 
22, 1987, are disregarded.
    (3) Treatment of interest expense of the cooperative described in 
section 216(a)(2). For purposes of section 163(h) and Sec.  1.163-9T 
(disallowance of deduction for personal interest) and section 163(d) 
(limitation on investment interest), any amount allowable as a deduction 
to a tenant-stockholder under section 216(a)(2) shall be treated as 
interest paid or accrued by the tenant-stockholder. If a tenant-
stockholder's stock in a cooperative housing corporation is a qualified 
residence of the tenant-shareholder, any amount allowable as a deduction 
to the tenant-stockholder under section 216(a)(2) is qualified residence 
interest.
    (4) Special rule to prevent tax avoidance. If the amount treated as 
qualified residence interest under this section exceeds the amount which 
would be so treated if the tenant-stockholder were treated as directly 
owning his proportionate share of the assets and liabilities of the 
cooperative and one of the principal purposes of the cooperative 
arrangement is to permit the tenant-stockholder to increase the amount 
of qualified residence interest, the district director may determine 
that such excess is not qualified residence interest.
    (5) Other definitions. For purposes of this section, the terms 
``tenant-stockholder,'' ``cooperative housing corporation'' and 
``proportionate share'' shall have the meaning given by section 216 and 
the regulations thereunder.
    (r) Effective date. The provisions of this section are effective for 
taxable years beginning after December 31, 1986.

[T.D. 8168, 52 FR 48410, Dec. 22, 1987]

[[Page 335]]



Sec.  1.163-11  Allocation of certain prepaid qualified 
mortgage insurance premiums.

    (a) Allocation--(1) In general. As provided in section 163(h)(3)(E), 
premiums paid or accrued for qualified mortgage insurance during the 
taxable year in connection with acquisition indebtedness with respect to 
a qualified residence (as defined in section 163(h)(4)(A)) of the 
taxpayer shall be treated as qualified residence interest (as defined in 
section 163(h)(3)(A)). If an individual taxpayer pays such a premium 
that is properly allocable to a mortgage the payment of which extends to 
periods beyond the close of the taxable year in which the premium is 
paid, the taxpayer must allocate the premium to determine the amount 
treated as qualified residence interest for each taxable year. The 
premium must be allocated ratably over the shorter of--
    (i) The stated term of the mortgage; or
    (ii) A period of 84 months, beginning with the month in which the 
insurance was obtained.
    (2) Limitation. If a mortgage is satisfied before the end of its 
stated term, no deduction as qualified residence interest shall be 
allowed for any amount of the premium that is allocable to periods after 
the mortgage is satisfied.
    (b) Scope. The allocation requirement in paragraph (a) of this 
section applies only to mortgage insurance provided by the Federal 
Housing Administration or private mortgage insurance (as defined by 
section 2 of the Homeowners Protection Act of 1998 (12 U.S.C. 4901) as 
in effect on December 20, 2006). It does not apply to mortgage insurance 
provided by the Department of Veterans Affairs or the Rural Housing 
Service. Paragraph (a) of this section applies whether the qualified 
mortgage insurance premiums are paid in cash or are financed, without 
regard to source.
    (c) Limitation on the treatment of mortgage insurance premiums as 
interest. This section applies to prepaid qualified mortgage insurance 
premiums described in paragraph (a) of this section that are paid or 
accrued on or after January 1, 2011, and during periods to which section 
163(h)(3)(E) is applicable. This section does not apply to any amount of 
prepaid qualified mortgage insurance premiums that are allocable to any 
periods to which section 163(h)(3)(E) is not applicable.
    (d) Effective/applicability date. This section is applicable on and 
after January 1, 2011. For regulations applicable before January 1, 
2011, see Sec.  1.163-11T in effect prior to January 1, 2011 (Sec.  
1.163-11T as contained in 26 CFR part 1 edition revised as of April 1, 
2011).

[T.D. 9588, 77 FR 26699, May 7, 2012]



Sec.  1.163-12  Deduction of original issue discount on instrument 
held by related foreign person.

    (a) General rules--(1) Deferral of deduction. Except as provided in 
paragraph (b) of this section, section 163(e)(3) requires a taxpayer to 
use the cash method of accounting with respect to the deduction of 
original issue discount owed to a related foreign person. A deduction 
for an otherwise deductible portion of original issue discount with 
respect to a debt instrument will not be allowable as a deduction to the 
issuer until paid if, at the close of the issuer's taxable year in which 
such amount would otherwise be deductible, the person holding the debt 
instrument is a related foreign person. For purposes of this section, a 
related foreign person is any person that is not a United States person 
within the meaning of section 7701(a)(30), and that is related (within 
the meaning of section 267(b)) to the issuer at the close of the taxable 
year in which the amount incurred by the taxpayer would otherwise be 
deductible. Section 267(f) defines ``controlled group'' for purposes of 
section 267(b) without regard to the limitations of section 1563(b). An 
amount is treated as paid for purposes of this section if the amount is 
considered paid for purposes of section 1441 or section 1442 (including 
an amount taken into account pursuant to section 871(a)(1)(C), section 
881(a)(3), or section 884(f)). The rules of this paragraph (a) apply 
even if the original issue discount is not subject to United States tax, 
or is subject to a reduced rate of tax, pursuant to a provision of the 
Internal Revenue Code or a treaty obligation of the United States. For 
purposes of this section, original issue discount is an amount described 
in section 1273,

[[Page 336]]

whether from sources inside or outside the United States.
    (2) Change in method of accounting. A taxpayer that uses a method of 
accounting other than that required by the rules of this section must 
change its method of accounting to conform its method to the rules of 
this section. The taxpayer's change in method must be made pursuant to 
the rules of section 446(e), the regulations thereunder, and any 
applicable administrative procedures prescribed by the Commissioner. 
Because the rules of this section prescribe a method of accounting, 
these rules apply in the determination of a taxpayer's earnings and 
profits pursuant to Sec.  1.312-6(a).
    (b) Exceptions and special rules--(1) Effectively connected income. 
The provisions of section 267(a)(2) and the regulations thereunder, and 
not the provisions of paragraph (a) of this section, apply to an amount 
of original issue discount that is income of the related foreign person 
that is effectively connected with the conduct of a United States trade 
or business of such related foreign person. An amount described in this 
paragraph (b)(1) thus is allowable as a deduction as of the day on which 
the amount is includible in the gross income of the related foreign 
person as effectively connected income under sections 872(a)(2) or 
882(b) (or, if later, as of the day on which the deduction would be so 
allowable but for section 267(a)(2)). However, this paragraph (b)(1) 
does not apply if the related foreign person is exempt from United 
States income tax on the amount owed, or is subject to a reduced rate of 
tax, pursuant to a treaty obligation of the United States (such as under 
an article relating to the taxation of business profits).
    (2) Certain obligations issued by natural persons. This section does 
not apply to any debt instrument described in section 163(e)(4) 
(relating to obligations issued by natural persons before March 2, 1984, 
and to loans between natural persons).
    (3) Amounts owed to a foreign personal holding company, controlled 
foreign corporation, or passive foreign investment company--(i) Foreign 
personal holding companies. If an amount to which paragraph (a) of this 
section otherwise applies is owed to a related foreign person that is a 
foreign personal holding company within the meaning of section 552, then 
the amount is allowable as a deduction as of the day on which the amount 
is includible in the income of the foreign personal holding company. The 
day on which the amount is includible in income is determined with 
reference to the method of accounting under which the foreign personal 
holding company computes its taxable income and earnings and profits for 
purposes of sections 551 through 558. See section 551(c) and the 
regulations thereunder for the reporting requirements of the foreign 
personal holding company provisions (sections 551 through 558).
    (ii) Controlled foreign corporations. If an amount to which 
paragraph (a) of this section otherwise applies is owed to a related 
foreign person that is a controlled foreign corporation within the 
meaning of section 957, then the amount is allowable as a deduction as 
of the day on which the amount is includible in the income of the 
controlled foreign corporation. The day on which the amount is 
includible in income is determined with reference to the method of 
accounting under which the controlled foreign corporation computes its 
taxable income and earnings and profits for purposes of sections 951 
through 964. See section 6038 and the regulations thereunder for the 
reporting requirements of the controlled foreign corporation provisions 
(sections 951 through 964).
    (iii) Passive foreign investment companies. If an amount to which 
paragraph (a) of this section otherwise applies is owed to a related 
foreign person that is a passive foreign investment company within the 
meaning of section 1296, then the amount is allowable as a deduction as 
of the day on which amount is includible in the income of the passive 
foreign investment company. The day on which the amount is includible in 
income is determined with reference to the method of accounting under 
which the earnings and profits of the passive foreign investment company 
are computed for purposes of sections 1291 through 1297. See sections 
1291 through 1297 and the regulations thereunder for the reporting 
requirements of

[[Page 337]]

the passive foreign investment company provisions. This exception shall 
apply, however, only if the person that owes the amount at issue has 
made and has in effect an election pursuant to section 1295 with respect 
to the passive foreign investment company to which the amount at issue 
is owed.
    (c) Application of section 267. Except as limited in paragraph 
(b)(1) of this section, the provisions of section 267 and the 
regulations thereunder shall apply to any amount of original issue 
discount to which the provisions of this section do not apply.
    (d) Effective date. The rules of this section are effective with 
respect to all original issue discount on debt instruments issued after 
June 9, 1984.

[T.D. 8465, 58 FR 236, Jan. 5, 1993; 58 FR 8098, Feb. 11, 1993]



Sec.  1.163-13  Treatment of bond issuance premium.

    (a) General rule. If a debt instrument is issued with bond issuance 
premium, this section limits the amount of the issuer's interest 
deduction otherwise allowable under section 163(a). In general, the 
issuer determines its interest deduction by offsetting the interest 
allocable to an accrual period with the bond issuance premium allocable 
to that period. Bond issuance premium is allocable to an accrual period 
based on a constant yield. The use of a constant yield to amortize bond 
issuance premium is intended to generally conform the treatment of debt 
instruments having bond issuance premium with those having original 
issue discount. Unless otherwise provided, the terms used in this 
section have the same meaning as those terms in section 163(e), sections 
1271 through 1275, and the corresponding regulations. Moreover, unless 
otherwise provided, the provisions of this section apply in a manner 
consistent with those of section 163(e), sections 1271 through 1275, and 
the corresponding regulations. In addition, the anti-abuse rule in Sec.  
1.1275-2(g) applies for purposes of this section. For rules dealing with 
the treatment of bond premium by a holder, see Sec. Sec.  1.171-1 
through 1.171-5.
    (b) Exceptions. This section does not apply to--
    (1) A debt instrument described in section 1272(a)(6)(C) (regular 
interests in a REMIC, qualified mortgages held by a REMIC, and certain 
other debt instruments, or pools of debt instruments, with payments 
subject to acceleration); or
    (2) A debt instrument to which Sec.  1.1275-4 applies (relating to 
certain debt instruments that provide for contingent payments).
    (c) Bond issuance premium. Bond issuance premium is the excess, if 
any, of the issue price of a debt instrument over its stated redemption 
price at maturity. For purposes of this section, the issue price of a 
convertible bond (as defined in Sec.  1.171-1(e)(1)(iii)(C)) does not 
include an amount equal to the value of the conversion option (as 
determined under Sec.  1.171-1(e)(1)(iii)(A)).
    (d) Offsetting qualified stated interest with bond issuance 
premium--(1) In general. An issuer amortizes bond issuance premium by 
offsetting the qualified stated interest allocable to an accrual period 
with the bond issuance premium allocable to the accrual period. This 
offset occurs when the issuer takes the qualified stated interest into 
account under its regular method of accounting.
    (2) Qualified stated interest allocable to an accrual period. See 
Sec.  1.446-2(b) to determine the accrual period to which qualified 
stated interest is allocable and to determine the accrual of qualified 
stated interest within an accrual period.
    (3) Bond issuance premium allocable to an accrual period. The bond 
issuance premium allocable to an accrual period is determined under this 
paragraph (d)(3). Within an accrual period, the bond issuance premium 
allocable to the period accrues ratably.
    (i) Step one: Determine the debt instrument's yield to maturity. The 
yield to maturity of a debt instrument is determined under the rules of 
Sec.  1.1272-1(b)(1)(i).
    (ii) Step two: Determine the accrual periods. The accrual periods 
are determined under the rules of Sec.  1.1272-1(b)(1)(ii).
    (iii) Step three: Determine the bond issuance premium allocable to 
the accrual

[[Page 338]]

period. The bond issuance premium allocable to an accrual period is the 
excess of the qualified stated interest allocable to the accrual period 
over the product of the adjusted issue price at the beginning of the 
accrual period and the yield. In performing this calculation, the yield 
must be stated appropriately taking into account the length of the 
particular accrual period. Principles similar to those in Sec.  1.1272-
1(b)(4) apply in determining the bond issuance premium allocable to an 
accrual period.
    (4) Bond issuance premium in excess of qualified stated interest--
(i) Ordinary income. If the bond issuance premium allocable to an 
accrual period exceeds the qualified stated interest allocable to the 
accrual period, the excess is treated as ordinary income by the issuer 
for the accrual period. However, the amount treated as ordinary income 
is limited to the amount by which the issuer's total interest deductions 
on the debt instrument in prior accrual periods exceed the total amount 
treated by the issuer as ordinary income on the debt instrument in prior 
accrual periods.
    (ii) Carryforward. If the bond issuance premium allocable to an 
accrual period exceeds the sum of the qualified stated interest 
allocable to the accrual period and the amount treated as ordinary 
income for the accrual period under paragraph (d)(4)(i) of this section, 
the excess is carried forward to the next accrual period and is treated 
as bond issuance premium allocable to that period. If a carryforward 
exists on the date the debt instrument is retired, the carryforward is 
treated as ordinary income on that date.
    (e) Special rules--(1) Variable rate debt instruments. An issuer 
determines bond issuance premium on a variable rate debt instrument by 
reference to the stated redemption price at maturity of the equivalent 
fixed rate debt instrument constructed for the variable rate debt 
instrument. The issuer also allocates any bond issuance premium among 
the accrual periods by reference to the equivalent fixed rate debt 
instrument. The issuer constructs the equivalent fixed rate debt 
instrument, as of the issue date, by using the principles of Sec.  
1.1275-5(e).
    (2) Inflation-indexed debt instruments. An issuer determines bond 
issuance premium on an inflation-indexed debt instrument by assuming 
that there will be no inflation or deflation over the term of the 
instrument. The issuer also allocates any bond issuance premium among 
the accrual periods by assuming that there will be no inflation or 
deflation over the term of the instrument. The bond issuance premium 
allocable to an accrual period offsets qualified stated interest 
allocable to the period. Notwithstanding paragraph (d)(4) of this 
section, if the bond issuance premium allocable to an accrual period 
exceeds the qualified stated interest allocable to the period, the 
excess is treated as a deflation adjustment under Sec.  1.1275-
7(f)(1)(ii). See Sec.  1.1275-7 for other rules relating to inflation-
indexed debt instruments.
    (3) Certain debt instruments subject to contingencies--(i) In 
general. Except as provided in paragraph (e)(3)(ii) of this section, the 
rules of Sec.  1.1272-1(c) apply to determine a debt instrument's 
payment schedule for purposes of this section. For example, an issuer 
uses the payment schedule determined under Sec.  1.1272-1(c) to 
determine the amount, if any, of bond issuance premium on the debt 
instrument, the yield and maturity of the debt instrument, and the 
allocation of bond issuance premium to an accrual period.
    (ii) Mandatory sinking fund provision. Notwithstanding paragraph 
(e)(3)(i) of this section, if a debt instrument is subject to a 
mandatory sinking fund provision described in Sec.  1.1272-1(c)(3), the 
issuer must determine the payment schedule by assuming that a pro rata 
portion of the debt instrument will be called under the sinking fund 
provision.
    (4) Remote and incidental contingencies. For purposes of determining 
the amount of bond issuance premium and allocating bond issuance premium 
among accrual periods, if a bond provides for a contingency that is 
remote or incidental (within the meaning of Sec.  1.1275-2(h)), the 
issuer takes the contingency into account under the rules for remote and 
incidental contingencies in Sec.  1.1275-2(h).
    (f) Example. The following example illustrates the rules of this 
section:


[[Page 339]]


    Example. (i) Facts. On February 1, 1999, X issues for $110,000 a 
debt instrument maturing on February 1, 2006, with a stated principal 
amount of $100,000, payable at maturity. The debt instrument provides 
for unconditional payments of interest of $10,000, payable on February 1 
of each year. X uses the calendar year as its taxable year, X uses the 
cash receipts and disbursements method of accounting, and X decides to 
use annual accrual periods ending on February 1 of each year. X's 
calculations assume a 30-day month and 360-day year.
    (ii) Amount of bond issuance premium. The issue price of the debt 
instrument is $110,000. Because the interest payments on the debt 
instrument are qualified stated interest, the stated redemption price at 
maturity of the debt instrument is $100,000. Therefore, the amount of 
bond issuance premium is $10,000 ($110,000-$100,000).
    (iii) Bond issuance premium allocable to the first accrual period. 
Based on the payment schedule and the issue price of the debt 
instrument, the yield of the debt instrument is 8.07 percent, compounded 
annually. (Although, for purposes of simplicity, the yield as stated is 
rounded to two decimal places, the computations do not reflect this 
rounding convention.) The bond issuance premium allocable to the accrual 
period ending on February 1, 2000, is the excess of the qualified stated 
interest allocable to the period ($10,000) over the product of the 
adjusted issue price at the beginning of the period ($110,000) and the 
yield (8.07 percent, compounded annually). Therefore, the bond issuance 
premium allocable to the accrual period is $1,118.17 ($10,000-
$8,881.83).
    (iv) Premium used to offset interest. Although X makes an interest 
payment of $10,000 on February 1, 2000, X only deducts interest of 
$8,881.83, the qualified stated interest allocable to the period 
($10,000) offset with the bond issuance premium allocable to the period 
($1,118.17).

    (g) Effective date. This section applies to debt instruments issued 
on or after March 2, 1998.
    (h) Accounting method changes--(1) Consent to change. An issuer 
required to change its method of accounting for bond issuance premium to 
comply with this section must secure the consent of the Commissioner in 
accordance with the requirements of Sec.  1.446-1(e). Paragraph (h)(2) 
of this section provides the Commissioner's automatic consent for 
certain changes.
    (2) Automatic consent. The Commissioner grants consent for an issuer 
to change its method of accounting for bond issuance premium on debt 
instruments issued on or after March 2, 1998. Because this change is 
made on a cut-off basis, no items of income or deduction are omitted or 
duplicated and, therefore, no adjustment under section 481 is allowed. 
The consent granted by this paragraph (h)(2) applies provided--
    (i) The change is made to comply with this section;
    (ii) The change is made for the first taxable year for which the 
issuer must account for a debt instrument under this section; and
    (iii) The issuer attaches to its federal income tax return for the 
taxable year containing the change a statement that it has changed its 
method of accounting under this section.

[T.D. 8746, 62 FR 68176, Dec. 31, 1997, as amended by T.D. 8838, 64 FR 
48547, Sept. 7, 1999]



Sec.  1.163(d)-1  Time and manner for making elections under 
the Omnibus Budget Reconciliation Act of 1993 and the Jobs and 
Growth Tax Relief Reconciliation Act of 2003.

    (a) Description. Section 163(d)(4)(B)(iii), as added by section 
13206(d) of the Omnibus Budget Reconciliation Act of 1993 (Pub. L. 103-
66, 107 Stat. 467), allows an electing taxpayer to take all or a portion 
of certain net capital gain attributable to dispositions of property 
held for investment into account as investment income. Section 
163(d)(4)(B), as amended by section 302(b) of the Jobs and Growth Tax 
Relief Reconciliation Act of 2003 (Pub. L. 108-27, 117 Stat. 762), 
allows an electing taxpayer to take all or a portion of qualified 
dividend income, as defined in section 1(h)(11)(B), into account as 
investment income. As a consequence, the net capital gain and qualified 
dividend income taken into account as investment income under these 
elections are not eligible to be taxed at the capital gains rates. An 
election may be made for net capital gain recognized by noncorporate 
taxpayers during any taxable year beginning after December 31, 1992. An 
election may be made for qualified dividend income received by 
noncorporate taxpayers during any taxable year beginning after December 
31, 2002, but before January 1, 2009.
    (b) Time and manner for making the elections. The elections for net 
capital gain and qualified dividend income

[[Page 340]]

must be made on or before the due date (including extensions) of the 
income tax return for the taxable year in which the net capital gain is 
recognized or the qualified dividend income is received. The elections 
are to be made on Form 4952, ``Investment Interest Expense Deduction,'' 
in accordance with the form and its instructions.
    (c) Revocability of elections. The elections described in this 
section are revocable with the consent of the Commissioner.
    (d) Effective date. The rules set forth in this section regarding 
the net capital gain election apply beginning December 12, 1996. The 
rules set forth in this section regarding the qualified dividend income 
election apply to any taxable year beginning after December 31, 2002, 
but before January 1, 2009.

[T.D. 9191, 70 FR 13100, Mar. 18, 2005]



Sec.  1.164-1  Deduction for taxes.

    (a) In general. Only the following taxes shall be allowed as a 
deduction under this section for the taxable year within which paid or 
accrued, according to the method of accounting used in computing taxable 
income:
    (1) State and local, and foreign, real property taxes.
    (2) State and local personal property taxes.
    (3) State and local, and foreign, income, war profits, and excess 
profits taxes.
    (4) State and local general sales taxes.
    (5) State and local taxes on the sale of gasoline, diesel fuel, and 
other motor fuels.

In addition, there shall be allowed as a deduction under this section 
State and local and foreign taxes not described in subparagraphs (1) 
through (5) of this paragraph which are paid or accrued within the 
taxable year in carrying on a trade or business or an activity described 
in section 212 (relating to expenses for production of income). For 
example, dealers or investors in securities and dealers or investors in 
real estate may deduct State stock transfer and real estate transfer 
taxes, respectively, under section 164, to the extent they are expenses 
incurred in carrying on a trade or business or an activity for the 
production of income. In general, taxes are deductible only by the 
person upon whom they are imposed. However, see Sec.  1.164-5 in the 
case of certain taxes paid by the consumer. Also, in the case of a 
qualified State individual income tax (as defined in section 6362 and 
the regulations thereunder) which is determined by reference to a 
percentage of the Federal income tax (pursuant to section 6362 (c)), an 
accrual method taxpayer shall use the cash receipts and disbursements 
method to compute the amount of his deduction therefor. Thus, the 
deduction under section 164 is in the amount actually paid with respect 
to the qualified tax, rather than the amount accrued with respect 
thereto, during the taxable year even though the taxpayer uses the 
accrual method of accounting for other purposes. In addition, see 
paragraph (f)(1) of Sec.  301.6361-1 of this chapter (Regulations on 
Procedure and Administration) with respect to rules relating to 
allocation and reallocation of amounts collected on account of the 
Federal income tax and qualified taxes.
    (b) Taxable years beginning before January 1, 1964. For taxable 
years beginning before January 1, 1964, except as otherwise provided in 
Sec. Sec.  1.164-2 through 1.164-8, inclusive, taxes imposed by the 
United States, any State, territory, possession of the United States, or 
a political subdivision of any of the foregoing, or by any foreign 
country, are deductible from gross income for the taxable year in which 
paid or accrued, according to the method of accounting used in computing 
taxable income. For this purpose, postage is not a tax and automobile 
license or registration fees are ordinarily taxes.
    (c) Cross references. For the definition of the term ``real property 
taxes'', see paragraph (d) of Sec.  1.164-3. For the definition of the 
term ``foreign taxes'', see paragraph (d) of Sec.  1.164-3. For the 
definition of the term ``general sales taxes'', see paragraph (f) of 
Sec.  1.164-3. For the treatment of gasoline, diesel fuel, and other 
motor fuel taxes, see Sec.  1.164-5. For apportionment of taxes on real 
property between seller and purchaser, see section 164(d) and Sec.  
1.164-6. For the general rule for taxable year of

[[Page 341]]

deduction, see section 461. For provisions disallowing any deduction for 
the tax paid at the source on interest from tax-free covenant bonds, see 
section 1451(f).

[T.D. 6780, 29 FR 18145, Dec. 22, 1964, as amended by T.D. 7577, 43 FR 
59357, Dec. 20, 1978]



Sec.  1.164-2  Deduction denied in case of certain taxes.

    This section and Sec.  1.275 describe certain taxes for which no 
deduction is allowed. In the case of taxable years beginning before 
January 1, 1964, the denial is provided for by section 164(b) (prior to 
being amended by section 207 of the Revenue Act of 1964 (78 Stat. 40)). 
In the case of taxable years beginning after December 31, 1963, the 
denial is governed by sections 164 and 275. No deduction is allowed for 
the following taxes:
    (a) Federal income taxes. Federal income taxes, including the taxes 
imposed by section 3101, relating to the tax on employees under the 
Federal Insurance Contributions Act (chapter 21 of the Code); sections 
3201 and 3211, relating to the taxes on railroad employees and railroad 
employee representatives; section 3402, relating to the tax withheld at 
source on wages; and by corresponding provisions of prior internal 
revenue laws.
    (b) Federal war profits and excess profits taxes. Federal war 
profits and excess profits taxes including those imposed by title II of 
the Revenue Act of 1917 (39 Stat. 1000), title III of the Revenue Act of 
1918 (40 Stat. 1088), title III of the Revenue Act of 1921 (42 Stat. 
271), section 216 of the National Industrial Recovery Act (48 Stat. 
208), section 702 of the Revenue Act of 1934 (48 Stat. 770), Subchapter 
D, Chapter 1 of the Internal Revenue Code of 1939, and Subchapter E, 
Chapter 2 of the Internal Revenue Code of 1939.
    (c) Estate and gift taxes. Estate, inheritance, legacy, succession, 
and gift taxes.
    (d) Foreign income, war profits, and excess profits taxes. Income, 
war profits, and excess profits taxes imposed by the authority of any 
foreign country or possession of the United States, if the taxpayer 
chooses to take to any extent the benefits of section 901, relating to 
the credit for taxes of foreign countries and possessions of the United 
States.
    (e) Real property taxes. Taxes on real property, to the extent that 
section 164(d) and Sec.  1.164-6 require such taxes to be treated as 
imposed on another taxpayer.
    (f) Federal duties and excise taxes. Federal import or tariff 
duties, business, license, privilege, excise, and stamp taxes (not 
described in paragraphs (a), (b), (c), or (h) of this section, or Sec.  
1.164-4) paid or accrued within the taxable year. The fact that any such 
tax is not deductible as a tax under section 164 does not prevent (1) 
its deduction under section 162 or section 212, provided it represents 
an ordinary and necessary expense paid or incurred during the taxable 
year by a corporation or an individual in the conduct of any trade or 
business or, in the case of an individual for the production or 
collection of income, for the management, conservation, or maintenance 
of property held for the production of income, or in connection with the 
determination, collection, or refund of any tax, or (2) its being taken 
into account during the taxable year by a corporation or an individual 
as a part of the cost of acquiring or producing property in the trade or 
business or, in the case of an individual, as a part of the cost of 
property held for the production of income with respect to which it 
relates.
    (g) Taxes for local benefits. Except as provided in Sec.  1.164-4, 
taxes assessed against local benefits of a kind tending to increase the 
value of the property assessed.
    (h) Excise tax on real estate investment trusts. The excise tax 
imposed on certain real estate investment trusts by section 4981.

[T.D. 6780, 29 FR 18145, Dec. 22, 1964, as amended by T.D. 7767, 46 FR 
11263, Feb. 6, 1981]



Sec.  1.164-3  Definitions and special rules.

    For purposes of section 164 and Sec.  1.164-1 to Sec.  1.164-8, 
inclusive--
    (a) State or local taxes. A State or local tax includes only a tax 
imposed by a State, a possession of the United States, or a political 
subdivision of any of the foregoing, or by the District of Columbia.

[[Page 342]]

    (b) Real property taxes. The term ``real property taxes'' means 
taxes imposed on interests in real property and levied for the general 
public welfare, but it does not include taxes assessed against local 
benefits. See Sec.  1.164-4.
    (c) Personal property taxes. The term ``personal property tax'' 
means an ad valorem tax which is imposed on an annual basis in respect 
of personal property. To qualify as a personal property tax, a tax must 
meet the following three tests:
    (1) The tax must be ad valorem--that is, substantially in proportion 
to the value of the personal property. A tax which is based on criteria 
other than value does not qualify as ad valorem. For example, a motor 
vehicle tax based on weight, model year, and horsepower, or any of these 
characteristics is not an ad valorem tax. However, a tax which is partly 
based on value and partly based on other criteria may qualify in part. 
For example, in the case of a motor vehicle tax of 1 percent of value 
plus 40 cents per hundredweight, the part of the tax equal to 1 percent 
of value qualifies as an ad valorem tax and the balance does not 
qualify.
    (2) The tax must be imposed on an annual basis, even if collected 
more frequently or less frequently.
    (3) The tax must be imposed in respect of personal property. A tax 
may be considered to be imposed in respect of personal property even if 
in form it is imposed on the exercise of a privilege. Thus, for taxable 
years beginning after December 31, 1963, State and local taxes on the 
registration or licensing of highway motor vehicles are not deductible 
as personal property taxes unless and to the extent that the tests 
prescribed in this subparagraph are met. For example, an annual ad 
valorem tax qualifies as a personal property tax although it is 
denominated a registration fee imposed for the privilege of registering 
motor vehicles or of using them on the highways.
    (d) Foreign taxes. The term ``foreign tax'' includes only a tax 
imposed by the authority of a foreign country. A tax-imposed by a 
political subdivision of a foreign country is considered to be imposed 
by the authority of that foreign country.
    (e) Sales tax. (1) The term ``sales tax'' means a tax imposed upon 
persons engaged in selling tangible personal property, or upon the 
consumers of such property, including persons selling gasoline or other 
motor vehicle fuels at wholesale or retail, which is a stated sum per 
unit of property sold or which is measured by the gross sales price or 
the gross receipts from the sale. The term also includes a tax imposed 
upon persons engaged in furnishing services which is measured by the 
gross receipts for furnishing such services.
    (2) In general, the term ``consumer'' means the ultimate user or 
purchaser; it does not include a purchaser such as a retailer, who 
acquires the property for resale.
    (f) General sales tax. A ``general sales tax'' is a sales tax which 
is imposed at one rate in respect of the sale at retail of a broad range 
of classes of items. No foreign sales tax is deductible under section 
164(a) and paragraph (a)(4) of Sec.  1.164-1. To qualify as a general 
sales tax, a tax must meet the following two tests:
    (1) The tax must be a tax in respect of sales at retail. This may 
include a tax imposed on persons engaged in selling property at retail 
or furnishing services at retail, for example, if the tax is measured by 
gross sales price or by gross receipts from sales or services. Rentals 
qualify as sales at retail if so treated under applicable State sales 
tax laws.
    (2) The tax must be general--that is, it must be imposed at one rate 
in respect of the retail sales of a broad range of classes of items. A 
sales tax is considered to be general although imposed on sales of 
various classes of items at more than one rate provided that one rate 
applies to the retail sales of a broad range of classes of items. The 
term ``items'' includes both commodities and services.
    (g) Special rules relating to general sales taxes. (1) A sales tax 
which is general is usually imposed at one rate in respect of the retail 
sales of all tangible personal property (with exceptions and additions). 
However, a sales tax which is selective--that is, a tax which applies at 
one rate with respect to retail sales of specified classes of items also 
qualifies as general if the

[[Page 343]]

specified classes represent a broad range of classes of items. A 
selective sales tax which does not apply at one rate to the retail sales 
of a broad range of classes of items is not general. For example, a tax 
which applies only to sales of alcoholic beverages, tobacco, admissions, 
luxury items, and a few other items is not general. Similarly, a tax 
imposed solely on services is not general. However, a selective sales 
tax may be deemed to be part of the general sales tax and hence may be 
deductible, even if imposed by a separate title, etc., of the State or 
local law, if imposed at the same rate as the general rate of tax (as 
defined in subparagraph (4) of this paragraph) which qualifies a tax in 
the taxing jurisdiction as a general sales tax. For example, if a State 
has a 5 percent general sales tax and a separate selective sales tax of 
5 percent on transient accommodations, the tax on transient 
accommodations is deductible.
    (2) A tax is imposed at one rate only if it is imposed at that rate 
on generally the same base for all items subject to tax. For example, a 
sales tax imposed at a 3 percent rate on 100 percent of the sales price 
of some classes of items and at a 3 percent rate on 50 percent of the 
sales price of other classes of items would not be imposed at one rate 
with respect to all such classes. However, a tax is considered to be 
imposed at one rate although it allows dollar exemptions, if the 
exemptions are designed to exclude all sales under a certain dollar 
amount. For example, a tax may be imposed at one rate although it 
applies to all sales of tangible personal property but applies only to 
sales amounting to more than 10 cents.
    (3) The fact that a sales tax exempts food, clothing, medical 
supplies, and motor vehicles, or any of them, shall not be taken into 
account in determining whether the tax applies to a broad range of 
classes of items. The fact that a sales tax applies to food, clothing, 
medical supplies, and motor vehicles, or any of them, at a rate which is 
lower than the general rate of tax (as defined in subparagraph (4) of 
this paragraph) is not taken into account in determining whether the tax 
is imposed at one rate on the retail sales of a broad range of classes 
of items. For purposes of this section, the term ``food'' means food for 
human consumption off the premises where sold, and the term ``medical 
supplies'' includes drugs, medicines, and medical devices.
    (4) Except in the case of a lower rate of tax applicable in respect 
of food, clothing, medical supplies, and motor vehicles, or any of them, 
no deduction is allowed for a general sales tax in respect of any item 
if the tax is imposed on such item at a rate other than the general rate 
of tax. The general rate of tax is the one rate which qualifies a tax in 
a taxing jurisdiction as a general sales tax because the tax is imposed 
at such one rate on a broad range of classes of items. There can be only 
one general rate of tax in any one taxing jurisdiction. However, a 
general sales tax imposed at a lower rate or rates on food, clothing, 
motor vehicles, and medical supplies, or any of them, may nonetheless be 
deductible with respect to such items. For example, a sales tax which is 
imposed at 1 percent with respect to food, imposed at 3 percent with 
respect to a broad range of classes of tangible personal property, and 
imposed at 4 percent with respect to transient accommodations would 
qualify as a general sales tax. Taxes paid at the 1 percent and the 3 
percent rates are deductible, but tax paid at the 4 percent rate is not 
deductible. The fact that a sales tax provides for the adjustment of the 
general rate of tax to reflect the sales tax rate in another taxing 
jurisdiction shall not be taken into account in determining whether the 
tax is imposed at one rate on the retail sales of a broad range of 
classes of items. Moreover, a general sales tax imposed at a lower rate 
with respect to an item in order to reflect the tax rate in another 
jurisdiction is also deductible at such lower rate. For example, State E 
imposes a general sales tax whose general rate is 3 percent. The State E 
sales tax law provides that in areas bordering on States with general 
sales taxes, selective sales taxes, or special excise taxes, the rate 
applied in the adjoining State will be used if such rate is under 3 
percent. State F imposes a 2 percent sales tax. The 2 percent sales tax 
paid by

[[Page 344]]

residents of State E in areas bordering on State F is deductible.
    (h) Compensating use taxes. A compensating use tax in respect of any 
item is treated as a general sales tax. The term ``compensating use 
tax'' means, in respect of any item, a tax which is imposed on the use, 
storage, or consumption of such item and which is complementary to a 
general sales tax which is deductible with respect to sales of similar 
items.
    (i) Special rules relating to compensating use taxes. (1) In 
general, a use tax on an item is complementary to a general sales tax on 
similar items if the use tax is imposed on an item which was not subject 
to such general sales tax but which would have been subject to such 
general sales tax if the sale of the item had taken place within the 
jurisdiction imposing the use tax. For example, a tax imposed by State A 
on the use of a motor vehicle purchased in State B is complementary to 
the general sales tax of State A on similar items, if the latter tax 
applies to motor vehicles sold in State A.
    (2) Since a compensating use tax is treated as a general sales tax, 
it is subject to the rule of subparagraph (C) of section 164(b)(2) and 
paragraph (g)(4) of this section that no deduction is allowed for a 
general sales tax imposed in respect of an item at a rate other than the 
general rate of tax (except in the case of lower rates on the sale of 
food, clothing, medical supplies, and motor vehicles). The fact that a 
compensating use tax in respect of any item provides for an adjustment 
in the rate of the compensating use tax or the amount of such tax to be 
paid on account of a sales tax on such item imposed by another taxing 
jurisdiction is not taken into account in determining whether the 
compensating use tax is imposed in respect of the item at a rate other 
than the general rate of tax. For example, a compensating use tax 
imposed by State C on the use of an item purchased in State D is 
considered to be imposed at the general rate of tax even though the tax 
imposed by State C allows a credit for any sales tax paid on such item 
in State D, or the rate of such compensating use tax is adjusted to 
reflect the rate of sales tax imposed by State D.

[T.D. 6780, 29 FR 18146, Dec. 22, 1964]



Sec.  1.164-4  Taxes for local benefits.

    (a) So-called taxes for local benefits referred to in paragraph (g) 
of Sec.  1.164-2, more properly assessments, paid for local benefits 
such as street, sidewalk, and other like improvements, imposed because 
of and measured by some benefit inuring directly to the property against 
which the assessment is levied are not deductible as taxes. A tax is 
considered assessed against local benefits when the property subject to 
the tax is limited to property benefited. Special assessments are not 
deductible, even though an incidental benefit may inure to the public 
welfare. The real property taxes deductible are those levied for the 
general public welfare by the proper taxing authorities at a like rate 
against all property in the territory over which such authorities have 
jurisdiction. Assessments under the statutes of California relating to 
irrigation, and of Iowa relating to drainage, and under certain statutes 
of Tennessee relating to levees, are limited to property benefited, and 
if the assessments are so limited, the amounts paid thereunder are not 
deductible as taxes. For treatment of assessments for local benefits as 
adjustments to the basis of property, see section 1016(a)(1) and the 
regulations thereunder.
    (b)(1) Insofar as assessments against local benefits are made for 
the purpose of maintenance or repair or for the purpose of meeting 
interest charges with respect to such benefits, they are deductible. In 
such cases, the burden is on the taxpayer to show the allocation of the 
amounts assessed to the different purposes. If the allocation cannot be 
made, none of the amount so paid is deductible.
    (2) Taxes levied by a special taxing district which was in existence 
on December 31, 1963, for the purpose of retiring indebtedness existing 
on such date, are deductible, to the extent levied for such purpose, if 
(i) the district covers the whole of at least one county, (ii) if at 
least 1,000 persons are subject to the taxes levied by the district, and 
(iii) if the district levies its assessments annually at a uniform rate 
on the same

[[Page 345]]

assessed value of real property, including improvements, as is used for 
purposes of the real property tax generally.

[T.D. 6780, 29 FR 18147, Dec. 22, 1964]



Sec.  1.164-5  Certain retail sales taxes and gasoline taxes.

    For taxable years beginning before January 1, 1964, any amount 
representing a State or local sales tax paid by a consumer of services 
or tangible personal property is deductible by such consumer as a tax, 
provided it is separately stated and not paid in connection with his 
trade or business. For taxable years beginning after December 31, 1963, 
only the amount of any separately stated State and local general sales 
tax (as defined in paragraph (g) of Sec.  1.164-3) and tax on the sale 
of gasoline, diesel fuel or other motor fuel paid by the consumer (other 
than in connection with his trade or business) is deductible by the 
consumer as tax. The fact that, under the law imposing it, the incidence 
of such State or local tax does not fall on the consumer is immaterial. 
The requirement that the amount of tax must be separately stated will be 
deemed complied with where it clearly appears that at the time of sale 
to the consumer, the tax was added to the sales price and collected or 
charged as a separate item. It is not necessary, for the purpose of this 
section, that the consumer be furnished with a sales slip, bill, 
invoice, or other statement on which the tax is separately stated. For 
example, where the law imposing the State or local tax for which the 
taxpayer seeks a deduction contains a prohibition against the seller 
absorbing the tax, or a provision requiring a posted notice stating that 
the tax will be added to the quoted price, or a requirement that the tax 
be separately shown in advertisements or separately stated on all bills 
and invoices, it is presumed that the amount of the State or local tax 
was separately stated at the time paid by the consumer; except that such 
presumption shall have no application to a tax on the sale of gasoline, 
diesel fuel or other motor fuel imposed upon a wholesaler unless such 
provisions of law apply with respect to both the sale at wholesale and 
the sale at retail.

[T.D. 6780, 29 FR 18147, Dec. 22, 1964]



Sec.  1.164-6  Apportionment of taxes on real property 
between seller and purchaser.

    (a) Scope. Except as provided otherwise in section 164(f) and Sec.  
1.164-8, when real property is sold, section 164(d)(1) governs the 
deduction by the seller and the purchaser of current real property 
taxes. Section 164(d)(1) performs two functions: (1) It provides a 
method by which a portion of the taxes for the real property tax year in 
which the property is sold may be deducted by the seller and a portion 
by the purchaser; and (2) it limits the deduction of the seller and the 
purchaser to the portion of the taxes corresponding to the part of the 
real property tax year during which each was the owner of the property. 
These functions are accomplished by treating a portion of the taxes for 
the real property tax year in which the property is sold as imposed on 
the seller and a portion as imposed on the purchaser. To the extent that 
the taxes are treated as imposed on the seller and the purchaser, each 
shall be allowed a deduction, under section 164(a), in the taxable year 
such tax is paid or accrued, or treated as paid or accrued under section 
164(d)(2) (A) or (D) and this section. No deduction is allowed for taxes 
on real property to the extent that they are imposed on another 
taxpayer, or are treated as imposed on another taxpayer under section 
164(d). For the election to accrue real property taxes ratably see 
section 461(c) and the regulations thereunder.
    (b) Application of rule of apportionment. (1)(i) For purposes of the 
deduction provided by section 164(a), if real property is sold during 
any real property tax year, the portion of the real property tax 
properly allocable to that part of the real property tax year which ends 
on the day before the date of the sale shall be treated as a tax imposed 
on the seller, and the portion of such tax properly allocable to that 
part of such real property tax year which begins on the date of the sale 
shall be treated as a tax imposed on the purchased. For definition of 
``real property

[[Page 346]]

tax year'' see paragraph (c) of this section. This rule shall apply 
whether or not the seller and the purchaser apportion such tax. The rule 
of apportionment contained in section 164(d)(1) applies even though the 
same real property is sold more than once during the real property tax 
year. (See paragraph (d)(5) of this section for rule requiring inclusion 
in gross income of excess deductions.)
    (ii) Where the real property tax becomes a personal liability or a 
lien before the beginning of the real property tax year to which it 
relates and the real property is sold subsequent to the time the tax 
becomes a personal liability or a lien but prior to the beginning of the 
related real property tax year--
    (a) The seller may not deduct any amount for real property taxes for 
the related real property tax year, and
    (b) To the extent that he holds the property for such real property 
tax year, the purchaser may deduct the amount of such taxes for the 
taxable year they are paid (or amounts representing such taxes are paid 
to the seller, mortgagee, trustee or other person having an interest in 
the property as security) or accrued by him according to his method of 
accounting.
    (iii) Similarly, where the real property tax becomes a personal 
liability or a lien after the end of the real property tax year to which 
it relates and the real property is sold prior to the time the tax 
becomes a personal liability or a lien but after the end of the related 
real property tax year--
    (a) The purchaser may not deduct any amount for real property taxes 
for the related real property tax year, and
    (b) To the extent that he holds the property for such real property 
tax year, the seller may deduct the amount of such taxes for the taxable 
year they are paid (or amounts representing such taxes are paid to the 
purchaser, mortgagee, trustee, or other person having an interest in the 
property as security) or accrued by him according to his method of 
accounting.
    (iv) Where the real property is sold (or purchased) during the 
related real property tax year the real property taxes for such year are 
apportioned between the parties to such sale and may be deducted by such 
parties in accordance with the provisions of paragraph (d) of this 
section.
    (2) Section 164(d) does not apply to delinquent real property taxes 
for any real property tax year prior to the real property tax year in 
which the property is sold.
    (3) The provisions of this paragraph may be illustrated by the 
following examples:

    Example 1. The real property tax year in County R is April 1 to 
March 31. A, the owner on April 1, 1954, of real property located in 
County R sells the real property to B on June 30, 1954. B owns the real 
property from June 30, 1954, through March 31, 1955. The real property 
tax for the real property tax year April 1, 1954-March 31, 1955 is $365. 
For purposes of section 164(a), $90 (90/365 x $365, April 1, 1954-June 
29, 1954) of the real property tax is treated as imposed on A, the 
seller, and $275 (275/365 x $365, June 30, 1954-March 31, 1955) of such 
real property tax is treated as imposed on B, the purchaser.
    Example 2. In County S the real property tax year is the calendar 
year. The real property tax becomes a lien on June 1 and is payable on 
July 1 of the current real property tax year, but there is no personal 
liability for such tax. On April 30, 1955, C, the owner of real property 
in County S on January 1, 1955, sells the real property to D. On July 1, 
1955, D pays the 1955 real property tax. On August 31, 1955, D sells the 
same real property to E. C, D, and E use the cash receipts and 
disbursements method of accounting. Under the provisions of section 
164(d)(1), 119/365 (January 1-April 29, 1955) of the real property tax 
payable on July 1, 1955, for the 1955 real property tax year is treated 
as imposed on C, and, under the provisions of section 164(d)(2)(A), such 
portion is treated as having been paid by him on the date of sale. Under 
the provisions of section 164(d)(1), 123/365 (April 30-August 30, 1955) 
of the real property tax paid July 1, 1955, for the 1955 real property 
tax year is treated as imposed on D and may be deducted by him. Under 
the provisions of section 164(d)(1), 123/365 (August 31-December 31, 
1955) of the real property tax due and paid on July 1, 1955, for the 
1955 real property tax year is treated as imposed on E and, under the 
provisions of section 164(d)(2)(A) such portion is treated as having 
been paid by him on the date of sale.
    Example 3. In State X the real property tax year is the calendar 
year. The real property tax becomes a lien on November 1 of the 
preceding calendar year. On November 15, 1955, F sells real property in 
State X to G. G owns the real property through December 31, 1956. Under 
section 164(d)(1), the real property tax (which became a lien on 
November 1, 1954) for the 1955 real property tax year is apportioned 
between F and G. No part of the real

[[Page 347]]

property tax for the 1956 real property tax year may be deducted by F. 
The entire real property tax for the 1956 real property tax year may be 
deducted by G when paid or accrued, depending upon the method of 
accounting used by him. See subparagraph (6) of paragraph (d) and 
section 461(c) and the regulations thereunder.

    (c) Real property tax year. As used in section 164(d), the term 
``real property tax year'' refers to the period which, under the law 
imposing the tax, is regarded as the period to which the tax imposed 
relates. Where the State and one or more local governmental units each 
imposes a tax on real property, the real property tax year for each tax 
must be determined for purposes of applying the rule of apportionment of 
section 164(d)(1) to each tax. The time when the tax rate is determined, 
the time when the assessment is made, the time when the tax becomes a 
lien, or the time when the tax becomes due or delinquent does not 
necessarily determine the real property tax year. The real property tax 
year may or may not correspond to the fiscal year of the governmental 
unit imposing the tax. In each case the State or local law determines 
what constitutes the real property tax year. Although the seller and the 
purchaser may or may not make an allocation of real property taxes, the 
meaning of ``real property tax year'' in section 164(d) and the 
application of section 164(d) do not depend upon what real property 
taxes were allocated nor the method of allocation used by the parties.
    (d) Special rules--(1) Seller using cash receipts and disbursements 
method of accounting. Under the provisions of section 164(d), if the 
seller by reason of his method of accounting may not deduct any amount 
for taxes unless paid, and--
    (i) The purchaser (under the law imposing the real property tax) is 
liable for the real property tax for the real property tax year, or
    (ii) The seller (under the law imposing the real property tax) is 
liable for the real property tax for the real property tax year and the 
tax is not payable until after the date of sale, then the portion of the 
tax treated under section 164(d)(1) as imposed upon the seller (whether 
or not actually paid by him in the taxable year in which the sale 
occurs) shall be considered as having been paid by him in such taxable 
year. Such portion may be deducted by him for the taxable year in which 
the sale occurs, or, if at a later time, for the taxable year (which 
would be proper under the taxpayer's method of accounting) in which the 
tax is actually paid, or an amount representing such tax is paid to the 
purchaser, mortgagee, trustee, or other person having an interest in the 
property as security.
    (2) Purchasers using the cash receipts and disbursements method of 
accounting. Under the provisions of section 164(d), if the purchaser by 
reason of his method of accounting may not deduct any amount for taxes 
unless paid and the seller (under the law imposing the real property 
tax) is liable for the real property tax for the real property tax year, 
the portion of the tax treated under section 164(d)(1) as imposed upon 
the purchaser (whether or not actually paid by him in the taxable year 
in which the sale occurs) shall be considered as having been paid by him 
in such taxable year. Such portion may be deducted by him for the 
taxable year in which the sale occurs, or, if at a later time, for the 
taxable year (which would be proper under the taxpayer's method of 
accounting) in which the tax is actually paid, or an amount representing 
such tax is paid to the seller, mortgagee, trustee, or other person 
having an interest in the property as security.
    (3) Persons considered liable for tax. Where the tax is not a 
liability of any person, the person who holds the property at the time 
the tax becomes a lien on the property shall be considered liable for 
the tax. As to a particular sale, in determining:
    (i) Whether the other party to the sale is liable for the tax or,
    (ii) The person who holds the property at the time the tax becomes a 
lien on the property (where the tax is not a liability of any person),

prior or subsequent sales of the property during the real property tax 
year shall be disregarded.
    (4) Examples. The provisions of subparagraphs (1), (2), and (3) of 
this paragraph may be illustrated as follows:

    Example 1. In County X the real property tax year is the calendar 
year. The real property tax is a personal liability of the owner

[[Page 348]]

of the real property on June 30 of the current real property tax year, 
but is not payable until February 28 of the following real property tax 
year. A, the owner of real property in County X on January 1, 1955, uses 
the cash receipts and disbursements method of accounting. On May 30, 
1955, A sells the real property to B, who also uses the cash receipts 
and disbursements method of accounting. B retains ownership of the real 
property for the balance of the 1955 calendar year. Under the provisions 
of section 164(d)(1), 149/365 (January 1-May 29, 1955) of the real 
property tax payable on February 28, 1956, for the 1955 real property 
tax year is treated as imposed on A, the seller, and under the 
provisions of section 164(d)(2)(A) such portion is treated as having 
been paid by him on the date of sale and may be deducted by him for his 
taxable year in which the sale occurs (whether or not such portion is 
actually paid by him in that year) or for his taxable year in which the 
tax is actually paid or an amount representing such tax is paid. Under 
the provisions of section 164(d)(1), 216/365 (May 30-December 31, 1955) 
of the real property tax payable on February 28, 1956, for the 1955 real 
property tax year is treated as imposed on B, the purchaser, and may be 
deducted by him for his taxable year in which the tax is actually paid, 
or an amount representing such tax is paid.
    Example 2. In County Y, the real property tax year is the calendar 
year. The real property tax becomes a lien on January 1, 1955, and is 
payable on April 30, 1955. There is no personal liability for the real 
property tax imposed by County Y. On April 30, 1955, C, the owner of 
real property in County Y on January 1, 1955, pays the real property tax 
for the 1955 real property tax year. On May 1, 1955, C sells the real 
property to D. On September 1, 1955, D sells the real property to E. C, 
D, and E use the cash receipts and disbursements method of accounting. 
Under the provisions of section 164(d)(1), 120/365 (January 1-April 30, 
1955) of the real property tax is treated as imposed upon C and may be 
deducted by him for his taxable year in which the tax is actually paid. 
Under section 164(d)(1), 123/365 (May 1-August 31, 1955) of the real 
property tax is treated as imposed upon D and, under the provisions of 
section 164(d)(2)(A), is treated as having been paid by him on May 1, 
1955, and may be deducted by D for his taxable year in which the sale 
from C to him occurs (whether or not such portion is actually paid by 
him in that year), or for his taxable year in which an amount 
representing such tax is paid. Since, according to paragraph (d)(3) of 
this section, the prior sale by C to D is disregarded, under the 
provisions of section 164(d)(1), 122/365 (September 1-December 31, 1955) 
of the real property tax is treated as imposed on E and, under the 
provisions of section 164(d)(2)(A), is treated as having been paid by 
him on September 1, 1955, and may be deducted by E for his taxable year 
in which the sale from D to him occurs (whether or not such portion is 
actually paid by him in that year), or for his taxable year in which an 
amount representing such tax is paid.
    Example 3. In County X the real property tax year is the calendar 
year and the real property taxes are assessed and become a lien on June 
30 of the current real property tax year, but are not payable until 
September 1 of that year. There is no personal liability for the real 
property tax imposed by County X. A, the owner on January 1, 1955, of 
real property in County X, uses the cash receipts and disbursements 
method of accounting. On July 15, 1955, A sells the real property to B. 
Under the provisions of section 164(d)(1), 195/365 (January 1-July 14, 
1955) of the real property tax payable on September 1, 1955, for the 
1955 real property tax year is treated as imposed on A, and may be 
deducted by him for his taxable year in which the sale occurs (whether 
or not such portion is actually paid by him in that year) or for his 
taxable year in which the tax is actually paid or an amount representing 
such tax is paid. Under the provisions of section 164(d)(1), 170/365 
(July 15-December 31, 1955) of the real property tax is treated as 
imposed on B and may be deducted by him for his taxable year in which 
the sale occurs (whether or not such portion is actually paid by him in 
that year), or for his taxable year in which the tax is actually paid or 
an amount representing such tax is paid.

    (5) Treatment of excess deduction. If, for a taxable year prior to 
the taxable year of sale of real property, a taxpayer has deducted an 
amount for real property tax in excess of the portion of such real 
property tax treated as imposed on him under the provisions of section 
164(d), the excess of the amount deducted over the portion treated as 
imposed on him shall be included in his gross income for the taxable 
year of the sale, subject to the provisions of section 111, relating to 
the recovery of bad debts, prior taxes, and delinquency amounts. The 
provisions of this subparagraph may be illustrated as follows:

    Example 1. In Borough Y the real property tax is due and payable on 
November 30 for the succeeding calendar year, which is also the real 
property tax year. On November 30, 1954, taxpayer A, who reports his 
income on a calendar year under the cash receipts and disbursements 
method of accounting, pays the real property tax on real property owned 
by him in Borough Y for the 1955 real property tax year. On June 30, 
1955, A sells the

[[Page 349]]

real property. Under the provisions of section 164(d), only 180/365 
(January 1-June 29, 1955) of the real property tax for the 1955 real 
property tax year is treated as imposed on A, and the excess of the 
amount of real property tax for 1955 deducted by A, on his 1954 income 
tax return, over the 180/365 portion of such tax treated as imposed on 
him under section 164(d), must be included in gross income in A's 1955 
income tax return, subject to the provisions of section 111.
    Example 2. In County Z the real property tax year is the calendar 
year. The real property tax becomes a personal liability of the owner of 
real property on January 1 of the current real property tax year, and is 
payable on July 1 of the current real property tax year. On May 1, 1955, 
A, the owner of real property in County Z on January 1, 1955, sells the 
real property to B. On November 1, 1955, B sells the same real property 
to C. B uses the cash receipts and disbursements method of accounting 
and reports his income on the basis of a fiscal year ending July 31. B, 
on July 1, 1955, pays the entire real property tax for the real property 
tax year ending December 31, 1955. Under the provisions of section 
164(d), only 184/365 (May 1-October 31, 1955) of the real property tax 
for the 1955 real property tax year is treated as imposed on B, and the 
excess of the amount of real property tax for 1955 deducted by B on his 
income tax return for the fiscal year ending July 31, 1955, over the 
184/365 portion of such tax treated as imposed on him under section 
164(d), must be included in gross income in B's income tax return for 
his fiscal year ending July 31, 1956, subject to the provisions of 
section 111.

    (6) Persons using an accrual method of accounting. Where real 
property is sold and the seller or the purchaser computes his taxable 
income (for the taxable year during which the sale occurs) on an accrual 
method of accounting then, if the seller or the purchaser has not made 
the election provided in section 461(c) (relating to the accrual of real 
property taxes), the portion of any real property tax which is treated 
as imposed on him and which may not be deducted by him for any taxable 
year by reason of his method of accounting shall be treated as having 
accrued on the date of sale. The provisions of this subparagraph may be 
illustrated as follows:

    Example. In County X the real property tax becomes a lien on 
property and is assessed on November 30 for the current calendar year, 
which is also the real property tax year. There is no personal liability 
for the real property tax imposed by County X. A owns, on January 1, 
1955, real property in County X. A uses an accrual method of accounting 
and has not made any election under section 461(c) to accrue ratably 
real property taxes. A sells real property on June 30, 1955. By reason 
of A's method of accounting, he could not deduct any part of the real 
property tax for 1955 on the real property since he sold the real 
property prior to November 30, 1955, the accrual date. Under section 
164(d)(1), 180/365 (January 1-June 29, 1955) of the real property tax 
for the 1955 real property tax year is treated as imposed on A, and 
under section 164(d)(2)(D) that portion is treated as having accrued on 
June 30, 1955, and may be deducted by A for his taxable year in which 
such date falls. B, the purchaser from A, who uses an accrual method of 
accounting, has likewise not made an election under section 461(c) to 
accrue real property taxes ratably. Under section 164(d)(1), 185/365 of 
the real property taxes may be accrued by B on November 30, 1955, and 
deducted for his taxable year in which such date falls.

    (7) Cross references. For determination of amount realized on a sale 
of real property, see section 1001(b) and the regulations thereunder. 
For determination of basis of real property acquired by purchase, see 
section 1012 and the regulations thereunder.
    (8) Effective dates. Section 164(d) applies to taxable years ending 
after December 31, 1953, but only in the case of sales made after 
December 31, 1953. However, section 164(d) does not apply to any real 
property tax to the extent that such tax was allowable as a deduction 
under the Internal Revenue Code of 1939 to the seller for any taxable 
year which ended before January 1, 1954.



Sec.  1.164-7  Taxes of shareholder paid by corporation.

    Banks and other corporations paying taxes assessed against their 
shareholders on account of their ownership of the shares of stock issued 
by such corporations without reimbursement from such shareholders may 
deduct the amount of taxes so paid. In such cases no deduction shall be 
allowed to the shareholders for such taxes. The amount so paid should 
not be included in the gross income of the shareholder.



Sec.  1.164-8  Payments for municipal services in atomic energy communities.

    (a) General. For taxable years beginning after December 31, 1957, 
amounts

[[Page 350]]

paid or accrued by any owner of real property within any community (as 
defined in section 21b of the Atomic Energy Community Act of 1955 (42 
U.S.C. 2304)) to compensate the Atomic Energy Commission for municipal-
type services (or any agent or contractor authorized by the Atomic 
Energy Commission to charge for such services) shall be treated as State 
real property taxes paid or accrued for purposes of section 164. Such 
amounts shall be deductible as taxes to the extent provided in section 
164, Sec. Sec.  1.164-1 through 1.164-7, and this section. See paragraph 
(b) of this section for definition of the term ``Atomic Energy 
Commission''; paragraph (c) of this section for the definition of the 
term ``municipal-type services''; and paragraph (d) of this section for 
the definition of the term ``owner''.
    (b) Atomic Energy Commission. For purposes of paragraph (a) of this 
section, the term ``Atomic Energy Commission'' shall mean--
    (1) The Atomic Energy Commission, and
    (2) Any other agency of the United States Government to which the 
duties and responsibilities of providing municipal-type services are 
delegated under the authority of section 101 of the Atomic Energy 
Community Act of 1955 (42 U.S.C. 2313).
    (c) Municipal-type services. For purposes of paragraph (a) of this 
section, the term ``municipal-type services'' includes services usually 
rendered by a municipality and usually paid for by taxes. Examples of 
municipal-type services are police protection, fire protection, public 
recreational facilities, public libraries, public schools, public 
health, public welfare, and the maintenance of roads and streets. The 
term shall include sewage and refuse disposal which are maintained out 
of revenues derived from a general charge for municipal-type services; 
however, the term shall not include sewage and refuse disposal if a 
separate charge for such services is made. Charges assessed against 
local benefits of a kind tending to increase the value of the property 
assessed are not charges for municipal-type services. See section 
164(c)(1) and Sec.  1.164-4.
    (d) Owner. For purposes of paragraph (a) of this section, the term 
``owner'' includes a person who holds the real property under a 
leasehold of 40 or more years from the Atomic Energy Commission (or any 
agency of the United States Government to which the duties and 
responsibilities of leasing real property are delegated under section 
101 of the Atomic Energy Community Act of 1955), and a person who has 
entered into a contract to purchase under section 61 of the Atomic 
Energy Community Act of 1955 (42 U.S.C. 2361). An assignee (either 
immediate or more remote) of a lessee referred to in the preceding 
sentence will also qualify as an owner for purposes of paragraph (a) of 
this section.
    (e) Nonapplication of section 164(d). Section 164(d) and Sec.  
1.164-6, relating to apportionment of taxes on real property between 
seller and purchaser, do not apply to a sale by the United States or any 
of its agencies of real property to which section 164(f) and this 
section apply. Thus, amounts paid or accrued which qualify under 
paragraph (a) of this section will continue to be deductible as taxes to 
the extent provided in this section, even in the taxable year in which 
the owner actually purchases the real property from the United States or 
any of its agencies. However, the provisions of section 164(d) and Sec.  
1.164-6 shall apply to a sale of real property to which section 164(f) 
and this section apply, if the seller is other than the United States or 
any of its agencies.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6789, 29 FR 
18147, Dec. 22, 1964]



Sec.  1.165-1  Losses.

    (a) Allowance of deduction. Section 165(a) provides that, in 
computing taxable income under section 63, any loss actually sustained 
during the taxable year and not made good by insurance or some other 
form of compensation shall be allowed as a deduction subject to any 
provision of the internal revenue laws which prohibits or limits the 
amount of the deduction. This deduction for losses sustained shall be 
taken in accordance with section 165 and the regulations thereunder. For 
the disallowance of deductions for worthless securities issued by a 
political party, see Sec.  1.271-1.

[[Page 351]]

    (b) Nature of loss allowable. To be allowable as a deduction under 
section 165(a), a loss must be evidenced by closed and completed 
transactions, fixed by identifiable events, and, except as otherwise 
provided in section 165(h) and Sec.  1.165-11, relating to disaster 
losses, actually sustained during the taxable year. Only a bona fide 
loss is allowable. Substance and not mere form shall govern in 
determining a deductible loss.
    (c) Amount deductible. (1) The amount of loss allowable as a 
deduction under section 165(a) shall not exceed the amount prescribed by 
Sec.  1.1011-1 as the adjusted basis for determining the loss from the 
sale or other disposition of the property involved. In the case of each 
such deduction claimed, therefore, the basis of the property must be 
properly adjusted as prescribed by Sec.  1.1011-1 for such items as 
expenditures, receipts, or losses, properly chargeable to capital 
account, and for such items as depreciation, obsolescence, amortization, 
and depletion, in order to determine the amount of loss allowable as a 
deduction. To determine the allowable loss in the case of property 
acquired before March 1, 1913, see also paragraph (b) of Sec.  1.1053-1.
    (2) The amount of loss recognized upon the sale or exchange of 
property shall be determined for purposes of section 165(a) in 
accordance with Sec.  1.1002-1.
    (3) A loss from the sale or exchange of a capital asset shall be 
allowed as a deduction under section 165(a) but only to the extent 
allowed in section 1211 (relating to limitation on capital losses) and 
section 1212 (relating to capital loss carrybacks and carryovers), and 
in the regulations under those sections.
    (4) In determining the amount of loss actually sustained for 
purposes of section 165(a), proper adjustment shall be made for any 
salvage value and for any insurance or other compensation received.
    (d) Year of deduction. (1) A loss shall be allowed as a deduction 
under section 165(a) only for the taxable year in which the loss is 
sustained. For this purpose, a loss shall be treated as sustained during 
the taxable year in which the loss occurs as evidenced by closed and 
completed transactions and as fixed by identifiable events occurring in 
such taxable year. For provisions relating to situations where a loss 
attributable to a disaster will be treated as sustained in the taxable 
year immediately preceding the taxable year in which the disaster 
actually occurred, see section 165(h) and Sec.  1.165-11.
    (2)(i) If a casualty or other event occurs which may result in a 
loss and, in the year of such casualty or event, there exists a claim 
for reimbursement with respect to which there is a reasonable prospect 
of recovery, no portion of the loss with respect to which reimbursement 
may be received is sustained, for purposes of section 165, until it can 
be ascertained with reasonable certainty whether or not such 
reimbursement will be received. Whether a reasonable prospect of 
recovery exists with respect to a claim for reimbursement of a loss is a 
question of fact to be determined upon an examination of all facts and 
circumstances. Whether or not such reimbursement will be received may be 
ascertained with reasonable certainty, for example, by a settlement of 
the claim, by an adjudication of the claim, or by an abandonment of the 
claim. When a taxpayer claims that the taxable year in which a loss is 
sustained is fixed by his abandonment of the claim for reimbursement, he 
must be able to produce objective evidence of his having abandoned the 
claim, such as the execution of a release.
    (ii) If in the year of the casualty or other event a portion of the 
loss is not covered by a claim for reimbursement with respect to which 
there is a reasonable prospect of recovery, then such portion of the 
loss is sustained during the taxable year in which the casualty or other 
event occurs. For example, if property having an adjusted basis of 
$10,000 is completely destroyed by fire in 1961, and if the taxpayer's 
only claim for reimbursement consists of an insurance claim for $8,000 
which is settled in 1962, the taxpayer sustains a loss of $2,000 in 
1961. However, if the taxpayer's automobile is completely destroyed in 
1961 as a result of the negligence of another person and there exists a 
reasonable prospect of recovery on a claim for the full value of the 
automobile against such person, the taxpayer does not sustain any loss

[[Page 352]]

until the taxable year in which the claim is adjudicated or otherwise 
settled. If the automobile had an adjusted basis of $5,000 and the 
taxpayer secures a judgment of $4,000 in 1962, $1,000 is deductible for 
the taxable year 1962. If in 1963 it becomes reasonably certain that 
only $3,500 can ever be collected on such judgment, $500 is deductible 
for the taxable year 1963.
    (iii) If the taxpayer deducted a loss in accordance with the 
provisions of this paragraph and in a subsequent taxable year receives 
reimbursement for such loss, he does not recompute the tax for the 
taxable year in which the deduction was taken but includes the amount of 
such reimbursement in his gross income for the taxable year in which 
received, subject to the provisions of section 111, relating to recovery 
of amounts previously deducted.
    (3) Any loss arising from theft shall be treated as sustained during 
the taxable year in which the taxpayer discovers the loss (see Sec.  
1.165-8, relating to theft losses). However, if in the year of discovery 
there exists a claim for reimbursement with respect to which there is a 
reasonable prospect of recovery, no portion of the loss with respect to 
which reimbursement may be received is sustained, for purposes of 
section 165, until the taxable year in which it can be ascertained with 
reasonable certainty whether or not such reimbursement will be received.
    (4) The rules of this paragraph are applicable with respect to a 
casualty or other event which may result in a loss and which occurs 
after January 16, 1960. If the casualty or other event occurs on or 
before such date, a taxpayer may treat any loss resulting therefrom in 
accordance with the rules then applicable, or, if he so desires, in 
accordance with the provisions of this paragraph; but no provision of 
this paragraph shall be construed to permit a deduction of the same loss 
or any part thereof in more than one taxable year or to extend the 
period of limitations within which a claim for credit or refund may be 
filed under section 6511.
    (e) Limitation on losses of individuals. In the case of an 
individual, the deduction for losses granted by section 165(a) shall, 
subject to the provisions of section 165(c) and paragraph (a) of this 
section, be limited to:
    (1) Losses incurred in a trade or business;
    (2) Losses incurred in any transaction entered into for profit, 
though not connected with a trade or business; and
    (3) Losses of property not connected with a trade or business and 
not incurred in any transaction entered into for profit, if such losses 
arise from fire, storm, shipwreck, or other causalty, or from theft, and 
if the loss involved has not been allowed for estate tax purposes in the 
estate tax return. For additional provisions pertaining to the allowance 
of casualty and theft losses, see Sec. Sec.  1.165-7 and 1.165-8, 
respectively.

For special rules relating to an election by a taxpayer to deduct 
disaster losses in the taxable year immediately preceding the taxable 
year in which the disaster occurred, see section 165(h) and Sec.  1.165-
11.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6735, 29 FR 
6493, May 19, 1964; T.D. 6996, 34 FR 835, Jan. 18, 1969; T.D. 7301, 39 
FR 963, Jan. 4, 1974; T.D. 7522, 42 FR 63411, Dec. 16, 1977]



Sec.  1.165-2  Obsolescence of nondepreciable property.

    (a) Allowance of deduction. A loss incurred in a business or in a 
transaction entered into for profit and arising from the sudden 
termination of the usefulness in such business or transaction of any 
nondepreciable property, in a case where such business or transaction is 
discontinued or where such property is permanently discarded from use 
therein, shall be allowed as a deduction under section 165(a) for the 
taxable year in which the loss is actually sustained. For this purpose, 
the taxable year in which the loss is sustained is not necessarily the 
taxable year in which the overt act of abandonment, or the loss of title 
to the property, occurs.
    (b) Exceptions. This section does not apply to losses sustained upon 
the sale or exchange of property, losses sustained upon the obsolescence 
or worthlessness of depreciable property, casualty losses, or losses 
reflected in inventories required to be taken under section 471. The 
limitations contained in sections 1211 and 1212 upon losses

[[Page 353]]

from the sale or exchange of capital assets do not apply to losses 
allowable under this section.
    (c) Cross references. For the allowance under section 165(a) of 
losses arising from the permanent withdrawal of depreciable property 
from use in the trade or business or in the production of income, see 
Sec.  1.167(a)-8, Sec.  1.168(i)-1, or Sec.  1.168(i)-8, as applicable. 
For provisions respecting the obsolescence of depreciable property for 
which depreciation is determined under section 167 (but not under 
section 168, section 1400I, section 1400L(c), section 168 prior to its 
amendment by the Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 
2121 (1986)), or under an additional first year depreciation deduction 
provision of the Internal Revenue Code (for example, section 168(k) 
through (n), 1400L(b), or 1400N(d))), see Sec.  1.167(a)-9. For the 
allowance of casualty losses, see Sec.  1.165-7.
    (d) Effective/applicability date--(1) In general. This section 
applies to taxable years beginning on or after January 1, 2014. Except 
as provided in paragraphs (d)(2) and (d)(3) of this section, Sec.  
1.165-2 as contained in 26 CFR part 1 edition revised as of April 1, 
2011, applies to taxable years beginning before January 1, 2014.
    (2) Early application of Sec.  1.165-2(c). A taxpayer may choose to 
apply paragraph (c) of this section to taxable years beginning on or 
after January 1, 2012.
    (3) Optional application of TD 9564. A taxpayer may choose to apply 
Sec.  1.165-2T as contained in TD 9564 (76 FR 81060) December 27, 2011, 
to taxable years beginning on or after January 1, 2012, and before 
January 1, 2014.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960, as 
amended by T.D. 9564, 76 FR 81084, Dec. 27, 2011; T.D. 9636, 78 FR 
57706, Sept. 19, 2013; T.D. 9689, 79 FR 48667, Aug. 18, 2014]



Sec.  1.165-3  Demolition of buildings.

    (a) Intent to demolish formed at time of purchase. (1) Except as 
provided in subparagraph (2) of this paragraph, the following rule shall 
apply when, in the course of a trade or business or in a transaction 
entered into for profit, real property is purchased with the intention 
of demolishing either immediately or subsequently the buildings situated 
thereon: No deduction shall be allowed under section 165(a) on account 
of the demolition of the old buildings even though any demolition 
originally planned is subsequently deferred or abandoned. The entire 
basis of the property so purchased shall, notwithstanding the provisions 
of Sec.  1.167(a)-5, be allocated to the land only. Such basis shall be 
increased by the net cost of demolition or decreased by the net proceeds 
from demolition.
    (2)(i) If the property is purchased with the intention of 
demolishing the buildings and the buildings are used in a trade or 
business or held for the production of income before their demolition, a 
portion of the basis of the property may be allocated to such buildings 
and depreciated over the period during which they are so used or held. 
The fact that the taxpayer intends to demolish the buildings shall be 
taken into account in making the apportionment of basis between the land 
and buildings under Sec.  1.167(a)-5. In any event, the portion of the 
purchase price which may be allocated to the buildings shall not exceed 
the present value of the right to receive rentals from the buildings 
over the period of their intended use. The present value of such right 
shall be determined at the time that the buildings are first used in the 
trade or business or first held for the production of income. If the 
taxpayer does not rent the buildings, but uses them in his own trade or 
business or in the production of his income, the present value of such 
right shall be determined by reference to the rentals which could be 
realized during such period of intended use. The fact that the taxpayer 
intends to rent or use the buildings for a limited period before their 
demolition shall also be taken into account in computing the useful life 
in accordance with paragraph (b) of Sec.  1.167(a)-1.
    (ii) Any portion of the purchase price which is allocated to the 
buildings in accordance with this subparagraph shall not be included in 
the basis of the land computed under subparagraph (1) of this paragraph, 
and any portion of the basis of the buildings which has not been 
recovered through depreciation or otherwise at the time of the 
demolition

[[Page 354]]

of the buildings is allowable as a deduction under section 165.
    (iii) The application of this subparagraph may be illustrated by the 
following example:

    Example. In January 1958, A purchased land and a building for 
$60,000 with the intention of demolishing the building. In the following 
April, A concludes that he will be unable to commence the construction 
of a proposed new building for a period of more than 3 years. 
Accordingly, on June 1, 1958, he leased the building for a period of 3 
years at an annual rental of $1,200. A intends to demolish the building 
upon expiration of the lease. A may allocate a portion of the $60,000 
basis of the property to the building to be depreciated over the 3-year 
period. That portion is equal to the present value of the right to 
receive $3,600 (3 times $1,200). Assuming that the present value of that 
right determined as of June 1, 1958, is $2,850, A may allocate that 
amount to the building and, if A files his return on the basis of a 
taxable year ending May 31, 1959, A may take a depreciation deduction 
with respect to such building of $950 for such taxable year. The basis 
of the land to A as determined under subparagraph (1) of this paragraph 
is reduced by $2,850. If on June 1, 1960, A ceases to rent the building 
and demolishes it, the balance of the undepreciated portion allocated to 
the buildings, $950, may be deducted from gross income under section 
165.

    (3) The basis of any building acquired in replacement of the old 
buildings shall not include any part of the basis of the property 
originally purchased even though such part was, at the time of purchase, 
allocated to the buildings to be demolished for purposes of determining 
allowable depreciation for the period before demolition.
    (b) Intent to demolish formed subsequent to the time of acquisition. 
(1) Except as provided in subparagraph (2) of this paragraph, the loss 
incurred in a trade or business or in a transaction entered into for 
profit and arising from a demolition of old buildings shall be allowed 
as a deduction under section 165(a) if the demolition occurs as a result 
of a plan formed subsequent to the acquisition of the buildings 
demolished. The amount of the loss shall be the adjusted basis of the 
buildings demolished increased by the net cost of demolition or 
decreased by the net proceeds from demolition. See paragraph (c) of 
Sec.  1.165-1 relating to amount deductible under section 165. The basis 
of any building acquired in replacement of the old buildings shall not 
include any part of the basis of the property demolished.
    (2) If a lessor or lessee of real property demolishes the buildings 
situated thereon pursuant to a lease or an agreement which resulted in a 
lease, under which either the lessor was required or the lessee was 
required or permitted to demolish such buildings, no deduction shall be 
allowed to the lessor under section 165(a) on account of the demolition 
of the old buildings. However, the adjusted basis of the demolished 
buildings, increased by the net cost of demolition or decreased by the 
net proceeds from demolition, shall be considered as a part of the cost 
of the lease to be amortized over the remaining term thereof.
    (c) Evidence of intention. (1) Whether real property has been 
purchased with the intention of demolishing the buildings thereon or 
whether the demolition of the buildings occurs as a result of a plan 
formed subsequent to their acquisition is a question of fact, and the 
answer depends upon an examination of all the surrounding facts and 
circumstances. The answer to the question does not depend solely upon 
the statements of the taxpayer at the time he acquired the property or 
demolished the buildings, but such statements, if made, are relevant and 
will be considered. Certain other relevant facts and circumstances that 
exist in some cases and the inferences that might reasonably be drawn 
from them are described in subparagraphs (2) and (3) of this paragraph. 
The question as to the taxpayer's intention is not answered by any 
inference that is drawn from any one fact or circumstance but can be 
answered only by a consideration of all relevant facts and circumstances 
and the reasonable inferences to be drawn therefrom.
    (2) An intention at the time of acquisition to demolish may be 
suggested by:
    (i) A short delay between the date of acquisition and the date of 
demolition;
    (ii) Evidence of prohibitive remodeling costs determined at the time 
of acquisition;
    (iii) Existence of municipal regulations at the time of acquisition 
which

[[Page 355]]

would prohibit the continued use of the buildings for profit purposes;
    (iv) Unsuitability of the buildings for the taxpayer's trade or 
business at the time of acquisition; or
    (v) Inability at the time of acquisition to realize a reasonable 
income from the buildings.
    (3) The fact that the demolition occurred pursuant to a plan formed 
subsequent to the acquisition of the property may be suggested by:
    (i) Substantial improvement of the buildings immediately after their 
acquisition;
    (ii) Prolonged use of the buildings for business purposes after 
their acquisition;
    (iii) Suitability of the buildings for investment purposes at the 
time of acquisition;
    (iv) Substantial change in economic or business conditions after the 
date of acquisition;
    (v) Loss of useful value occurring after the date of acquisition;
    (vi) Substantial damage to the buildings occurring after their 
acquisition;
    (vii) Discovery of latent structural defects in the buildings after 
their acquisition;
    (viii) Decline in the taxpayer's business after the date of 
acquisition;
    (ix) Condemnation of the property by municipal authorities after the 
date of acquisition; or
    (x) Inability after acquisition to obtain building material 
necessary for the improvement of the property.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 74474, 41 FR 
55710, Dec. 22, 1976]



Sec.  1.165-4  Decline in value of stock.

    (a) Deduction disallowed. No deduction shall be allowed under 
section 165(a) solely on account of a decline in the value of stock 
owned by the taxpayer when the decline is due to a fluctuation in the 
market price of the stock or to other similar cause. A mere shrinkage in 
the value of stock owned by the taxpayer, even though extensive, does 
not give rise to a deduction under section 165(a) if the stock has any 
recognizable value on the date claimed as the date of loss. No loss for 
a decline in the value of stock owned by the taxpayer shall be allowed 
as a deduction under section 165(a) except insofar as the loss is 
recognized under Sec.  1.1002-1 upon the sale or exchange of the stock 
and except as otherwise provided in Sec.  1.165-5 with respect to stock 
which becomes worthless during the taxable year.
    (b) Stock owned by banks. (1) In the regulation of banks and certain 
other corporations, Federal and State authorities may require that stock 
owned by such organizations be charged off as worthless or written down 
to a nominal value. If, in any such case, this requirement is premised 
upon the worthlessness of the stock, the charging off or writing down 
will be considered prima facie evidence of worthlessness for purposes of 
section 165(a); but, if the charging off or writing down is due to a 
fluctuation in the market price of the stock or if no reasonable attempt 
to determine the worthlessness of the stock has been made, then no 
deduction shall be allowed under section 165(a) for the amount so 
charged off or written down.
    (2) This paragraph shall not be construed, however, to permit a 
deduction under section 165(a) unless the stock owned by the bank or 
other corporation actually becomes worthless in the taxable year. Such a 
taxpayer owning stock which becomes worthless during the taxable year is 
not precluded from deducting the loss under section 165(a) merely 
because, in obedience to the specific orders or general policy of such 
supervisory authorities, the value of the stock is written down to a 
nominal amount instead of being charged off completely.
    (c) Application to inventories. This section does not apply to a 
decline in the value of corporate stock reflected in inventories 
required to be taken by a dealer in securities under section 471. See 
Sec.  1.471-5.
    (d) Definition. As used in this section, the term ``stock'' means a 
share of stock in a corporation or a right to subscribe for, or to 
receive, a share of stock in a corporation.



Sec.  1.165-5  Worthless securities.

    (a) Definition of security. As used in section 165(g) and this 
section, the term ``security'' means:
    (1) A share of stock in a corporation;

[[Page 356]]

    (2) A right to subscribe for, or to receive, a share of stock in a 
corporation; or
    (3) A bond, debenture, note, or certificate, or other evidence of 
indebtedness to pay a fixed or determinable sum of money, which has been 
issued with interest coupons or in registered form by a domestic or 
foreign corporation or by any government or political subdivision 
thereof.
    (b) Ordinary loss. If any security which is not a capital asset 
becomes wholly worthless during the taxable year, the loss resulting 
therefrom may be deducted under section 165(a) as an ordinary loss.
    (c) Capital loss. If any security which is a capital asset becomes 
wholly worthless at any time during the taxable year, the loss resulting 
therefrom may be deducted under section 165(a) but only as though it 
were a loss from a sale or exchange, on the last day of the taxable 
year, of a capital asset. See section 165(g)(1). The amount so allowed 
as a deduction shall be subject to the limitations upon capital losses 
described in paragraph (c)(3) of Sec.  1.165-1.
    (d) Loss on worthless securities of an affiliated corporation--(1) 
Deductible as an ordinary loss. If a taxpayer which is a domestic 
corporation owns any security of a domestic or foreign corporation which 
is affiliated with the taxpayer within the meaning of subparagraph (2) 
of this paragraph and such security becomes wholly worthless during the 
taxable year, the loss resulting therefrom may be deducted under section 
165(a) as an ordinary loss in accordance with paragraph (b) of this 
section. The fact that the security is in fact a capital asset of the 
taxpayer is immaterial for this purpose, since section 165(g)(3) 
provides that such security shall be treated as though it were not a 
capital asset for the purposes of section 165(g)(1). A debt which 
becomes wholly worthless during the taxable year shall be as an ordinary 
loss in accordance with the provisions of this subparagraph, to the 
extent that such debt is a security within the meaning of paragraph 
(a)(3) of this section.
    (2) Affiliated corporation defined. For purposes of this paragraph, 
a corporation shall be treated as affiliated with the taxpayer owning 
the security if--
    (i)(a) In the case of a taxable year beginning on or after January 
1, 1970, the taxpayer owns directly--
    (1) Stock possessing at least 80 percent of the voting power of all 
classes of such corporation's stock, and
    (2) At least 80 percent of each class of such corporation's 
nonvoting stock excluding for purposes of this subdivision (i)(a) 
nonvoting stock which is limited and preferred as to dividends (see 
section 1504(a)), or
    (b) In the case of a taxable year beginning before January 1, 1970, 
the taxpayer owns directly at least 95 percent of each class of the 
stock of such corporation;
    (ii) None of the stock of such corporation was acquired by the 
taxpayer solely for the purpose of converting a capital loss sustained 
by reason of the worthlessness of any such stock into an ordinary loss 
under section 165(g)(3), and
    (iii) More than 90 percent of the aggregate of the gross receipts of 
such corporation for all the taxable years during which it has been in 
existence has been from sources other than royalties, rents (except 
rents derived from rental of properties to employees of such corporation 
in the ordinary course of its operating business), dividends, interest 
(except interest received on the deferred purchase price of operating 
assets sold), annuities, and gains from sales or exchanges of stocks and 
securities. For this purpose, the term ``gross receipts'' means total 
receipts determined without any deduction for cost of goods sold, and 
gross receipts from sales or exchanges of stocks and securities shall be 
taken into account only to the extent of gains from such sales or 
exchanges.
    (e) Bonds issued by an insolvent corporation. A bond of an insolvent 
corporation secured only by a mortgage from which nothing is realized 
for the bondholders on foreclosure shall be regarded as having become 
worthless not later than the year of the foreclosure sale, and no 
deduction in respect of the loss shall be allowed under section 165(a) 
in computing a bondholder's taxable income for a subsequent year. See 
also paragraph (d) of Sec.  1.165-1.

[[Page 357]]

    (f) Decline in market value. A taxpayer possessing a security to 
which this section relates shall not be allowed any deduction under 
section 165(a) on account of mere market fluctuation in the value of 
such security. See also Sec.  1.165-4.
    (g) Application to inventories. This section does not apply to any 
loss upon the worthlessness of any security reflected in inventories 
required to be taken by a dealer in securities under section 471. See 
Sec.  1.471-5.
    (h) Special rules for banks. For special rules applicable under this 
section to worthless securities of a bank, including securities issued 
by an affiliated bank, see Sec.  1.582-1.
    (i) Abandonment of securities--(1) In general. For purposes of 
section 165 and this section, a security that becomes wholly worthless 
includes a security described in paragraph (a) of this section that is 
abandoned and otherwise satisfies the requirements for a deductible loss 
under section 165. If the abandoned security is a capital asset and is 
not described in section 165(g)(3) and paragraph (d) of this section 
(concerning worthless securities of certain affiliated corporations), 
the resulting loss is treated as a loss from the sale or exchange, on 
the last day of the taxable year, of a capital asset. See section 
165(g)(1) and paragraph (c) of this section. To abandon a security, a 
taxpayer must permanently surrender and relinquish all rights in the 
security and receive no consideration in exchange for the security. For 
purposes of this section, all the facts and circumstances determine 
whether the transaction is properly characterized as an abandonment or 
other type of transaction, such as an actual sale or exchange, 
contribution to capital, dividend, or gift.
    (2) Effective/applicability date. This paragraph (i) applies to any 
abandonment of stock or other securities after March 12, 2008.
    (j) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. (i) X Corporation, a domestic manufacturing corporation 
which makes its return on the basis of the calendar year, owns 100 
percent of each class of the stock of Y Corporation; and, in addition, 
19 percent of the common stock (the only class of stock) of Z 
Corporation, which it acquired in 1948. Y Corporation, a domestic 
manufacturing corporation which makes its return on the basis of the 
calendar year, owns 81 percent of the common stock of Z Corporation, 
which it acquired in 1946. It is established that the stock of Z 
Corporation, which has from its inception derived all of its gross 
receipts from manufacturing operations, became worthless during 1971.
    (ii) Since the stock of Z Corporation which is owned by X 
Corporation is a capital asset and since X Corporation does not directly 
own at least 80 percent of the stock of Z Corporation, any loss 
sustained by X Corporation upon the worthlessness of such stock shall be 
deducted under section 165(g)(1) and paragraph (c) of this section as a 
loss from a sale or exchange on December 31, 1971, of a capital asset. 
The loss so sustained by X Corporation shall be considered a long-term 
capital loss under the provisions of section 1222(4), since the stock 
was held by that corporation for more than 6 months.
    (iii) Since Z Corporation is considered to be affiliated with Y 
Corporation under the provisions of paragraph (d)(2) of this section, 
any loss sustained by Y Corporation upon the worthlessness of the stock 
of Z Corporation shall be deducted in 1971 under section 165(g)(3) and 
paragraph (d)(1) of this section as an ordinary loss.
    Example 2. (i) On January 1, 1971, X Corporation, a domestic 
manufacturing corporation which makes its return on the basis of the 
calendar year, owns 60 percent of each class of the stock of Y 
Corporation, a foreign corporation, which it acquired in 1950. Y 
Corporation has, from the date of its incorporation, derived all of its 
gross receipts from manufacturing operations. It is established that the 
stock of Y Corporation became worthless on June 30, 1971. On August 1, 
1971, X Corporation acquires the balance of the stock of Y Corporation 
for the purpose of obtaining the benefit of section 165(g)(3) with 
respect to the loss it has sustained on the worthlessness of the stock 
of Y Corporation.
    (ii) Since the stock of Y Corporation which is owned by X 
Corporation is a capital asset and since Y Corporation is not to be 
treated as affiliated with X Corporation under the provisions of 
paragraph (d)(2) of this section, notwithstanding the fact that, at the 
close of 1971, X Corporation owns 100 percent of each class of stock of 
Y Corporation, any loss sustained by X Corporation upon the 
worthlessness of such stock shall be deducted under the provisions of 
section 165(g)(1) and paragraph (c) of this section as a loss from a 
sale or exchange on December 31, 1971, of a capital asset.
    Example 3. (i) X Corporation, a domestic manufacturing corporation 
which makes its return on the basis of the calendar year, owns 80 
percent of each class of the stock of Y Corporation, which from its 
inception has

[[Page 358]]

derived all of its gross receipts from manufacturing operations. As one 
of its capital assets, X Corporation owns $100,000 in registered bonds 
issued by Y Corporation payable at maturity on December 31, 1974. It is 
established that these bonds became worthless during 1971.
    (ii) Since Y Corporation is considered to be affiliated with X 
Corporation under the provisions of paragraph (d)(2) of this section, 
any loss sustained by X Corporation upon the worthlessness of these 
bonds may be deducted in 1971 under section 165(g)(3) and paragraph 
(d)(1) of this section as an ordinary loss. The loss may not be deducted 
under section 166 as a bad debt. See section 166(e).

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 7224, 37 FR 25928, Dec. 6, 1972; T.D. 9386, 73 FR 13124, 
Mar. 12, 2008]



Sec.  1.165-6  Farming losses.

    (a) Allowance of losses. (1) Except as otherwise provided in this 
section, any loss incurred in the operation of a farm as a trade or 
business shall be allowed as a deduction under section 165(a) or as a 
net operating loss deduction in accordance with the provisions of 
section 172. See Sec.  1.172-1.
    (2) If the taxpayer owns and operates a farm for profit in addition 
to being engaged in another trade or business, but sustains a loss from 
the operation of the farming business, then the amount of loss sustained 
in the operation of the farm may be deducted from gross income, if any, 
from all other sources.
    (3) Loss incurred in the operation of a farm for recreation or 
pleasure shall not be allowed as a deduction from gross income. See 
Sec.  1.162-12.
    (b) Loss from shrinkage. If, in the course of the business of 
farming, farm products are held for a favorable market, no deduction 
shall be allowed under section 165(a) in respect of such products merely 
because of shrinkage in weight, decline in value, or deterioration in 
storage.
    (c) Loss of prospective crop. The total loss by frost, storm, flood, 
or fire of a prospective crop being grown in the business of farming 
shall not be allowed as a deduction under section 165(a).
    (d) Loss of livestock--(1) Raised stock. A taxpayer engaged in the 
business of raising and selling livestock, such as cattle, sheep, or 
horses, may not deduct as a loss under section 165(a) the value of 
animals that perish from among those which were raised on the farm.
    (2) Purchased stock. The loss sustained upon the death by disease, 
exposure, or injury of any livestock purchased and used in the trade or 
business of farming shall be allowed as a deduction under section 
165(a). See, also, paragraph (e) of this section.
    (e) Loss due to compliance with orders of governmental authority. 
The loss sustained upon the destruction by order of the United States, a 
State, or any other governmental authority, of any livestock, or other 
property, purchased and used in the trade or business of farming shall 
be allowed as a deduction under section 165(a).
    (f) Amount deductible--(1) Expenses of operation. The cost of any 
feed, pasture, or care which is allowed under section 162 as an expense 
of operating a farm for profit shall not be included as a part of the 
cost of livestock for purposes of determining the amount of loss 
deductible under section 165(a) and this section. For the deduction of 
farming expenses, see Sec.  1.162-12.
    (2) Losses reflected in inventories. If inventories are taken into 
account in determining the income from the trade or business of farming, 
no deduction shall be allowed under this section for losses sustained 
during the taxable year upon livestock or other products, whether 
purchased for resale or produced on the farm, to the extent such losses 
are reflected in the inventory on hand at the close of the taxable year. 
Nothing in this section shall be construed to disallow the deduction of 
any loss reflected in the inventories of the taxpayer. For provisions 
relating to inventories of farmers, see section 471 and the regulations 
thereunder.
    (3) Other limitations. For other provisions relating to the amount 
deductible under this section, see paragraph (c) of Sec.  1.165-1, 
relating to the amount deductible under section 165(a); Sec.  1.165-7, 
relating to casualty losses; and Sec.  1.1231-1, relating to gains and 
losses from the sale or exchange of certain property used in the trade 
or business.
    (g) Other provisions applicable to farmers. For other provisions 
relating to

[[Page 359]]

farmers, see Sec.  1.61-4, relating to gross income of farmers; 
paragraph (b) of Sec.  1.167(a)-6, relating to depreciation in the case 
of farmers; and Sec.  1.175-1, relating to soil and water conservation 
expenditures.



Sec.  1.165-7  Casualty losses.

    (a) In general--(1) Allowance of deduction. Except as otherwise 
provided in paragraphs (b)(4) and (c) of this section, any loss arising 
from fire, storm, shipwreck, or other casualty is allowable as a 
deduction under section 165(a) for the taxable year in which the loss is 
sustained. However, see Sec.  1.165-6, relating to farming losses, and 
Sec.  1.165-11, relating to an election by a taxpayer to deduct disaster 
losses in the taxable year immediately preceding the taxable year in 
which the disaster occurred. The manner of determining the amount of a 
casualty loss allowable as a deduction in computing taxable income under 
section 63 is the same whether the loss has been incurred in a trade or 
business or in any transaction entered into for profit, or whether it 
has been a loss of property not connected with a trade or business and 
not incurred in any transaction entered into for profit. The amount of a 
casualty loss shall be determined in accordance with paragraph (b) of 
this section. For other rules relating to the treatment of deductible 
casualty losses, see Sec.  1.1231-1, relating to the involuntary 
conversion of property.
    (2) Method of valuation. (i) In determining the amount of loss 
deductible under this section, the fair market value of the property 
immediately before and immediately after the casualty shall generally be 
ascertained by competent appraisal. This appraisal must recognize the 
effects of any general market decline affecting undamaged as well as 
damaged property which may occur simultaneously with the casualty, in 
order that any deduction under this section shall be limited to the 
actual loss resulting from damage to the property.
    (ii) The cost of repairs to the property damaged is acceptable as 
evidence of the loss of value if the taxpayer shows that (a) the repairs 
are necessary to restore the property to its condition immediately 
before the casualty, (b) the amount spent for such repairs is not 
excessive, (c) the repairs do not care for more than the damage 
suffered, and (d) the value of the property after the repairs does not 
as a result of the repairs exceed the value of the property immediately 
before the casualty.
    (3) Damage to automobiles. An automobile owned by the taxpayer, 
whether used for business purposes or maintained for recreation or 
pleasure, may be the subject of a casualty loss, including those losses 
specifically referred to in subparagraph (1) of this paragraph. In 
addition, a casualty loss occurs when an automobile owned by the 
taxpayer is damaged and when:
    (i) The damage results from the faulty driving of the taxpayer or 
other person operating the automobile but is not due to the willful act 
or willful negligence of the taxpayer or of one acting in his behalf or
    (ii) The damage results from the faulty driving of the operator of 
the vehicle with which the automobile of the taxpayer collides.
    (4) Application to inventories. This section does not apply to a 
casualty loss reflected in the inventories of the taxpayer. For 
provisions relating to inventories, see section 471 and the regulations 
thereunder.
    (5) Property converted from personal use. In the case of property 
which originally was not used in the trade or business or for income-
producing purposes and which is thereafter converted to either of such 
uses, the fair market value of the property on the date of conversion, 
if less than the adjusted basis of the property at such time, shall be 
used, after making proper adjustments in respect of basis, as the basis 
for determining the amount of loss under paragraph (b)(1) of this 
section. See paragraph (b) of Sec.  1.165-9, and Sec.  1.167(g)-1.
    (6) Theft losses. A loss which arises from theft is not considered a 
casualty loss for purposes of this section. See Sec.  1.165-8, relating 
to theft losses.
    (b) Amount deductible--(1) General rule. In the case of any casualty 
loss whether or not incurred in a trade or business or in any 
transaction entered into for profit, the amount of loss to be

[[Page 360]]

taken into account for purposes of section 165(a) shall be the lesser of 
either--
    (i) The amount which is equal to the fair market value of the 
property immediately before the casualty reduced by the fair market 
value of the property immediately after the casualty; or
    (ii) The amount of the adjusted basis prescribed in Sec.  1.1011-1 
for determining the loss from the sale or other disposition of the 
property involved.

However, if property used in a trade or business or held for the 
production of income is totally destroyed by casualty, and if the fair 
market value of such property immediately before the casualty is less 
than the adjusted basis of such property, the amount of the adjusted 
basis of such property shall be treated as the amount of the loss for 
purposes of section 165(a).
    (2) Aggregation of property for computing loss. (i) A loss incurred 
in a trade or business or in any transaction entered into for profit 
shall be determined under subparagraph (1) of this paragraph by 
reference to the single, identifiable property damaged or destroyed. 
Thus, for example, in determining the fair market value of the property 
before and after the casualty in a case where damage by casualty has 
occurred to a building and ornamental or fruit trees used in a trade or 
business, the decrease in value shall be measured by taking the building 
and trees into account separately, and not together as an integral part 
of the realty, and separate losses shall be determined for such building 
and trees.
    (ii) In determining a casualty loss involving real property and 
improvements thereon not used in a trade or business or in any 
transaction entered into for profit, the improvements (such as buildings 
and ornamental trees and shrubbery) to the property damaged or destroyed 
shall be considered an integral part of the property, for purposes of 
subparagraph (1) of this paragraph, and no separate basis need be 
apportioned to such improvements.
    (3) Examples. The application of this paragraph may be illustrated 
by the following examples:

    Example 1. In 1956 B purchases for $3,600 an automobile which he 
uses for nonbusiness purposes. In 1959 the automobile is damaged in an 
accidental collision with another automobile. The fair market value of 
B's automobile is $2,000 immediately before the collision and $1,500 
immediately after the collision. B receives insurance proceeds of $300 
to cover the loss. The amount of the deduction allowable under section 
165(a) for the taxable year 1959 is $200, computed as follows:

Value of automobile immediately before casualty...............    $2,000
Less: Value of automobile immediately after casualty..........     1,500
                                                               ---------
Value of property actually destroyed..........................       500
                                                               =========
Loss to be taken into account for purposes of section 165(a):        500
 Lesser amount of property actually destroyed ($500) or
 adjusted basis of property ($3,600)..........................
Less: Insurance received......................................       300
                                                               ---------
Deduction allowable...........................................       200
 

    Example 2. In 1958 A purchases land containing an office building 
for the lump sum of $90,000. The purchase price is allocated between the 
land ($18,000) and the building ($72,000) for purposes of determining 
basis. After the purchase A planted trees and ornamental shrubs on the 
grounds surrounding the building. In 1961 the land, building, trees, and 
shrubs are damaged by hurricane. At the time of the casualty the 
adjusted basis of the land is $18,000 and the adjusted basis of the 
building is $66,000. At that time the trees and shrubs have an adjusted 
basis of $1,200. The fair market value of the land and building 
immediately before the casualty is $18,000 and $70,000, respectively, 
and immediately after the casualty is $18,000 and $52,000, respectively. 
The fair market value of the trees and shrubs immediately before the 
casualty is $2,000 and immediately after the casualty is $400. In 1961 
insurance of $5,000 is received to cover the loss to the building. A has 
no other gains or losses in 1961 subject to section 1231 and Sec.  
1.1231-1. The amount of the deduction allowable under section 165(a) 
with respect to the building for the taxable year 1961 is $13,000, 
computed as follows:

Value of property immediately before casualty.................   $70,000
Less: Value of property immediately after casualty............    52,000
                                                               ---------
Value of property actually destroyed..........................    18,000
                                                               =========
Less: Insurance received......................................     5,000
Loss to be taken into account for purposes of section 165(a):     18,000
 Lesser amount of property actually destroyed ($18,000) or
 adjusted basis of property ($66,000).........................
Less: Insurance received......................................     5,000
                                                               ---------
Deduction allowable...........................................    13,000
 


The amount of the deduction allowable under section 165(a) with respect 
to the trees and shrubs for the taxable year 1961 is $1,200, computed as 
follows:

Value of property immediately before casualty.................    $2,000
Less: Value of property immediately after casualty............      $400
                                                               ---------

[[Page 361]]

 
Value of property actually destroyed..........................     1,600
                                                               =========
Loss to be taken into account for purposes of section 165(a):      1,200
 Lesser amount of property actually destroyed ($1,600) or
 adjusted basis of property ($1,200)..........................
 

    Example 3. Assume the same facts as in example (2) except that A 
purchases land containing a house instead of an office building. The 
house is used as his private residence. Since the property is used for 
personal purposes, no allocation of the purchase price is necessary for 
the land and house. Likewise, no individual determination of the fair 
market values of the land, house, trees, and shrubs is necessary. The 
amount of the deduction allowable under section 165(a) with respect to 
the land, house, trees, and shrubs for the taxable year 1961 is $14,600, 
computed as follows:

Value of property immediately before casualty.................   $90,000
Less: Value of property immediately after casualty............    70,400
                                                               ---------
Value of property actually destroyed..........................    19,600
                                                               =========
Loss to be taken into account for purposes of section 165(a):     19,600
 Lesser amount of property actually destroyed ($19,600) or
 adjusted basis of property ($91,200).........................
Less: Insurance received......................................     5,000
                                                               ---------
Deduction allowable...........................................    14,600
 


    (4) Limitation on certain losses sustained by individuals after 
December 31, 1963. (i) Pursuant to section 165(c)(3), the deduction 
allowable under section 165(a) in respect of a loss sustained--
    (a) After December 31, 1963, in a taxable year ending after such 
date,
    (b) In respect of property not used in a trade or business or for 
income producing purposes, and
    (c) From a single casualty

shall be limited to that portion of the loss which is in excess of $100. 
The nondeductibility of the first $100 of loss applies to a loss 
sustained after December 31, 1963, without regard to when the casualty 
occurred. Thus, if property not used in a trade or business or for 
income producing purposes is damaged or destroyed by a casualty which 
occurred prior to January 1, 1964, and loss resulting therefrom is 
sustained after December 31, 1963, the $100 limitation applies.
    (ii) The $100 limitation applies separately in respect of each 
casualty and applies to the entire loss sustained from each casualty. 
Thus, if as a result of a particular casualty occurring in 1964, a 
taxpayer sustains in 1964 a loss of $40 and in 1965 a loss of $250, no 
deduction is allowable for the loss sustained in 1964 and the loss 
sustained in 1965 must be reduced by $60 ($100-$40). The determination 
of whether damage to, or destruction of, property resulted from a single 
casualty or from two or more separate casualties will be made upon the 
basis of the particular facts of each case. However, events which are 
closely related in origin generally give rise to a single casualty. For 
example, if a storm damages a taxpayer's residence and his automobile 
parked in his driveway, any loss sustained results from a single 
casualty. Similarly, if a hurricane causes high waves, all wind and 
flood damage to a taxpayer's property caused by the hurricane and the 
waves results from a single casualty.
    (iii) Except as otherwise provided in this subdivision, the $100 
limitation applies separately to each individual taxpayer who sustains a 
loss even though the property damaged or destroyed is owned by two or 
more individuals. Thus, if a house occupied by two sisters and jointly 
owned by them is damaged or destroyed, the $100 limitation applies 
separately to each sister in respect of any loss sustained by her. 
However, for purposes of applying the $100 limitation, a husband and 
wife who file a joint return for the first taxable year in which the 
loss is allowable as a deduction are treated as one individual taxpayer. 
Accordingly, if property jointly owned by a husband and wife, or 
property separately owned by the husband or by the wife, is damaged or 
destroyed by a single casualty in 1964, and a loss is sustained in that 
year by either or both the husband or wife, only one $100 limitation 
applies if a joint return is filed for 1964. If, however, the husband 
and wife file separate returns for 1964, the $100 limitation applies 
separately in respect of any loss sustained by the husband and in 
respect of any loss sustained by the wife. Where losses from a single 
casualty are sustained in two or more separate tax years, the husband 
and wife shall, for purposes of applying the $100 limitation to such 
losses, be treated as one individual for all such years if they file a 
joint return for the first year in which a loss is sustained from the 
casualty; they shall be treated as separate individuals for all such 
years if they

[[Page 362]]

file separate returns for the first such year. If a joint return is 
filed in the first loss year but separate returns are filed in a 
subsequent year, any unused portion of the $100 limitation shall be 
allocated equally between the husband and wife in the latter year.
    (iv) If a loss is sustained in respect of property used partially 
for business and partially for nonbusiness purposes, the $100 limitation 
applies only to that portion of the loss properly attributable to the 
nonbusiness use. For example, if a taxpayer sustains a $1,000 loss in 
respect of an automobile which he uses 60 percent for business and 40 
percent for nonbusiness, the loss is allocated 60 percent to business 
use and 40 percent to nonbusiness use. The $100 limitation applies to 
the portion of the loss allocable to the nonbusiness loss.
    (c) Loss sustained by an estate. A casualty loss of property not 
connected with a trade or business and not incurred in any transaction 
entered into for profit which is sustained during the settlement of an 
estate shall be allowed as a deduction under sections 165(a) and 641(b) 
in computing the taxable income of the estate if the loss has not been 
allowed under section 2054 in computing the taxable estate of the 
decedent and if the statement has been filed in accordance with Sec.  
1.642(g)-1. See section 165(c)(3).
    (d) Loss treated as though attributable to a trade or business. For 
the rule treating a casualty loss not connected with a trade or business 
as though it were a deduction attributable to a trade or business for 
purposes of computing a net operating loss, see paragraph (a)(3)(iii) of 
Sec.  1.172-3.
    (e) Effective date. The rules of this section are applicable to any 
taxable year beginning after January 16, 1960. If, for any taxable year 
beginning on or before such date, a taxpayer computed the amount of any 
casualty loss in accordance with the rules then applicable, such 
taxpayer is not required to change the amount of the casualty loss 
allowable for any such prior taxable year. On the other hand, the 
taxpayer may, if he so desires, amend his income tax return for such 
year to compute the amount of a casualty loss in accordance with the 
provisions of this section, but no provision in this section shall be 
construed as extending the period of limitations within which a claim 
for credit or refund may be filed under section 6511.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6712, 29 FR 
3652, Mar. 24, 1964; T.D. 6786, 29 FR 18501, Dec. 29, 1964; T.D. 7522, 
42 FR 63411, Dec. 16, 1977]



Sec.  1.165-8  Theft losses.

    (a) Allowance of deduction. (1) Except as otherwise provided in 
paragraphs (b) and (c) of this section, any loss arising from theft is 
allowable as a deduction under section 165(a) for the taxable year in 
which the loss is sustained. See section 165(c)(3).
    (2) A loss arising from theft shall be treated under section 165(a) 
as sustained during the taxable year in which the taxpayer discovers the 
loss. See section 165(e). Thus, a theft loss is not deductible under 
section 165(a) for the taxable year in which the theft actually occurs 
unless that is also the year in which the taxpayer discovers the loss. 
However, if in the year of discovery there exists a claim for 
reimbursement with respect to which there is a reasonable prospect of 
recovery, see paragraph (d) of Sec.  1.165-1.
    (3) The same theft loss shall not be taken into account both in 
computing a tax under chapter 1, relating to the income tax, or chapter 
2, relating to additional income taxes, of the Internal Revenue Code of 
1939 and in computing the income tax under the Internal Revenue Code of 
1954. See section 7852(c), relating to items not to be twice deducted 
from income.
    (b) Loss sustained by an estate. A theft loss of property not 
connected with a trade or business and not incurred in any transaction 
entered into for profit which is discovered during the settlement of an 
estate, even though the theft actually occurred during a taxable year of 
the decedent, shall be allowed as a deduction under sections 165(a) and 
641(b) in computing the taxable income of the estate if the loss has not 
been allowed under section 2054 in computing the taxable estate of the 
decedent and if the statement has been filed in accordance with Sec.  
1.642(g)-1. See section 165(c)(3). For purposes of determining the year 
of deduction, see paragraph (a)(2) of this section.

[[Page 363]]

    (c) Amount deductible. The amount deductible under this section in 
respect of a theft loss shall be determined consistently with the manner 
prescribed in Sec.  1.165-7 for determining the amount of casualty loss 
allowable as a deduction under section 165(a). In applying the 
provisions of paragraph (b) of Sec.  1.165-7 for this purpose, the fair 
market value of the property immediately after the theft shall be 
considered to be zero. In the case of a loss sustained after December 
31, 1963, in a taxable year ending after such date, in respect of 
property not used in a trade or business or for income producing 
purposes, the amount deductible shall be limited to that portion of the 
loss which is in excess of $100. For rules applicable in applying the 
$100 limitation, see paragraph (b)(4) of Sec.  1.165-7. For other rules 
relating to the treatment of deductible theft losses, see Sec.  1.1231-
1, relating to the involuntary conversion of property.
    (d) Definition. For purposes of this section the term ``theft'' 
shall be deemed to include, but shall not necessarily be limited to, 
larceny, embezzlement, and robbery.
    (e) Application to inventories. This section does not apply to a 
theft loss reflected in the inventories of the taxpayer. For provisions 
relating to inventories, see section 471 and the regulations thereunder.
    (f) Example. The application of this section may be illustrated by 
the following example:

    Example. In 1955 B, who makes her return on the basis of the 
calendar year, purchases for personal use a diamond brooch costing 
$4,000. On November 30, 1961, at which time it has a fair market value 
of $3,500, the brooch is stolen; but B does not discover the loss until 
January 1962. The brooch was fully insured against theft. A controversy 
develops with the insurance company over its liability in respect of the 
loss. However, in 1962, B has a reasonable prospect of recovery of the 
fair market value of the brooch from the insurance company. The 
controversy is settled in March 1963, at which time B receives $2,000 in 
insurance proceeds to cover the loss from theft. No deduction for the 
loss is allowable for 1961 or 1962; but the amount of the deduction 
allowable under section 165(a) for the taxable year 1963 is $1,500, 
computed as follows:

Value of property immediately before theft....................    $3,500
Less: Value of property immediately after the theft...........         0
                                                               ---------
 
Balance.......................................................     3,500
                                                               =========
 
Loss to be taken into account for purposes of section 165(a):     $3,500
 ($3,500 but not to exceed adjusted basis of $4,000 at time of
 theft).......................................................
Less: Insurance received in 1963..............................     2,000
                                                               ---------
 
Deduction allowable for 1963..................................     1,500
 


[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6786, 29 FR 
18502, Dec. 29, 1964]



Sec.  1.165-9  Sale of residential property.

    (a) Losses not allowed. A loss sustained on the sale of residential 
property purchased or constructed by the taxpayer for use as his 
personal residence and so used by him up to the time of the sale is not 
deductible under section 165(a).
    (b) Property converted from personal use. (1) If property purchased 
or constructed by the taxpayer for use as his personal residence is, 
prior to its sale, rented or otherwise appropriated to income-producing 
purposes and is used for such purposes up to the time of its sale, a 
loss sustained on the sale of the property shall be allowed as a 
deduction under section 165(a).
    (2) The loss allowed under this paragraph upon the sale of the 
property shall be the excess of the adjusted basis prescribed in Sec.  
1.1011-1 for determining loss over the amount realized from the sale. 
For this purpose, the adjusted basis for determining loss shall be the 
lesser of either of the following amounts, adjusted as prescribed in 
Sec.  1.1011-1 for the period subsequent to the conversion of the 
property to income-producing purposes:
    (i) The fair market value of the property at the time of conversion, 
or
    (ii) The adjusted basis for loss, at the time of conversion, 
determined under Sec.  1.1011-1 but without reference to the fair market 
value.
    (3) For rules relating to casualty losses of property converted from 
personal use, see paragraph (a)(5) of Sec.  1.165-7. To determine the 
basis for depreciation in the case of such property, see Sec.  1.167(g)-
1. For limitations on the loss from the sale of a capital asset, see 
paragraph (c)(3) of Sec.  1.165-1.

[[Page 364]]

    (c) Examples. The application of paragraph (b) of this section may 
be illustrated by the following examples:

    Example 1. Residential property is purchased by the taxpayer in 1943 
for use as his personal residence at a cost of $25,000, of which $15,000 
is allocable to the building. The taxpayer uses the property as his 
personal residence until January 1, 1952, at which time its fair market 
value is $22,000, of which $12,000 is allocable to the building. The 
taxpayer rents the property from January 1, 1952, until January 1, 1955, 
at which time it is sold for $16,000. On January 1, 1952, the building 
has an estimated useful life of 20 years. It is assumed that the 
building has no estimated salvage value and that there are no 
adjustments in respect of basis other than depreciation, which is 
computed on the straight-line method. The loss to be taken into account 
for purposes of section 165(a) for the taxable year 1955 is $4,200, 
computed as follows:

Basis of property at time of conversion for purposes of this     $22,000
 section (that is, the lesser of $25,000 cost or $22,000 fair
 market value)................................................
Less: Depreciation allowable from January 1, 1952, to January      1,800
 1, 1955 (3 years at 5 percent based on $12,000, the value of
 the building at time of conversion, as prescribed by Sec.
 1.167(g)-1)..................................................
                                                               ---------
 
Adjusted basis prescribed in Sec.   1.1011-1 for determining      20,200
 loss on sale of the property.................................
Less: Amount realized on sale.................................    16,000
                                                               ---------
 
Loss to be taken into account for purposes of section 165(a)..     4,200
 


In this example the value of the building at the time of conversion is 
used as the basis for computing depreciation. See example (2) of this 
paragraph wherein the adjusted basis of the building is required to be 
used for such purpose.
    Example 2. Residential property is purchased by the taxpayer in 1940 
for use as his personal residence at a cost of $23,000, of which $10,000 
is allocable to the building. The taxpayer uses the property as his 
personal residence until January 1, 1953, at which time its fair market 
value is $20,000, of which $12,000 is allocable to the building. The 
taxpayer rents the property from January 1, 1953, until January 1, 1957, 
at which time it is sold for $17,000. On January 1, 1953, the building 
has an estimated useful life of 20 years. It is assumed that the 
building has no estimated salvage value and that there are no 
adjustments in respect of basis other than depreciation, which is 
computed on the straight-line method. The loss to be taken into account 
for purposes of section 165(a) for the taxable year 1957 is $1,000, 
computed as follows:

Basis of property at time of conversion for purposes of this     $20,000
 section (that is, the lesser of $23,000 cost or $20,000 fair
 market value)................................................
Less: Depreciation allowable from January 1, 1953, to January      2,000
 1, 1957 (4 years at 5 percent based on $10,000, the cost of
 the building, as prescribed by Sec.   1.167(g)-1.............
                                                               ---------
 
Adjusted basis prescribed in Sec.   1.1011-1 for determining     $18,000
 loss on sale of the property.................................
Less: Amount realized on sale.................................    17,000
                                                               ---------
 
Loss to be taken into account for purposes of section 165(a)..     1,000
 


[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6712, 29 FR 
3652, Mar. 24, 1964]



Sec.  1.165-10  Wagering losses.

    Losses sustained during the taxable year on wagering transactions 
shall be allowed as a deduction but only to the extent of the gains 
during the taxable year from such transactions. In the case of a husband 
and wife making a joint return for the taxable year, the combined losses 
of the spouses from wagering transactions shall be allowed to the extent 
of the combined gains of the spouses from wagering transactions.



Sec.  1.165-11  Election in respect of losses attributable to a disaster.

    (a) through (j) [Reserved]. For further guidance, see Sec.  1.165-
11T(a) through (j).

[T.D. 9789, 81 FR 70940, Oct. 14, 2016]



Sec.  1.165-11T  Election to take disaster loss deduction for preceding year 
(temporary).

    (a) In general. Section 165(i) allows a taxpayer who has sustained a 
loss attributable to a federally declared disaster in a taxable year to 
elect to deduct that disaster loss in the preceding year. This section 
provides rules and procedures for making and revoking an election to 
claim a disaster loss in the preceding year.
    (b) Definitions. The following definitions apply for purposes of 
this section:
    (1) A federally declared disaster means any disaster subsequently 
determined by the President of the United States to warrant assistance 
by the Federal Government under the Robert T. Stafford Disaster Relief 
and Emergency Assistance Act or a successor enactment.

[[Page 365]]

    (2) A federally declared disaster area is the area determined to be 
eligible for assistance pursuant to the Presidential declaration in 
paragraph (b)(1) of this section.
    (3) A disaster loss is a loss occurring in a federally declared 
disaster area that is attributable to a federally declared disaster and 
that is otherwise allowable as a deduction for the disaster year under 
section 165(a) and Sec. Sec.  1.165-1 through 1.165-10.
    (4) The disaster year is the taxable year in which a taxpayer 
sustains a loss attributable to a federally declared disaster.
    (5) The preceding year is the taxable year immediately prior to the 
disaster year.
    (c) Scope and effect of election. An election made pursuant to 
section 165(i) for a disaster loss attributable to a particular disaster 
applies to the entire loss sustained by the taxpayer from that disaster 
during the disaster year. If the taxpayer makes a section 165(i) 
election with respect to a particular disaster occurring during the 
disaster year, the disaster to which the election relates is deemed to 
have occurred, and the disaster loss to which the election applies is 
deemed to have been sustained, in the preceding year.
    (d) Requirement to file consistent returns. A taxpayer may not make 
a section 165(i) election for a disaster loss if the taxpayer claims a 
deduction (as a loss, as cost of goods sold, or otherwise) for the same 
loss for the disaster year. If a taxpayer has claimed a deduction for a 
disaster loss for the disaster year and the taxpayer wishes to make a 
section 165(i) election with respect to such loss, the taxpayer must 
file an amended return to remove the previously deducted loss on or 
before the date that the taxpayer makes the section 165(i) election for 
such loss. Similarly, if a taxpayer has claimed a deduction for a 
disaster loss for the preceding year based on a section 165(i) election 
and the taxpayer wishes to revoke that election, the taxpayer must file 
an amended return to remove the loss for the preceding year on or before 
the date the taxpayer files the return or amended return for the 
disaster year that includes the loss.
    (e) Manner of making election. An election under section 165(i) to 
deduct a disaster loss for the preceding year is made on an original 
federal tax return for the preceding year or an amended federal tax 
return for the preceding year in the manner specified by guidance issued 
pursuant to these regulations. See paragraph (h) of this section.
    (f) Due date for making election. The due date for making the 
section 165(i) election is six months after the due date for filing the 
taxpayer's federal income tax return for the disaster year (determined 
without regard to any extension of time to file).
    (g) Revocation. Subject to the requirements in paragraph (d) of this 
section, a section 165(i) election may be revoked on or before the date 
that is ninety (90) days after the due date for making the election.
    (h) Additional guidance. The time and manner for making and revoking 
a section 165(i) election under paragraphs (d), (e), (f), and (g) of 
this section may be modified through guidance published in the Federal 
Register or in the Internal Revenue Bulletin (see Sec.  601.601(d) of 
this chapter).
    (i) Effective/applicability date. This section is effective October 
13, 2016 and applies to elections, revocations, and any other related 
actions that can be made or taken on or after October 13, 2016.
    (j) Expiration date. The section expires October 13, 2019.

[T.D. 9789, 81 FR 70940, Oct. 14, 2016]



Sec.  1.165-12  Denial of deduction for losses on registration-required 
obligations not in registered form.

    (a) In general. Except as provided in paragraph (c) of this section, 
nothing in section 165(a) and the regulations thereunder, or in any 
other provision of law, shall be construed to provide a deduction for 
any loss sustained on any registration-required obligation held after 
December 31, 1982, unless the obligation is in registered form or the 
issuance of the obligation was subject to tax under section 4701. The 
term ``registration-required obligation'' has the meaning given to that 
term in section 163(f)(2), except that clause (iv) of subparagraph (A) 
thereof shall not

[[Page 366]]

apply. Therefore, although an obligation that is not in registered form 
is described in Sec.  1.163-5(c)(1), the holder of such an obligation 
shall not be allowed a deduction for any loss sustained on such 
obligation unless paragraph (c) of this section applies. The term 
``holder'' means the person that would be denied a loss deduction under 
section 165(j)(1) or denied capital gain treatment under section 
1287(a). For purposes of this section, the term United States means the 
United States and its possessions within the meaning of Sec.  1.163-
5(c)(2)(iv).
    (b) Registered form--(1) Obligations issued after September 21, 
1984. With respect to any obligation originally issued after September 
21, 1984, the term ``registered form'' has the meaning given that term 
in section 103(j)(3) and the regulations thereunder. Therefore, an 
obligation that would otherwise be in registered form is not considered 
to be in registered form if it can be transferred at that time or at any 
time until its maturity by any means not described in Sec.  5f.103-1(c). 
An obligation that, as of a particular time, is not considered to be in 
registered form because it can be transferred by any means not described 
in Sec.  5f.103-1(c) is considered to be in registered form at all times 
during the period beginning with a later time and ending with the 
maturity of the obligation in which the obligation can be transferred 
only by a means described in Sec.  5f.103-1(c).
    (2) Obligations issued after December 31, 1982 and on or before 
September 21, 1984. With respect to any obligation originally issued 
after December 31, 1982 and on or before September 21, 1984 or an 
obligation originally issued after September 21, 1984 pursuant to the 
exercise of a warrant or the conversion of a convertible obligation, 
which warrant or obligation (including conversion privilege) was issued 
after December 31, 1982 and on or before September 21, 1984, that 
obligation will be considered in registered form if it satisfied Sec.  
5f.163-1 or the proposed regulations provided in Sec.  1.163-5(c) and 
published in the Federal Register on September 2, 1983 (48 FR 39953).
    (c) Registration-required obligations not in registered form which 
are not subject to section 165(j)(1). Notwithstanding the fact that an 
obligation is a registration-required obligation that is not in 
registered form, the holder will not be subject to section 165(j)(1) if 
the holder meets the conditions of any one of the following 
subparagraphs (1), (2), (3), or (4) of this paragraph (c).
    (1) Persons permitted to hold in connection with the conduct of a 
trade or business. (i) The holder is an underwriter, broker, dealer, 
bank, or other financial institution (defined in paragraph (c)(1)(iv)) 
that holds such obligation in connection with its trade or business 
conducted outside the United States; or the holder is a broker-dealer 
(registered under Federal or State law or exempted from registration by 
the provisions of such law because it is a bank) that holds such 
obligation for sale to customers in the ordinary course of its trade or 
business.
    (ii) The holder must offer to sell, sell and deliver the obligation 
in bearer form only outside of the United States except that a holder 
that is a registered broker-dealer as described in paragraph (c)(1)(i) 
of this section may offer to sell and sell the obligation in bearer form 
inside the United States to a financial institution as defined in 
paragraph (c)(1)(iv) of this section for its own account or for the 
account of another financial institution or of an exempt organization as 
defined in section 501(c)(3).
    (iii) The holder may deliver an obligation in bearer form that is 
offered or sold inside the United States only if the holder delivers it 
to a financial institution that is purchasing for its own account, or 
for the account of another financial institution or of an exempt 
organization, and the financial institution or organization that 
purchases the obligation for its own account or for whose account the 
obligation is purchased represents that it will comply with the 
requirements of section 165(j)(3) (A), (B), or (C). Absent actual 
knowledge that the representation is false, the holder may rely on a 
written statement provided by the financial institution or exempt 
organization, including a statement that is delivered in electronic 
form. The holder may deliver a registration-required obligation in 
bearer form that is offered and sold outside the United States to a 
person other than a financial institution only

[[Page 367]]

if the holder has evidence in its records that such person is not a U.S. 
citizen or resident and does not have actual knowledge that such 
evidence is false. Such evidence may include a written statement by that 
person, including a statement that is delivered electronically. For 
purposes of this paragraph (c), the term deliver includes a transfer of 
an obligation evidenced by a book entry including a book entry notation 
by a clearing organization evidencing transfer of the obligation from 
one member of the organization to another member. For purposes of this 
paragraph (c), the term deliver does not include a transfer of an 
obligation to the issuer or its agent for cancellation or 
extinguishment. The record-retention provisions in Sec.  1.1441-
1(e)(4)(iii) shall apply to any statement that a holder receives 
pursuant to this paragraph (c)(1)(iii).
    (iv) For purposes of paragraph (c) of this section, the term 
``financial institution'' means a person which itself is, or more than 
50 percent of the total combined voting power of all classes of whose 
stock entitled to vote is owned by a person which is--
    (A) Engaged in the conduct of a banking, financing, or similar 
business within the meaning of section 954(c)(3)(B) as in effect before 
the Tax Reform Act of 1986, and the regulations thereunder;
    (B) Engaged in business as a broker or dealer in securities;
    (C) An insurance company;
    (D) A person that provides pensions or other similar benefits to 
retired employees;
    (E) Primarily engaged in the business of rendering investment 
advice;
    (F) A regulated investment company or other mutual fund; or
    (G) A finance corporation a substantial part of the business of 
which consists of making loans (including the acquisition of obligations 
under a lease which is entered into primarily as a financing 
transaction), acquiring accounts receivable, notes or installment 
obligations arising out of the sale of tangible personal property or the 
performing of services, or servicing debt obligations.
    (2) Persons permitted to hold obligations for their own investment 
account. The holder is a financial institution holding the obligation 
for its own investment account that satisfies the conditions set forth 
in subdivisions (i), (ii), (iii), and (iv) of his paragraph (c) (2).
    (i) The holder reports on its Federal income tax return for the 
taxable year any interest payments received (including original issue 
discount includable in gross income for such taxable year) with respect 
to such obligation and gain or loss on the sale or other disposition of 
such obligation;
    (ii) The holder indicates on its Federal income tax return that 
income, gain or loss described in paragraph (c)(2)(i) is attributable to 
registration-required obligations held in bearer form for its own 
account;
    (iii) The holder of a bearer obligation that resells the obligation 
inside the United States resells the obligation only to another 
financial institution for its own account or for the account of another 
financial institution or exempt organization; and
    (iv) The holder delivers such obligation in bearer form to any other 
person in accordance with paragraph (c)(1) (ii) and (iii) of this 
section.
    (3) Persons permitted to hold through financial institutions. The 
holder is any person that purchases and holds a registration-required 
obligation in bearer form through a financial institution with which the 
holder maintains a customer, custodial or nominee relationship and such 
institution agrees to satisfy, and does in fact satisfy, the conditions 
set forth in subdivisions (i), (ii), (iii), (iv) and (v) of this 
paragraph (c)(3).
    (i) The financial institution makes a return of information to the 
Internal Revenue Service with respect to any interest payments received. 
The financial institution must report original issue discount includable 
in the holder's gross income for the taxable year on any obligation so 
held, but only if the obligation appears in an Internal Revenue Service 
publication of obligations issued at an original issue discount and only 
in an amount determined in accordance with information contained in that 
publication. An information return for any interest payment shall be 
made on a Form 1099 for the calendar year. It shall indicate the

[[Page 368]]

aggregate amount of the payment received, the name, address and taxpayer 
identification number of the holder, and such other information as is 
required by the form. No return of information is required under this 
subdivision if the financial institution reports payments under section 
6041 or 6049.
    (ii) The financial institution makes a return of information on Form 
1099B with respect to any disposition by the holder of such obligation. 
The return shall show the name, address, and taxpayer identification 
number of the holder of the obligation, Committee on Uniform Security 
Information Procedures (CUSIP), gross proceeds, sale date, and such 
other information as may be required by the form. No return of 
information is required under this subdivision if such financial 
institution reports with respect to the disposition under section 6045.
    (iii) In the case of a bearer obligation offered for resale or 
resold in the United States, the financial institution may resell the 
obligation only to another financial institution for its own account or 
for the account of an exempt organization.
    (iv) The financial institution covenants with the holder that the 
financial institution will deliver the obligation in bearer form in 
accordance with the requirements set forth in paragraph (c)(1) (ii) and 
(iii).
    (v) The financial institution delivers the obligation in bearer form 
in accordance with paragraph (c)(1) (ii) and (iv) as if the financial 
institution delivering the obligation were the holder referred to in 
such paragraph.
    (4) Conversion of obligations into registered form. The holder is 
not a person described in paragraph (c) (1), (2), or (3) of this 
section, and within thirty days of the date when the seller or other 
transferor is reasonably able to make the bearer obligation available to 
the holder, the holder surrenders the obligation to a transfer agent or 
the issuer for conversion of the obligation into registered form. If 
such obligation is not registered within such 30 day period, the holder 
shall be subject to sections 165(j) and 1287(a).
    (d) Effective date. These regulations apply generally to obligations 
issued after January 20, 1987. However, a taxpayer may choose to apply 
the rules of Sec.  1.165-12 with respect to an obligation issued after 
December 31, 1982 and on or before January 20, 1987, which obligation is 
held after January 20, 1987.

[T.D. 8110, 51 FR 45459, Dec. 19, 1986, as amended by T.D. 8734, 62 FR 
53416, Oct. 14, 1997]



Sec.  1.166-1  Bad debts.

    (a) Allowance of deduction. Section 166 provides that, in computing 
taxable income under section 63, a deduction shall be allowed in respect 
of bad debts owed to the taxpayer. For this purpose, bad debts shall, 
subject to the provisions of section 166 and the regulations thereunder, 
be taken into account either as--
    (1) A deduction in respect of debts which become worthless in whole 
or in part; or as
    (2) A deduction for a reasonable addition to a reserve for bad 
debts.
    (b) Manner of selecting method. (1) A taxpayer filing a return of 
income for the first taxable year for which he is entitled to a bad debt 
deduction may select either of the two methods prescribed by paragraph 
(a) of this section for treating bad debts, but such selection is 
subject to the approval of the district director upon examination of the 
return. If the method so selected is approved, it shall be used in 
returns for all subsequent taxable years unless the Commissioner grants 
permission to use the other method. A statement of facts substantiating 
any deduction claimed under section 166 on account of bad debts shall 
accompany each return of income.
    (2) Taxpayers who have properly selected one of the two methods for 
treating bad debts under provisions of prior law corresponding to 
section 166 shall continue to use that method for all subsequent taxable 
years unless the Commissioner grants permission to use the other method.
    (3)(i) For taxable years beginning after December 31, 1959, 
application for permission to change the method of treating bad debts 
shall be made in accordance with section 446(e) and paragraph (e)(3) of 
Sec.  1.446-1.
    (ii) For taxable years beginning before January 1, 1960, application 
for permission to change the method of

[[Page 369]]

treating bad debts shall be made at least 30 days before the close of 
the taxable year for which the change is effective.
    (4) Nothwithstanding paragraphs (b) (1), (2), and (3) of this 
section, a dealer in property currently employing the accrual method of 
accounting and currently maintaining a reserve for bad debts under 
section 166(c) (which may have included guaranteed debt obligations 
described in section 166(f)(1)(A)) may establish a reserve for section 
166(f)(1)(A) guaranteed debt obligations for a taxable year ending after 
October 21, 1965 under section 166(f) and Sec.  1.166-10 by filing on or 
before April 17, 1986 an amended return indicating that such a reserve 
has been established. The establishment of such a reserve will not be 
considered a change in method of accounting for purposes of section 
446(e). However, an election by a taxpayer to establish a reserve for 
bad debts under section 166(c) shall be treated as a change in method of 
accounting. See also Sec.  1.166-4, relating to reserve for bad debts, 
and Sec.  1.166-10, relating to reserve for guaranteed debt obligations.
    (c) Bona fide debt required. Only a bona fide debt qualifies for 
purposes of section 166. A bona fide debt is a debt which arises from a 
debtor-creditor relationship based upon a valid and enforceable 
obligation to pay a fixed or determinable sum of money. A debt arising 
out of the receivables of an accrual method taxpayer is deemed to be an 
enforceable obligation for purposes of the preceding sentence to the 
extent that the income such debt represents have been included in the 
return of income for the year for which the deduction as a bad debt is 
claimed or for a prior taxable year. For example, a debt arising out of 
gambling receivables that are unenforceable under state or local law, 
which an accrual method taxpayer includes in income under section 61, is 
an enforceable obligation for purposes of this pargarph. A gift or 
contribution to capital shall not be considered a debt for purposes of 
section 166. The fact that a bad debt its not due at the time of 
deduction shall not of itself prevent is allowance under section 166. 
For the disallowance of deductions for bad debts owed by a political 
party, see Sec.  1.271-1.
    (d) Amount deductible--(1) General rule. Except in the case of a 
deduction for a reasonable addition to a reserve for bad debts, the 
basis for determining the amount of deduction under section 166 in 
respect of a bad debt shall be the same as the adjusted basis prescribed 
by Sec.  1.1011-1 for determining the loss from the sale or other 
disposition of property. To determine the allowable deduction in the 
case of obligations acquired before March 1, 1913, see also paragraph 
(b) of Sec.  1.1053-1.
    (2) Specific cases. Subject to any provision of section 166 and the 
regulations thereunder which provides to the contrary, the following 
amounts are deductible as bad debts:
    (i) Notes or accounts receivable. (a) If, in computing taxable 
income, a taxpayer values his notes or accounts receivable at their fair 
market value when received, the amount deductible as a bad debt under 
section 166 in respect of such receivables shall be limited to such fair 
market value even though it is less than their face value.
    (b) A purchaser of accounts receivable which become worthless during 
the taxable year shall be entitled under section 166 to a deduction 
which is based upon the price he paid for such receivables but not upon 
their face value.
    (ii) Bankruptcy claim. Only the difference between the amount 
received in distribution of the assets of a bankrupt and the amount of 
the claim may be deducted under section 166 as a bad debt.
    (iii) Claim against decedent's estate. The excess of the amount of 
the claim over the amount received by a creditor of a decedent in 
distribution of the assets of the decedent's estate may be considered a 
worthless debt under section 166.
    (e) Prior inclusion in income required. Worthless debts arising from 
unpaid wages, salaries, fees, rents, and similar items of taxable income 
shall not be allowed as a deduction under section 166 unless the income 
such items represent has been included in the return of income for the 
year for which the deduction as a bad debt is claimed or for a prior 
taxable year.

[[Page 370]]

    (f) Recovery of bad debts. Any amount attributable to the recovery 
during the taxable year of a bad debt, or of a part of a bad debt, which 
was allowed as a deduction from gross income in a prior taxable year 
shall be included in gross income for the taxable year of recovery, 
except to the extent that the recovery is excluded from gross income 
under the provisions of Sec.  1.111-1, relating to the recovery of 
certain items previously deducted or credited. This paragraph shall not 
apply, however, to a bad debt which was previously charged against a 
reserve by a taxpayer on the reserve method of treating bad debts.
    (g) Worthless securities. (1) Section 166 and the regulations 
thereunder do not apply to a debt which is evidenced by a bond, 
debenture, note, or certificate, or other evidence of indebtedness, 
issued by a corporation or by a government or political subdivision 
thereof, with interest coupons or in registered form. See section 
166(e). For provisions allowing the deduction of a loss resulting from 
the worthlessness of such a debt, see Sec.  1.165-5.
    (2) The provisions of subparagraph (1) of this paragraph do not 
apply to any loss sustained by a bank and resulting from the 
worthlessness of a security described in section 165(g)(2)(C). See 
paragraph (a) of Sec.  1.582-1.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6996, 34 FR 
835, Jan. 18, 1969; T.D. 7902, 48 FR 33260, July 21, 1983; T.D. 8071, 51 
FR 2479, Jan. 17, 1986]



Sec.  1.166-2  Evidence of worthlessness.

    (a) General rule. In determining whether a debt is worthless in 
whole or in part the district director will consider all pertinent 
evidence, including the value of the collateral, if any, securing the 
debt and the financial condition of the debtor.
    (b) Legal action not required. Where the surrounding circumstances 
indicate that a debt is worthless and uncollectible and that legal 
action to enforce payment would in all probability not result in the 
satisfaction of execution on a judgment, a showing of these facts will 
be sufficient evidence of the worthlessness of the debt for purposes of 
the deduction under section 166.
    (c) Bankruptcy--(1) General rule. Bankruptcy is generally an 
indication of the worthlessness of at least a part of an unsecured and 
unpreferred debt.
    (2) Year of deduction. In bankruptcy cases a debt may become 
worthless before settlement in some instances; and in others, only when 
a settlement in bankruptcy has been reached. In either case, the mere 
fact that bankruptcy proceedings instituted against the debtor are 
terminated in a later year, thereby confirming the conclusion that the 
debt is worthless, shall not authorize the shifting of the deduction 
under section 166 to such later year.
    (d) Banks and other regulated corporations--(1) Worthlessness 
presumed in year of charge-off. If a bank or other corporation which is 
subject to supervision by Federal authorities, or by State authorities 
maintaining substantially equivalent standards, charges off a debt in 
whole or in part, either--
    (i) In obedience to the specific orders of such authorities, or
    (ii) In accordance with established policies of such authorities, 
and, upon their first audit of the bank or other corporation subsequent 
to the charge-off, such authorities confirm in writing that the charge-
off would have been subject to such specific orders if the audit had 
been made on the date of the charge-off,

then the debt shall, to the extent charged off during the taxable year, 
be conclusively presumed to have become worthless, or worthless only in 
part, as the case may be, during such taxable year. But no such debt 
shall be so conclusively presumed to be worthless, or worthless only in 
part, as the case may be, if the amount so charged off is not claimed as 
a deduction by the taxpayer at the time of filing the return for the 
taxable year in which the charge-off takes place.
    (2) Evidence of worthlessness in later taxable year. If such a bank 
or other corporation does not claim a deduction for such a totally or 
partially worthless debt in its return for the taxable year in which the 
charge-off takes place, but claims the deduction for a later taxable 
year, then the charge-off in the prior taxable year shall be deemed to 
have been involuntary and the deduction under section 166 shall be

[[Page 371]]

allowed for the taxable year for which claimed, provided that the 
taxpayer produces sufficient evidence to show that--
    (i) The debt became wholly worthless in the later taxable year, or 
became recoverable only in part subsequent to the taxable year of the 
involuntary charge-off, as the case may be; and,
    (ii) To the extent that the deduction claimed in the later taxable 
year for a debt partially worthless was not involuntarily charged off in 
prior taxable years, it was charged off in the later taxable year.
    (3) Conformity election--(i) Eligibility for election. In lieu of 
applying paragraphs (d)(1) and (2) of this section, a bank (as defined 
in paragraph (d)(4)(i) of this section) that is subject to supervision 
by Federal authorities, or by state authorities maintaining 
substantially equivalent standards, may elect under this paragraph 
(d)(3) to use a method of accounting that establishes a conclusive 
presumption of worthlessness for debts, provided that the bank meets the 
express determination requirement of paragraph (d)(3)(iii)(D) of this 
section for the taxable year of the election.
    (ii) Conclusive presumption--(A) In general. If a bank satisfies the 
express determination requirement of paragraph (d)(3)(iii)(D) of this 
section and elects to use the method of accounting under this paragraph 
(d)(3)--
    (1) Debts charged off, in whole or in part, for regulatory purposes 
during a taxable year are conclusively presumed to have become 
worthless, or worthless only in part, as the case may be, during that 
year, but only if the charge-off results from a specific order of the 
bank's supervisory authority or corresponds to the bank's classification 
of the debt, in whole or in part, as a loss asset, as described in 
paragraph (d)(3)(ii)(C) of this section; and
    (2) A bad debt deduction for a debt that is subject to regulatory 
loss classification standards is allowed for a taxable year only to the 
extent that the debt is conclusively presumed to have become worthless 
under paragraph (d)(3)(ii)(A)(1) of this section during that year.
    (B) Charge-off should have been made in earlier year. The conclusive 
presumption that a debt is worthless in the year that it is charged off 
for regulatory purposes applies even if the bank's supervisory authority 
determines in a subsequent year that the charge-off should have been 
made in an earlier year. A pattern of charge-offs in the wrong year, 
however, may result in revocation of the bank's election by the 
Commissioner pursuant to paragraph (d)(3)(iv)(D) of this section.
    (C) Loss asset defined. A debt is classified as a loss asset by a 
bank if the bank assigns the debt to a class that corresponds to a loss 
asset classification under the standards set forth in the ``Uniform 
Agreement on the Classification of Assets and Securities Held by Banks'' 
(See Attachment to Comptroller of the Currency Banking Circular No. 127, 
Rev. 4-26-91, Comptroller of the Currency, Communications Department, 
Washington, DC 20219) or similar guidance issued by the Office of the 
Comptroller of the Currency, the Federal Deposit Insurance Corporation, 
the Board of Governors of the Federal Reserve, or the Farm Credit 
Administration; or for institutions under the supervision of the Office 
of Thrift Supervision, 12 CFR 563.160(b)(3).
    (iii) Election--(A) In general. An election under this paragraph 
(d)(3) is to be made on bank-by-bank basis and constitutes either the 
adoption of or a change in method of accounting, depending on the 
particular bank's facts. A change in method of accounting that results 
from the making of an election under this paragraph (d)(3) has the 
effects described in paragraph (d)(3)(iii)(B) of this section.
    (B) Effect of change in method of accounting. A change in method of 
accounting resulting from an election under this paragraph (d)(3) does 
not require or permit an adjustment under section 481(a). Under this 
cut-off approach--
    (1) There is no change in the Sec.  1.1011-1 adjusted basis of the 
bank's existing debts (as determined under the bank's former method of 
accounting for bad debts) as a result of the change in method of 
accounting;
    (2) With respect to debts that are subject to regulatory loss 
classification standards and are held by the bank at the beginning of 
the year of

[[Page 372]]

change (to the extent that they have not been charged off for regulatory 
purposes), and with respect to debts subject to regulatory loss 
classification standards that are originated or acquired subsequent to 
the beginning of the year of change, bad debt deductions in the year of 
change and thereafter are determined under the method of accounting for 
bad debts prescribed by this paragraph (d)(3);
    (3) With respect to debts that are not subject to regulatory loss 
classification standards or that have been totally charged off prior to 
the year of change, bad debt deductions are determined under the general 
rules of section 166; and
    (4) If there was any partial charge-off of a debt in a prechange 
year, any portion of which was not claimed as a deduction, the deduction 
reflecting that partial charge-off must be taken in the first year in 
which there is any further charge-off of the debt for regulatory 
purposes.
    (C) Procedures--(1) In general. A new bank adopts the method of 
accounting under this paragraph (d)(3) for any taxable year ending on or 
after December 31, 1991 (and for all subsequent taxable years) when it 
adopts its overall method of accounting for bad debts, by attaching a 
statement to this effect to its income tax return for that year. Any 
other bank makes an election for any taxable year ending on or after 
December 31, 1991 (and for all subsequent taxable years) by filing a 
completed Form 3115 (Application for Change in Accounting Method) in 
accordance with the rules of paragraph (d)(3)(iii)(C)(2) or (3) of this 
section. The statement or Form 3115 must include the name, address, and 
taxpayer identification number of the electing bank and contain a 
declaration that the express determination requirement of paragraph 
(d)(3)(iii)(D) of this section is satisfied for the taxable year of the 
election. When a Form 3115 is used, the declaration must be made in the 
space provided on the form for ``Other changes in method of 
accounting.'' The words ``ELECTION UNDER Sec.  1.166-2(d)(3)'' must be 
typed or legibly printed at the top of the statement or page 1 of the 
Form 3115.
    (2) First election. The first time a bank makes this election, the 
statement or Form 3115 must be attached to the bank's timely filed 
return (taking into account extensions of time to file) for the first 
taxable year covered by the election. The consent of the Commissioner to 
make a change in method of accounting under this paragraph (d)(3) is 
granted, pursuant to section 446(e), to any bank that makes the election 
in accordance with this paragraph (d)(3)(iii)(C), provided the bank has 
not made a prior election under this paragraph (d)(3).
    (3) Subsequent elections. The advance consent of the Commissioner is 
required to make any election under this paragraph (d)(3) after a 
previous election has been revoked pursuant to paragraph (d)(3)(iv) of 
this section. This consent must be requested under the procedures, 
terms, and conditions prescribed under the authority of section 446(e) 
and Sec.  1.446-1(e) for requesting a change in method of accounting.
    (D) Express determination requirement. In connection with its most 
recent examination involving the bank's loan review process, the bank's 
supervisory authority must have made an express determination (in 
accordance with any applicable administrative procedure prescribed 
hereunder) that the bank maintains and applies loan loss classification 
standards that are consistent with the regulatory standards of that 
supervisory authority. For purposes of this paragraph (d)(3)(iii)(D), 
the supervisory authority of a bank is the appropriate Federal banking 
agency for the bank, as that term is defined in 12 U.S.C. 1813(q), or, 
in the case of an institution in the Farm Credit System, the Farm Credit 
Administration.
    (E) Transition period election. For taxable years ending before 
completion of the first examination of the bank by its supervisory 
authority (as defined in paragraph (d)(3)(iii)(D) of this section) that 
is after October 1, 1992, and that involves the bank's loan review 
process, the statement or Form 3115 filed by the bank must include a 
declaration that the bank maintains and applies loan loss classification 
standards that are consistent with the regulatory

[[Page 373]]

standards of that supervisory authority. A bank that makes this 
declaration is deemed to satisfy the express determination requirement 
of paragraph (d)(3)(iii)(D) of this section for those years, even though 
an express determination has not yet been made.
    (iv) Revocation of Election--(A) In general. Revocation of an 
election under this paragraph (d)(3) constitutes a change in method of 
accounting that has the effects described in paragraph (d)(3)(iv)(B) of 
this section. If an election under this paragraph (d)(3) has been 
revoked, a bank may make a subsequent election only under the provisions 
of paragraph (d)(3)(iii)(C)(3) of this section.
    (B) Effect of change in method of accounting. A change in method of 
accounting resulting from revocation of an election under this paragraph 
(d)(3) does not require or permit an adjustment under section 481(a). 
Under this cut-off approach--
    (1) There is no change in the Sec.  1.1011-1 adjusted basis of the 
bank's existing debts (as determined under this paragraph (d)(3) method 
or any other former method of accounting used by the bank with respect 
to its bad debts) as a result of the change in method of accounting; and
    (2) Bad debt deductions in the year of change and thereafter with 
respect to all debts held by the bank, whether in existence at the 
beginning of the year of change or subsequently originated or acquired, 
are determined under the new method of accounting.
    (C) Automatic revocation--(1) In general--A bank's election under 
this paragraph (d)(3) is revoked automatically if, in connection with 
any examination involving the bank's loan review process by the bank's 
supervisory authority as defined in paragraph (d)(3)(iii)(D) of this 
section, the bank does not obtain the express determination required by 
that paragraph.
    (2) Year of revocation. If a bank makes the conformity election 
under the transition rules of paragraph (d)(3)(iii)(E) of this section 
and does not obtain the express determination in connection with the 
first examination involving the bank's loan review process that is after 
October 1, 1992, the election is revoked as of the beginning of the 
taxable year of the election or, if later, the earliest taxable year for 
which tax may be assessed. In other cases in which a bank does not 
obtain an express determination in connection with an examination of its 
loan review process, the election is revoked as of the beginning of the 
taxable year that includes the date as of which the supervisory 
authority conducts the examination even if the examination is completed 
in the following taxable year.
    (3) Consent granted. Under the Commissioner's authority in section 
446(e) and Sec.  1.446-1(e), the bank is directed to and is granted 
consent to change from this paragraph (3)(1) method as of the year of 
revocation (year of change) prescribed by paragraph (d)(3)(iv)(C)(2) of 
this section.
    (4) Requirements. A bank changing its method of accounting under the 
automatic revocation rules of this paragraph (d)(3)(iv)(C) must attach a 
completed Form 3115 to its income tax return for the year of revocation 
prescribed by paragraph (d)(3)(iv)(C)(2) of this section. The words 
``REVOCATION OF Sec.  1.166-2(d)(3) ELECTION'' must be typed or legibly 
printed at the top of page 1 of the Form 3115. If the year of revocation 
is a year for which the bank has already filed its income tax return, 
the bank must file an amended return for that year reflecting its change 
in method of accounting and must attach the completed Form 3115 to that 
amended return. The bank also must file amended returns reflecting the 
new method of accounting for all subsequent taxable years for which 
returns have been filed and tax may be assessed.
    (D) Revocation by Commissioner. An election under this paragraph 
(d)(3) may be revoked by the Commissioner as of the beginning of any 
taxable year for which a bank fails to follow the method of accounting 
prescribed by this paragraph. In addition, the Commissioner may revoke 
an election as of the beginning of any taxable year for which the 
Commissioner determines that a bank has taken charge-offs and deductions 
that, under all facts and circumstances existing at the time, were 
substantially in excess of those warranted by the exercise of reasonable

[[Page 374]]

business judgment in applying the regulatory standards of the bank's 
supervisory authority as defined in paragraph (d)(3)(III)(D) of this 
section.
    (E) Voluntary revocation. A bank may apply for revocation of its 
election made under this paragraph (d)(3) by timely filing a completed 
Form 3115 for the appropriate year and obtaining the consent of the 
Commissioner in accordance with section 446(e) and Sec.  1.446-1(e) 
(including any applicable administrative procedures prescribed 
thereunder). The words ``REVOCATION OF Sec.  1.166-2(d)(3) ELECTION'' 
must be typed or legibly printed at the top of page 1 of the Form 3115. 
If any bank has had its election automatically revoked pursuant to 
paragraph (d)(3)(iv)(C) of this section and has not changed its method 
of accounting in accordance with the requirements of that paragraph, the 
Commissioner will require that any voluntary change in method of 
accounting under this paragraph (d)(3)(iv)(E) be implemented 
retroactively pursuant to the same amended return terms and conditions 
as are prescribed by paragraph (d)(3)(iv)(C) of this section.
    (4) Definitions. For purposes of this paragraph (d)--
    (i) Bank. The term bank has the meaning assigned to it by section 
581. The term bank also includes any corporation that would be a bank 
within the meaning of section 581 except for the fact that it is a 
foreign corporation, but this paragraph (d) applies only with respect to 
loans the interest on which is effectively connected with the conduct of 
a banking business within the United States. In addition, the term bank 
includes a Farm Credit System institution that is subject to supervision 
by the Farm Credit Administration.
    (ii) Charge-off. For banks regulated by the Office of Thrift 
Supervision, the term charge-off includes the establishment of specific 
allowances for loan losses in the amount of 100 percent of the portion 
of the debt classified as loss.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 7254, 38 FR 2418, Jan. 26, 1973; T.D. 8396, 57 FR 6294, 
Feb. 24, 1992; T.D. 8441, 57 FR 45569, Oct. 2, 1992; T.D. 8492, 58 FR 
53658, Oct. 18, 1993]



Sec.  1.166-3  Partial or total worthlessness.

    (a) Partial worthlessness--(1) Applicable to specific debts only. A 
deduction under section 166(a)(2) on account of partially worthless 
debts shall be allowed with respect to specific debts only.
    (2) Charge-off required. (i) If, from all the surrounding and 
attending circumstances, the district director is satisfied that a debt 
is partially worthless, the amount which has become worthless shall be 
allowed as a deduction under section 166(a)(2) but only to the extent 
charged off during the taxable year.
    (ii) If a taxpayer claims a deduction for a part of a debt for the 
taxable year within which that part of the debt is charged off and the 
deduction is disallowed for that taxable year, then, in a case where the 
debt becomes partially worthless after the close of that taxable year, a 
deduction under section 166(a)(2) shall be allowed for a subsequent 
taxable year but not in excess of the amount charged off in the prior 
taxable year plus any amount charged off in the subsequent taxable year. 
In such instance, the charge-off in the prior taxable year shall, if 
consistently maintained as such, be sufficient to that extent to meet 
the charge-off requirement of section 166(a)(2) with respect to the 
subsequent taxable year.
    (iii) Before a taxpayer may deduct a debt in part, he must be able 
to demonstrate to the satisfaction of the district director the amount 
thereof which is worthless and the part thereof which has been charged 
off.
    (3) Significantly modified debt--(i) Deemed charge-off. If a 
significant modification of a debt instrument (within the meaning of 
Sec.  1.1001-3) during a taxable year results in the recognition of gain 
by a taxpayer under Sec.  1.1001-1(a), and if the requirements of 
paragraph (a)(3)(ii) of this section are met, there is a deemed charge-
off of the debt during that taxable year in the amount specified in 
paragraph (a)(3)(iii) of this section.
    (ii) Requirements for deemed charge-off. A debt is deemed to have 
been charged off only if--
    (A) The taxpayer (or, in the case of a debt that constitutes 
transferred basis

[[Page 375]]

property within the meaning of section 7701(a)(43), a transferor 
taxpayer) has claimed a deduction for partial worthlessness of the debt 
in any prior taxable year; and
    (B) Each prior charge-off and deduction for partial worthlessness 
satisfied the requirements of paragraphs (a) (1) and (2) of this 
section.
    (iii) Amount of deemed charge-off. The amount of the deemed charge-
off, if any, is the amount by which the tax basis of the debt exceeds 
the greater of the fair market value of the debt or the amount of the 
debt recorded on the taxpayer's books and records reduced as appropriate 
for a specific allowance for loan losses. The amount of the deemed 
charge-off, however, may not exceed the amount of recognized gain 
described in paragraph (a)(3)(i) of this section.
    (iv) Effective date. This paragraph (a)(3) applies to significant 
modifications of debt instruments occurring on or after September 23, 
1996.
    (b) Total worthlessness. If a debt becomes wholly worthless during 
the taxable year, the amount thereof which has not been allowed as a 
deduction from gross income for any prior taxable year shall be allowed 
as a deduction for the current taxable year.

[T.D. 6500, 25 FR 11402, Nov. 29, 1960, as amended by T.D. 8763, 63 FR 
4396, Jan. 29, 1998]



Sec.  1.166-4  Reserve for bad debts.

    (a) Allowance of deduction. A taxpayer who has established the 
reserve method of treating bad debts and has maintained proper reserve 
accounts for bad debts or who, in accordance with paragraph (b) of Sec.  
1.166-1, adopts the reserve method of treating bad debts may deduct from 
gross income a reasonable addition to a reserve for bad debts in lieu of 
deducting specific bad debt items. This paragraph applies both to bad 
debts owed to the taxpayer and to bad debts arising out of section 
166(f)(1)(A) guaranteed debt obligations. If a reserve is maintained for 
bad debts arising out of section 166(f)(1)(A) guaranteed debt 
obligations, then a separate reserve must also be maintained for all 
other debt obligations of the taxpayer in the same trade or business, if 
any. A taxpayer may not maintain a reserve for bad debts arising out of 
section 166(f)(1)(A) guaranteed debt obligations if with respect to 
direct debt obligations in the same trade or business the taxpayer takes 
deductions when the debts become worthless in whole or in part rather 
than maintaining a reserve for such obligations. See Sec.  1.166-10 for 
rules concerning section 166(f)(1)(A) guaranteed debt obligations.
    (b) Reasonableness of addition to reserve--(1) Relevant factors. 
What constitutes a reasonable addition to a reserve for bad debts shall 
be determined in the light of the facts existing at the close of the 
taxable year of the proposed addition. The reasonableness of the 
addition will vary as between classes of business and with conditions of 
business prosperity. It will depend primarily upon the total amount of 
debts outstanding as of the close of the taxable year, including those 
arising currently as well as those arising in prior taxable years, and 
the total amount of the existing reserve.
    (2) Correction of errors in prior estimates. In the event that 
subsequent realizations upon outstanding debts prove to be more or less 
than estimated at the time of the creation of the existing reserve, the 
amount of the excess or inadequacy in the existing reserve shall be 
reflected in the determination of the reasonable addition necessary in 
the current taxable year.
    (c) Statement required. A taxpayer using the reserve method shall 
file with his return a statement showing--
    (1) The volume of his charge sales or other business transactions 
for the taxable year and the percentage of the reserve to such amount;
    (2) The total amount of notes and accounts receivable at the 
beginning and close of the taxable year;
    (3) The amount of the debts which have become wholly or partially 
worthless and have been charged against the reserve account; and
    (4) The computation of the addition to the reserve for bad debts.

[[Page 376]]

    (d) Special rules applicable to financial institutions. For special 
rules for the addition to the bad debt reserves of certain banks, see 
Sec. Sec.  1.585-1 through 1.585-3.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6728, 29 FR 
5855, May 5, 1964; T.D. 7444, 41 FR 53481, Dec. 7, 1976; T.D. 8071, 51 
FR 2479, Jan. 17, 1986; T.D. 9849, 84 FR 9233, Mar. 14, 2019]



Sec.  1.166-5  Nonbusiness debts.

    (a) Allowance of deduction as capital loss. (1) The loss resulting 
from any nonbusiness debt's becoming partially or wholly worthless 
within the taxable year shall not be allowed as a deduction under either 
section 166(a) or section 166(c) in determining the taxable income of a 
taxpayer other than a corporation. See section 166(d)(1)(A).
    (2) If, in the case of a taxpayer other than a corporation, a 
nonbusiness debt becomes wholly worthless within the taxable year, the 
loss resulting therefrom shall be treated as a loss from the sale or 
exchange, during the taxable year, of a capital asset held for not more 
than 1 year (6 months for taxable years beginning before 1977; 9 months 
for taxable years beginning in 1977). Such a loss is subject to the 
limitations provided in section 1211, relating to the limitation on 
capital losses, and section 1212, relating to the capital loss 
carryover, and in the regulations under those sections. A loss on a 
nonbusiness debt shall be treated as sustained only if and when the debt 
has become totally worthless, and no deduction shall be allowed for a 
nonbusiness debt which is recoverable in part during the taxable year.
    (b) Nonbusiness debt defined. For purposes of section 166 and this 
section, a nonbusiness debt is any debt other than--
    (1) A debt which is created, or acquired, in the course of a trade 
or business of the taxpayer, determined without regard to the 
relationship of the debt to a trade or business of the taxpayer at the 
time when the debt becomes worthless; or
    (2) A debt the loss from the worthlessness of which is incurred in 
the taxpayer's trade or business.

The question whether a debt is a nonbusiness debt is a question of fact 
in each particular case. The determination of whether the loss on a 
debt's becoming worthless has been incurred in a trade or business of 
the taxpayer shall, for this purpose, be made in substantially the same 
manner for determining whether a loss has been incurred in a trade or 
business for purposes of section 165(c)(1). For purposes of subparagraph 
(2) of this paragraph, the character of the debt is to be determined by 
the relation which the loss resulting from the debt's becoming worthless 
bears to the trade or business of the taxpayer. If that relation is a 
proximate one in the conduct of the trade or business in which the 
taxpayer is engaged at the time the debt becomes worthless, the debt 
comes within the exception provided by that subparagraph. The use to 
which the borrowed funds are put by the debtor is of no consequence in 
making a determination under this paragraph. For purposes of section 166 
and this section, a nonbusiness debt does not include a debt described 
in section 165(g)(2)(C). See Sec.  1.165-5, relating to losses on 
worthless securities.
    (c) Guaranty of obligations. For provisions treating a loss 
sustained by a guarantor of obligations as a loss resulting from the 
worthlessness of a debt, see Sec. Sec.  1.166-8 and 1.166-9.
    (d) Examples. The application of this section may be illustrated by 
the following examples involving a case where A, an individual who is 
engaged in the grocery business and who makes his return on the basis of 
the calendar year, extends credit to B in 1955 on an open account:

    Example 1. In 1956 A sells the business but retains the claim 
against B. The claim becomes worthless in A's hands in 1957. A's loss is 
not controlled by the nonbusiness debt provisions, since the original 
consideration has been advanced by A in his trade or business.
    Example 2. In 1956 A sells the business to C but sells the claim 
against B to the taxpayer, D. The claim becomes worthless in D's hands 
in 1957. During 1956 and 1957, D is not engaged in any trade or 
business. D's loss is controlled by the nonbusiness debt provisions even 
though the original consideration has been advanced by A in his trade or 
business, since the debt has not been created or acquired in connection 
with a trade or business of D and since in 1957 D is not engaged

[[Page 377]]

in a trade or business incident to the conduct of which a loss from the 
worthlessness of such claim is a proximate result.
    Example 3. In 1956 A dies, leaving the business, including the 
accounts receivable, to his son, C, the taxpayer. The claim against B 
becomes worthless in C's hands in 1957. C's loss is not controlled by 
the nonbusiness debt provisions. While C does not advance any 
consideration for the claim, or create or acquire it in connection with 
his trade or business, the loss is sustained as a proximate incident to 
the conduct of the trade or business in which he is engaged at the time 
the debt becomes worthless.
    Example 4. In 1956 A dies, leaving the business to his son, C, but 
leaving the claim against B to his son, D, the taxpayer. The claim 
against B becomes worthless in D's hands in 1957. During 1956 and 1957, 
D is not engaged in any trade or business. D's loss is controlled by the 
nonbusiness debt provisions even though the original consideration has 
been advanced by A in his trade or business, since the debt has not been 
created or acquired in connection with a trade or business of D and 
since in 1957 D is not engaged in a trade or business incident to the 
conduct of which a loss from the worthlessness of such claim is a 
proximate result.
    Example 5. In 1956 A dies; and, while his executor, C, is carrying 
on the business, the claim against B becomes worthless in 1957. The loss 
sustained by A's estate is not controlled by the nonbusiness debt 
provisions. While C does not advance any consideration for the claim on 
behalf of the estate, or create or acquire it in connection with a trade 
or business in which the estate is engaged, the loss is sustained as a 
proximate incident to the conduct of the trade or business in which the 
estate is engaged at the time the debt becomes worthless.
    Example 6. In 1956, A, in liquidating the business, attempts to 
collect the claim against B but finds that it has become worthless. A's 
loss is not controlled by the nonbusiness debt provisions, since the 
original consideration has been advanced by A in his trade or business 
and since a loss incurred in liquidating a trade or business is a 
proximate incident to the conduct thereof.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7657, 44 FR 
68464, Nov. 29, 1979; T.D. 7728, 45 FR 72650, Nov. 3, 1980]



Sec.  1.166-6  Sale of mortgaged or pledged property.

    (a) Deficiency deductible as bad debt--(1) Principal amount. If 
mortgaged or pledged property is lawfully sold (whether to the creditor 
or another purchaser) for less than the amount of the debt, and the 
portion of the indebtedness remaining unsatisfied after the sale is 
wholly or partially uncollectible, the mortgagee or pledgee may deduct 
such amount under section 166(a) (to the extent that it constitutes 
capital or represents an item the income from which has been returned by 
him) as a bad debt for the taxable year in which it becomes wholly 
worthless or is charged off as partially worthless. See Sec.  1.166-3.
    (2) Accrued interest. Accrued interest may be included as part of 
the deduction allowable under this paragraph, but only if it has 
previously been returned as income.
    (b) Realization of gain or loss--(1) Determination of amount. If, in 
the case of a sale described in paragraph (a) of this section, the 
creditor buys in the mortgaged or pledged property, loss or gain is also 
realized, measured by the difference between the amount of those 
obligations of the debtor which are applied to the purchase or bid price 
of the property (to the extent that such obligations constitute capital 
or represent an item the income from which has been returned by the 
creditor) and the fair market value of the property.
    (2) Fair market value defined. The fair market value of the property 
for this purpose shall, in the absence of clear and convincing proof to 
the contrary, be presumed to be the amount for which it is bid in by the 
taxpayer.
    (c) Basis of property purchased. If the creditor subsequently sells 
the property so acquired, the basis for determining gain or loss upon 
the subsequent sale is the fair market value of the property at the date 
of its acquisition by the creditor.
    (d) Special rules applicable to certain banking organizations. For 
special rules relating to the treatment of mortgaged or pledged property 
by certain mutual savings banks, domestic building and loan 
associations, and cooperative banks, see section 595 and the regulations 
thereunder.
    (e) Special rules applicable to certain reacquisitions of real 
property. Notwithstanding this section, special rules apply for taxable 
years beginning after September 2, 1964 (and for certain taxable years 
beginning after December 31,

[[Page 378]]

1957), to the gain or loss on certain reacquisitions of real property, 
to indebtedness remaining unsatisfied as a result of such 
reacquisitions, and to the basis of the reacquired real property. See 
Sec. Sec.  1.1038-1 through 1.1038-3.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6814, 30 FR 
4472, Apr. 7, 1965, T.D. 6916, 32 FR 5923, Apr. 13, 1967]



Sec.  1.166-7  Worthless bonds issued by an individual.

    (a) Allowance of deduction. A bond or other similar obligation 
issued by an individual, if it becomes worthless in whole or in part, is 
subject to the bad debt provisions of section 166. The loss from the 
worthlessness of any such bond or obligation is deductible in accordance 
with section 166(a), unless such bond or obligation is a nonbusiness 
debt as defined in section 166(d)(2). If the bond or obligation is a 
nonbusiness debt, it is subject to section 166(d) and Sec.  1.166-5.
    (b) Decline in market value. A taxpayer possessing debts evidenced 
by bonds or other similar obligations issued by an individual shall not 
be allowed any deduction under section 166 on account of mere market 
fluctuation in the value of such obligations.
    (c) Worthless bonds issued by corporation. For provisions allowing 
the deduction under section 165(a) of the loss sustained upon the 
worthlessness of any bond or similar obligation issued by a corporation 
or a government, see Sec.  1.165-5.
    (d) Application to inventories. This section does not apply to any 
loss upon the worthlessness of any bond or similar obligation reflected 
in inventories required to be taken by a dealer in securities under 
section 471. See Sec.  1.471-5.



Sec.  1.166-8  Losses of guarantors, endorsers, and indemnitors incurred 
on agreements made before January 1, 1976.

    (a) Noncorporate obligations--(1) Deductible as bad debt. A payment 
during the taxable year by a taxpayer other than a corporation in 
discharge of part or all of his obligation as a guarantor, endorser, or 
indemnitor of an obligation issued by a person other than a corporation 
shall, for purposes of section 166 and the regulations thereunder, be 
treated as a debt's becoming worthless within the taxable year, if--
    (i) The proceeds of the obligation so issued have been used in the 
trade or business of the borrower, and
    (ii) The borrower's obligation to the person to whom the taxpayer's 
payment is made is worthless at the time of payment except for the 
existence of the guaranty, endorsement, or indemnity, whether or not 
such obligation has in fact become worthless within the taxable year in 
which payment is made.
    (2) Nonbusiness debt rule not applicable. If a payment is treated as 
a loss in accordance with the provisions of subparagraph (1) of this 
paragraph, section 166(d), relating to the special rule for losses 
sustained on the worthlessness of a nonbusiness debt, shall not apply. 
Accordingly, in each instance the loss shall be deducted under section 
166(a)(1) as a wholly worthless debt even though there has been a 
discharge of only a part of the taxpayer's obligation. Thus, if the 
taxpayer makes a payment during the taxable year in discharge of only 
part of his obligation as a guarantor, endorser, or indemnitor, he may 
treat such payment under section 166(a)(1) as a debt's becoming wholly 
worthless within the taxable year, provided that he can establish that 
such part of the borrower's obligation to the person to whom the 
taxpayer's payment is made is worthless at the time of payment and the 
conditions of subparagraph (1) of this paragraph have otherwise been 
satisfied.
    (3) Other applicable provisions. Other provisions of the internal 
revenue laws relating to bad debts, such as section 111, relating to the 
recovery of bad debts, shall be deemed to apply to any payment which, 
under the provisions of this paragraph, is treated as a bad debt. If the 
requirements of section 166(f) are not met, any loss sustained by a 
guarantor, endorser, or indemnitor upon the worthlessness of the 
debtor's obligation shall be treated under the provisions of law 
applicable thereto. See, for example, paragraph (b) of this section.
    (b) Corporate obligations. The loss sustained during the taxable 
year by a taxpayer other than a corporation in

[[Page 379]]

discharge of all of his obligation as a guarantor of an obligation 
issued by a corporation shall be treated, in accordance with section 
166(d) and the regulations thereunder, as a loss sustained on the 
worthlessness of a nonbusiness debt if the debt created in the 
guarantor's favor as a result of the payment does not come within the 
exceptions prescribed by section 166(d)(2) (A) or (B). See paragraph 
(a)(2) of Sec.  1.166-5.
    (c) Examples. The application of this section may be illustrated by 
the following examples:

    Example 1. During 1955, A, an individual who makes his return on the 
basis of the calendar year, guarantees payment of an obligation of B, an 
individual, to the X Bank, the proceeds of the obligation being used in 
B's business. B defaults on his obligation in 1956. A makes payment to 
the X Bank during 1957 in discharge of his entire obligation as a 
guarantor, the obligation of B to the X Bank being wholly worthless. For 
his taxable year 1957, A is entitled to a deduction under section 
166(a)(1) as a result of his payment during that year.
    Example 2. During 1955, A, an individual who makes his return on the 
basis of the calendar year, guarantees payment of an obligation of B, an 
individual, to the X Bank, the proceeds of the obligation being used in 
B's business. In 1956, B pays a part of his obligation to the X Bank but 
defaults on the remaining part. In 1957, A makes payment to the X Bank, 
in discharge of part of his obligation as a guarantor, of the remaining 
unpaid part of B's obligation to the bank, such part of B's obligation 
then being worthless. For his taxable year 1957, A is entitled to a 
deduction under section 166(a) (1) as a result of his payment of the 
remaining unpaid part of B's obligation.
    Example 3. During 1955, A, an individual who makes his return on the 
basis of the calendar year, guarantees payment of an obligation of B, an 
individual, to the X Bank, the proceeds of the obligation being used for 
B's personal use. B defaults on his obligation in 1956. A makes payment 
to the X Bank during 1957 in discharge of his entire obligation as a 
guarantor, the obligation of B to X Bank being wholly worthless. A may 
not apply the benefit of section 166(f) to his loss, since the proceeds 
of B's obligation have not been used in B's trade or business.
    Example 4. During 1955, A, an individual who makes his return on the 
basis of the calendar year, guarantees payment of an obligation of Y 
Corporation to the X Bank, the proceeds of the obligation being used in 
Y Corporation's business. Y Corporation defaults on its obligation in 
1956. A makes payment to the X Bank during 1957 in discharge of his 
entire obligation as a guarantor, the obligation of Y Corporation to the 
X Bank being wholly worthless. At no time during 1955 or 1957 is A 
engaged in a trade or business. For his taxable year 1957, A is entitled 
to deduct a capital loss in accordance with the provisions of section 
166(d) and paragraph (a) (2) of Sec.  1.166-5. He may not apply the 
benefit of section 166(f) to his loss, since his payment is in discharge 
of an obligation issued by a corporation.

    (d) Effective date. This section applies only to losses, regardless 
of the taxable year in which incurred, on agreements made before January 
1, 1976.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7657, 44 FR 
68464, Nov. 29, 1979]



Sec.  1.166-9  Losses of guarantors, endorsers, and indemnitors incurred, 
on agreements made after December 31, 1975, in taxable years beginning 
after such date.

    (a) Payment treated as worthless business debt. This paragraph 
applies to taxpayers who, after December 31, 1975, enter into an 
agreement in the course of their trade or business to act as (or in a 
manner essentially equivalent to) a guarantor, endorser, or indemnitor 
of (or other secondary obligor upon) a debt obligation. Subject to the 
provisions of paragraphs (c), (d), and (e) of this section, a payment of 
principal or interest made during a taxable year beginning after 
December 31, 1975, by the taxpayer in discharge of part or all of the 
taxpayer's obligation as a guarantor, endorser, or indemnitor is treated 
as a business debt becoming worthless in the taxable year in which the 
payment is made or in the taxable year described in paragraph (e)(2) of 
this section. Neither section 163 (relating to interest) nor section 165 
(relating to losses) shall apply with respect to such a payment.
    (b) Payment treated as worthless nonbusiness debt. This paragraph 
applies to taxpayers (other than corporations) who, after December 31, 
1975, enter into a transaction for profit, but not in the course of 
their trade or business, to act as (or in a manner essentially 
equivalent to) a guarantor, endorser, or indemnitor of (or other 
secondary obligor upon) a debt obligation. Subject to the provisions of 
paragraphs (c), (d), and (e) of this section, a payment of

[[Page 380]]

principal or interest made during a taxable year beginning after 
December 31, 1975, by the taxpayer in discharge of part or all of the 
taxpayer's obligation as a guarantor, endorser, or indemnitor is treated 
as a worthless nonbusiness debt in the taxable year in which the payment 
is made or in the taxable year described in paragraph (e)(2) of this 
section. Neither section 163 nor section 165 shall apply with respect to 
such a payment.
    (c) Obligations issued by corporations. No treatment as a worthless 
debt is allowed with respect to a payment made by the taxpayer in 
discharge of part or all of the taxpayer's obligation as a guarantor, 
endorser, or indemnitor of an obligation issued by a corporation if, on 
the basis of the facts and circumstances at the time the obligation was 
entered into, the payment constitutes a contribution to capital by a 
shareholder. The rule of this paragraph (c) applies to payments whenever 
made (see paragraph (f) of this section).
    (d) Certain payments treated as worthless debts. A payment in 
discharge of part or all of taxpayer's agreement to act as guarantor, 
endorser, or indemnitor of an obligation is to be treated as a worthless 
debt only if--
    (1) The agreement was entered into in the course of the taxpayer's 
trade or business or a transaction for profit;
    (2) There was an enforceable legal duty upon the taxpayer to make 
the payment (except that legal action need not have been brought against 
the taxpayer); and
    (3) The agreement was entered into before the obligation became 
worthless (or partially worthless in the case of an agreement entered 
into in the course of the taxpayer's trade or business). See Sec. Sec.  
1.166-2 and 1.166-3 for rules on worthless and partially worthless 
debts. For purposes of this paragraph (d)(3), an agreement is considered 
as entered into before the obligation became worthless (or partially 
worthless) if there was a reasonable expectation on the part of the 
taxpayer at the time the agreement was entered into that the taxpayer 
would not be called upon to pay the debt (subject to such agreement) 
without full reimbursement from the issuer of the obligation.
    (e) Special rules--(1) Reasonable consideration required. Treatment 
as a worthless debt of a payment made by a taxpayer in discharge of part 
or all of the taxpayer's agreement to act as a guarantor, endorser, or 
indemnitor of an obligation is allowed only if the taxpayer demonstrates 
that reasonable consideration was received for entering into the 
agreement. For purposes of this paragraph (e)(1), reasonable 
consideration is not limited to direct consideration in the form of cash 
or property. Thus, where a taxpayer can demonstrate that the agreement 
was given without direct consideration in the form of cash or property 
but in accordance with normal business practice or for a good faith 
business purpose, worthless debt treatment is allowed with respect to a 
payment in discharge of part or all of the agreement if the conditions 
of this section are met. However, consideration received from a 
taxpayer's spouse or any individual listed in section 152(a) must be 
direct consideration in the form of cash or property.
    (2) Right of subrogation. With respect to a payment made by a 
taxpayer in discharge of part or all of the taxpayer's agreement to act 
as a guarantor, endorser, or indemnitor where the agreement provides for 
a right of subrogation or other similar right against the issuer, 
treatment as a worthless debt is not allowed until the taxable year in 
which the right of subrogation or other similar right becomes totally 
worthless (or partially worthless in the case of an agreement which 
arose in the course of the taxpayer's trade or business).
    (3) Other applicable provisions. Unless inconsistent with this 
section, other Internal Revenue laws concerning worthless debts, such as 
section 111 relating to the recovery of bad debts, apply to any payment 
which, under the provisions of this section, is treated as giving rise 
to a worthless debt.
    (4) Taxpayer defined. For purposes of this section, except as 
otherwise provided, the term ``taxpayer'' means any taxpayer and 
includes individuals, corporations, partnerships, trusts and estates.
    (f) Effective date. This section applies to losses incurred on 
agreements made

[[Page 381]]

after December 31, 1975, in taxable years beginning after such date. 
However, paragraph (c) of this section also applies to payments, 
regardless of the taxable year in which made, under agreements made 
before January 1, 1976.

[T.D. 7657, 44 FR 68465, Nov. 29, 1979, as amended by T.D. 7920, 48 FR 
50712, Nov. 3, 1983]



Sec.  1.166-10  Reserve for guaranteed debt obligations.

    (a) Definitions. The following provisions apply for purposes of this 
section and section 166(f):
    (1) Dealer in property. A dealer in property is a person who 
regularly sells property in the ordinary course of the person's trade or 
business.
    (2) Guaranteed debt obligation. A guaranteed debt obligation is a 
legal duty of one person as a guarantor, endorser or indemnitor of a 
second person to pay a third person. It does not include duties based 
solely on moral or good public relations considerations that are not 
legally binding. A guaranteed debt obligation typically arises where a 
seller receives in payment for property or services the debt obligation 
of a purchaser and sells that obligation to a third party with recourse. 
However, a guaranteed debt obligation also may arise out of a sale in 
respect of which there is no direct debtor-creditor relationship between 
the debtor purchaser and the seller. For example, it arises where a 
purchaser borrows money from a third party to make payment to the seller 
and the seller guarantees the payment of the purchaser's debt. 
Generally, debt obligations which are sold without recourse do not 
result in any obligation of the seller as a guarantor, endorser, or 
indemnitor. However, there are certain without-recourse transactions 
which may give rise to a seller's liability as a guarantor or 
indemnitor. For example, such a liability may arise where a holder of a 
debt obligation holds money or other property of a seller which the 
holder may apply, without seeking permission of the seller, against any 
uncollectible debt obligations transferred to the holder by the seller 
without recourse, or where the seller is under a legal obligation to 
reacquire the real or tangible personal property from the holder of the 
debt obligation who repossessed property in satisfaction of the debt 
obligations.
    (3) Real or tangible personal property. Real or tangible personal 
property generally does not include other forms of property, such as 
securities. However, if the sale of other property is related to the 
sale of actual real or tangible personal property, the other property 
will be considered to be real or tangible personal property. In order 
for the sale of other property to be related, it must be--
    (i) Incidental to the sale of the actual real or tangible personal 
property; and
    (ii) Made under an agreement, entered into at the same time as the 
sale of actual real or tangible personal property, between the dealer in 
that property and the customer with respect to that property.

The other property may be charged for as a part of, or in addition to, 
the sales price of the actual real or tangible personal property. If the 
value of the other property is not greater than 20 percent of the total 
sales price, including the value of all related services other than 
financing services, the sale of the other property is related to the 
sale of actual real or tangible personal property.
    (4) Related services. In the case of a sale of both property and 
services a determination must be made as to whether the services are 
related to the property. Related services include only those services 
which are--
    (i) Incidental to the sale of the real or tangible personal 
property; and
    (ii) To be performed under an agreement, entered into at the same 
time as the sale of the property, between the dealer in property and the 
customer with respect to the property.

Delivery, financing installation. maintenance, repair, or instructional 
services generally qualify as related services. The services may be 
charged for as a part of, or in addition to, the sales price of the 
property. Where the value of all services other than financing services 
is not greater than 20 percent of the total of the sales price of the 
property, including the value of all the services other than financing 
services, all of the services are considered to be

[[Page 382]]

incidental to the sale of the property. Where the value of the services 
is greater than 20 percent, the determination as to whether a service is 
a related service in a particular case is to be made on the basis of all 
relevant facts and circumstances.
    (5) Examples. The following examples apply to paragraph (a)(4) of 
this section:

    Example 1. A. a dealer in television sets sells a television set to 
B, his customer. If at the time of the sale A, for a separate charge 
which is added to the sales price of the set and which is not greater 
than 20 percent of the total sales price, provides a 3-year service 
contract on only that television set, the service contract is a related 
service agreement. However, if A does not sell the service contract to B 
contemporaneously with the sale of the television set, as would be the 
case if the service agreement were entered into after the sale of the 
set were completed, or if the service contract includes services for a 
television set in addition to the one then sold by A to B, the service 
contract is not an agreement for a related service.
    Example 2. C, an automobile dealer, at the time of the sale by C of 
an automobile to D, agrees to made available to D driving instructions 
furnished by the M driving school, the cost of which is included in the 
sale price of the automobile and is not greater than 20 percent of the 
total sales price. C also agrees to pay M for the driving instructions 
furnished to D. Since C's agreement with D to make available driving 
instructions is incidental to the sale of the automobile, is made 
contemporaneously with the sale, and is charged for as part of the sales 
price of the automobile, it is an agreement for a related service. In 
contrast, however, because M's agreement with C is not an agreement 
between the dealer in property and the customer, M's agreement with C to 
provide driving instructions to C's customers is not an agreement for a 
related service.

    (b) Incorporation of section 166(c) rules. A reserve for section 
166(f)(1)(A) guaranteed debt obligations must be established and 
maintained under the rules applicable to the reserve for bad debts under 
section 166(c) (with the exception of the statement requirement under 
Sec.  1.166-4 (c)). For example, the rules in Sec.  1.166-4(b), relating 
to what constitutes a reasonable addition to a reserve for bad debts and 
to correction of errors in prior estimates, apply to a reserve for 
section 166(f)(1)(A) guaranteed debt obligations as well.
    (c) Special requirements. Any reserve for section 166(f)(1)(A) 
guaranteed debt obligations must be established and maintained 
separately from any reserve for other debt obligations. In addition, a 
taxpayer who charges off direct debts when they become worthless in 
whole or in part rather than maintaining a reserve for such obligations 
may not maintain a reserve for section 166(f)(1)(A) guaranteed debt 
obligations in the same trade or business.
    (d) Requirement of statement. A taxpayer who uses the reserve method 
of treating section 166(f)(1)(A) guaranteed debt obligations must attach 
to his return for each taxable year, returns for which are filed after 
April 17, 1986, and for each trade or business for which the reserve is 
maintained a statement showing--
    (1) The total amount of these obligations at the beginning of the 
taxable year;
    (2) The total amount of these obligations incurred during the 
taxable year;
    (3) The amount of the initial balance of the suspense account, if 
any, established with respect to these obligations;
    (4) The balance of the suspense account, if any, at the beginning of 
the taxable year,
    (5) The adjustment, if any, to that account;
    (6) The adjusted balance, if any, at the close of the taxable year;
    (7) The reconciliation of the beginning and closing balances of the 
reserve for these obligations and the computation of the addition to the 
reserve; and
    (8) The taxable year for which the reserve for these obligations was 
established.
    (e) Computation of opening balance--(1) In general. The opening 
balance of a reserve for section 166(f)(1)(A) guaranteed debt 
obligations established for the first taxable year for which a taxpayer 
maintains such a reserve shall be determined as if the taxpayer had 
maintained such a reserve for the taxable years preceding that taxable 
year. The amount of the opening balance may be determined under the 
following formula:

[[Page 383]]

[GRAPHIC] [TIFF OMITTED] TC14NO91.176

where--

OB = the opening balance at the beginning of the first taxable year
CG = the amount of these obligations at the close of the last preceding 
          taxable year
SG = the sum of the amounts of these obligations at the close of the 
          five preceding taxable years
SNL the sum of the amounts of net losses arising from these obligations 
          for the five preceding taxable years

    (2) Example. The following example applies to paragraph (e)(1) of 
this section.

    Example. For 1977, A, a dealer in automobiles who uses the calendar 
year as the taxable year, adopts in accordance with this section the 
reserve method of treating section 166(f)(1)(A) guaranteed debt 
obligations. A's first year in business as an automobile dealer is 1973. 
For 1972, 1973, 1974, 1975, and 1976, A's records disclose the following 
information with respect to these obligations:

----------------------------------------------------------------------------------------------------------------
                                                                              Gross
                                                             Obligations   losses from   Recoveries   Net losses
                           Year                            outstanding at     these      from these   from these
                                                            close of year  obligations  obligations  obligations
----------------------------------------------------------------------------------------------------------------
1972.....................................................              $0           $0           $0           $0
1973.....................................................         780,000        9,700        1,000        8,700
1974.....................................................         795,000        8,900        1,050        7,850
1975.....................................................         850,000        8,850          850        8,000
1976.....................................................         820,000        8,300        1,400        7,900
                                                          ------------------------------------------------------
  Total..................................................       3,245,000       36,750        4,300       32,450
----------------------------------------------------------------------------------------------------------------

    The opening balance for 1977 of A's reserve for these obligations is 
$8,200, determined as follows:
[GRAPHIC] [TIFF OMITTED] TC14NO91.177

    (3) More appropriate balance. A taxpayer may select a balance other 
than the one produced under paragraph (e)(1) of this section if it is 
more appropriate, based upon the taxpayer's actual experience, and in 
the event the taxpayer's return is examined, if the balance is approved 
by the district director.
    (4) No losses in the five preceding taxable years. If a taxpayer is 
in the taxpayer's first taxable year of a particular trade or business, 
or if the taxpayer has no losses arising from section 166(f)(1)(A) 
guaranteed debt obligations in a particular trade or business for any 
other reason in the five preceding taxable years, then the taxpayer's 
opening balance is zero for that particular trade or business.
    (5) Where reserve method was used before October 22, 1965. If for a 
taxable year ending before October 22, 1965, the taxpayer maintained a 
reserve for bad debts under section 166(c) which included guaranteed 
debt obligations described in section 166(f)(1)(A), and if the taxpayer 
is allowed a deduction referred to in paragraph (g)(2) of this section 
on account of those obligations, the amount of the opening balance of 
the reserve for section 166(f)(1)(A) guaranteed debt obligations for the 
taxpayer's first taxable year ending after October 21, 1965, shall be an 
amount equal to that portion of the section 166(c) reserve at the close 
of the last taxable year which is attributable to those debt 
obligations. The amount of the balance of the section 166(c) reserve for 
the taxable year shall be reduced by the amount of the opening balance 
of the reserve for those guaranteed debt obligations.
    (f) Suspense account--(1) Zero opening balance cases. No suspense 
account shall be maintained if the opening balance of the reserve for 
section 166(f)(1)(A) guaranteed debt obligations under section 166(f)(3) 
is zero
    (2) Example. The following example applies to section 166(f)(4)(B), 
relating to adjustments to the suspense account:

    Example. In 1977, A, an individual who operates an appliance store 
and uses the calendar year as the taxable year, adopts the reserve 
method of treating section 166(f)(1)(A) guaranteed debt obligations. The 
initial balance of A's suspense account is $8,200. At the close of 1977, 
1978, 1979, and 1980, the balance of A's reserve for these obligations 
is $8,400, $8,250,

[[Page 384]]

$8,150, and $8,175, respectively, after making the addition to the 
reserve for each year. The adjustments under section 166(f)(4)(B) to the 
suspense account at the close of each of the years involved are as 
follows:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
(1) Taxable year............       1977       1978       1979       1980
------------------------------------------------------------------------
(2) Closing reserve account      $8,400     $8,250     $8,150     $8,175
 balance....................
(3) Opening suspense account      8,200      8,200      8,200      8,150
 balance....................
(4) Line (2) less line (3)..        200         50        (50         25
(5) Adjustment to suspense            0          0        (50         25
 account balance............
(6) Closing suspense account      8,200      8,200      8,150      8,175
 balance (line 3 plus line
 5).........................
------------------------------------------------------------------------

    (g) Effective date--(1) In general. This section is generally 
effective for taxable years ending after October 21, 1965.
    (2) Transitional rule. Section 2(b) of the Act of November 2, 1966 
(Pub. L. 89-722, 80 Stat. 1151) allows additions to section 166(c) bad 
debt reserves in earlier taxable years on account of section 
166(f)(1)(A) guaranteed debt obligations to be deducted for those 
earlier taxable years. Paragraphs (c), (d), (e), and (f) of this section 
do not apply in determining whether a deduction is allowed under section 
2(b) of the Act. See Rev. Rul. 68-313 (1968-1C.B. 75) for rules relating 
to that deduction.

[T.D. 8071, 51 FR 2479, Jan. 17, 1986; 51 FR 9787, Mar. 21, 1986]



Sec.  1.167(a)-1  Depreciation in general.

    (a) Reasonable allowance. Section 167(a) provides that a reasonable 
allowance for the exhaustion, wear and tear, and obsolescence of 
property used in the trade or business or of property held by the 
taxpayer for the production of income shall be allowed as a depreciation 
deduction. The allowance is that amount which should be set aside for 
the taxable year in accordance with a reasonably consistent plan (not 
necessarily at a uniform rate), so that the aggregate of the amounts set 
aside, plus the salvage value, will, at the end of the estimated useful 
life of the depreciable property, equal the cost or other basis of the 
property as provided in section 167(g) and Sec.  1.167(g)-1. An asset 
shall not be depreciated below a reasonable salvage value under any 
method of computing depreciation. However, see section 167(f) and Sec.  
1.167(f)-1 for rules which permit a reduction in the amount of salvage 
value to be taken into account for certain personal property acquired 
after October 16, 1962. See also paragraph (c) of this section for 
definition of salvage. The allowance shall not reflect amounts 
representing a mere reduction in market value. See section 179 and Sec.  
1.179-1 for a further description of the term ``reasonable allowance.''
    (b) Useful life. For the purpose of section 167 the estimated useful 
life of an asset is not necessarily the useful life inherent in the 
asset but is the period over which the asset may reasonably be expected 
to be useful to the taxpayer in his trade or business or in the 
production of his income. This period shall be determined by reference 
to his experience with similar property taking into account present 
conditions and probable future developments. Some of the factors to be 
considered in determining this period are (1) wear and tear and decay or 
decline from natural causes, (2) the normal progress of the art, 
economic changes, inventions, and current developments within the 
industry and the taxpayer's trade or business, (3) the climatic and 
other local conditions peculiar to the taxpayer's trade or business, and 
(4) the taxpayer's policy as to repairs, renewals, and replacements. 
Salvage value is not a factor for the purpose of determining useful 
life. If the taxpayer's experience is inadequate, the general experience 
in the industry may be used until such time as the taxpayer's own 
experience forms an adequate basis for making the determination. The 
estimated remaining useful life may be subject to modification by reason 
of conditions known to exist at the end of the taxable year and shall be 
redetermined when necessary regardless of the method of computing 
depreciation. However, estimated remaining useful life shall be 
redetermined only when the change in the useful life is significant and 
there is a clear and convincing basis for the redetermination.

[[Page 385]]

For rules covering agreements with respect to useful life, see section 
167(d) and Sec.  1.167(d)-1. If a taxpayer claims an investment credit 
with respect to an asset for a taxable year preceding the taxable year 
in which the asset is considered as placed in service under Sec.  
1.167(a)-10(b) or Sec.  1.167(a)-11(e), the useful life of the asset 
under this paragraph shall be the same useful life assigned to the asset 
under Sec.  1.46-3(e).
    (c) Salvage. (1) Salvage value is the amount (determined at the time 
of acquisition) which is estimated will be realizable upon sale or other 
disposition of an asset when it is no longer useful in the taxpayer's 
trade or business or in the production of his income and is to be 
retired from service by the taxpayer. Salvage value shall not be changed 
at any time after the determination made at the time of acquisition 
merely because of changes in price levels. However, if there is a 
redetermination of useful life under the rules of paragraph (b) of this 
section, salvage value may be redetermined based upon facts known at the 
time of such redetermination of useful life. Salvage, when reduced by 
the cost of removal, is referred to as net salvage. The time at which an 
asset is retired from service may vary according to the policy of the 
taxpayer. If the taxpayer's policy is to dispose of assets which are 
still in good operating condition, the salvage value may represent a 
relatively large proportion of the original basis of the asset. However, 
if the taxpayer customarily uses an asset until its inherent useful life 
has been substantially exhausted, salvage value may represent no more 
than junk value. Salvage value must be taken into account in determining 
the depreciation deduction either by a reduction of the amount subject 
to depreciation or by a reduction in the rate of depreciation, but in no 
event shall an asset (or an account) be depreciated below a reasonable 
salvage value. See, however, paragraph (a) of Sec.  1.167(b)-2 for the 
treatment of salvage under the declining balance method, and Sec.  
1.179-1 for the treatment of salvage in computing the additional first-
year depreciation allowance. The taxpayer may use either salvage or net 
salvage in determining depreciation allowances but such practice must be 
consistently followed and the treatment of the costs of removal must be 
consistent with the practice adopted. For specific treatment of salvage 
value, see Sec. Sec.  1.167(b)-1, 1.167(b)-2, and 1.167(b)-3. When an 
asset is retired or disposed of, appropriate adjustments shall be made 
in the asset and depreciation reserve accounts. For example, the amount 
of the salvage adjusted for the costs of removal may be credited to the 
depreciation reserve.
    (2) For taxable years beginning after December 31, 1961, and ending 
after October 16, 1962, see section 167(f) and Sec.  1.167(f)-1 for 
rules applicable to the reduction of salvage value taken into account 
for certain personal property acquired after October 16, 1962.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6712, 29 FR 
3653, Mar. 24, 1964; T.D. 7203, 37 FR 17133, Aug. 25, 1972]



Sec.  1.167(a)-2  Tangible property.

    The depreciation allowance in the case of tangible property applies 
only to that part of the property which is subject to wear and tear, to 
decay or decline from natural causes, to exhaustion, and to 
obsolescence. The allowance does not apply to inventories or stock in 
trade, or to land apart from the improvements or physical development 
added to it. The allowance does not apply to natural resources which are 
subject to the allowance for depletion provided in section 611. No 
deduction for depreciation shall be allowed on automobiles or other 
vehicles used solely for pleasure, on a building used by the taxpayer 
solely as his residence, or on furniture or furnishings therein, 
personal effects, or clothing; but properties and costumes used 
exclusively in a business, such as a theatrical business, may be 
depreciated.



Sec.  1.167(a)-3  Intangibles.

    (a) In general. If an intangible asset is known from experience or 
other factors to be of use in the business or in the production of 
income for only a limited period, the length of which can be estimated 
with reasonable accuracy, such an intangible asset may be the subject of 
a depreciation allowance. Examples are patents and copyrights. An 
intangible asset, the useful life of which is

[[Page 386]]

not limited, is not subject to the allowance for depreciation. No 
allowance will be permitted merely because, in the unsupported opinion 
of the taxpayer, the intangible asset has a limited useful life. No 
deduction for depreciation is allowable with respect to goodwill. For 
rules with respect to organizational expenditures, see section 248 and 
the regulations thereunder. For rules with respect to trademark and 
trade name expenditures, see section 177 and the regulations thereunder. 
See sections 197 and 167(f) and, to the extent applicable, Sec. Sec.  
1.197-2 and 1.167(a)-14 for amortization of goodwill and certain other 
intangibles acquired after August 10, 1993, or after July 25, 1991, if a 
valid retroactive election under Sec.  1.197-1T has been made.
    (b) Safe harbor amortization for certain intangible assets--(1) 
Useful life. Solely for purposes of determining the depreciation 
allowance referred to in paragraph (a) of this section, a taxpayer may 
treat an intangible asset as having a useful life equal to 15 years 
unless--
    (i) An amortization period or useful life for the intangible asset 
is specifically prescribed or prohibited by the Internal Revenue Code, 
the regulations thereunder (other than by this paragraph (b)), or other 
published guidance in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2) of this chapter);
    (ii) The intangible asset is described in Sec.  1.263(a)-4(c) 
(relating to intangibles acquired from another person) or Sec.  
1.263(a)-4(d)(2) (relating to created financial interests);
    (iii) The intangible asset has a useful life the length of which can 
be estimated with reasonable accuracy; or
    (iv) The intangible asset is described in Sec.  1.263(a)-4(d)(8) 
(relating to certain benefits arising from the provision, production, or 
improvement of real property), in which case the taxpayer may treat the 
intangible asset as having a useful life equal to 25 years solely for 
purposes of determining the depreciation allowance referred to in 
paragraph (a) of this section.
    (2) Applicability to acquisitions of a trade or business, changes in 
the capital structure of a business entity, and certain other 
transactions. The safe harbor useful life provided by paragraph (b)(1) 
of this section does not apply to an amount required to be capitalized 
by Sec.  1.263(a)-5 (relating to amounts paid to facilitate an 
acquisition of a trade or business, a change in the capital structure of 
a business entity, and certain other transactions).
    (3) Depreciation method. A taxpayer that determines its depreciation 
allowance for an intangible asset using the 15-year useful life 
prescribed by paragraph (b)(1) of this section (or the 25-year useful 
life in the case of an intangible asset described in Sec.  1.263(a)-
4(d)(8)) must determine the allowance by amortizing the basis of the 
intangible asset (as determined under section 167(c) and without regard 
to salvage value) ratably over the useful life beginning on the first 
day of the month in which the intangible asset is placed in service by 
the taxpayer. The intangible asset is not eligible for amortization in 
the month of disposition.
    (4) Effective date. This paragraph (b) applies to intangible assets 
created on or after December 31, 2003.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960, as 
amended by T.D. 8867, 65 FR 3825, Jan. 25, 2000; T.D. 9107, 69 FR 444, 
Jan. 5, 2004]



Sec.  1.167(a)-4  Leased property.

    (a) In general. Capital expenditures made by either a lessee or 
lessor for the erection of a building or for other permanent 
improvements on leased property are recovered by the lessee or lessor 
under the provisions of the Internal Revenue Code (Code) applicable to 
the cost recovery of the building or improvements, if subject to 
depreciation or amortization, without regard to the period of the lease. 
For example, if the building or improvement is property to which section 
168 applies, the lessee or lessor determines the depreciation deduction 
for the building or improvement under section 168. See section 
168(i)(8)(A). If the improvement is property to which section 167 or 
section 197 applies, the lessee or lessor determines the depreciation or 
amortization deduction for the improvement under section 167 or section 
197, as applicable.
    (b) Effective/applicability date--(1) In general. Except as provided 
in paragraph (b)(2) or (b)(3) of this section,

[[Page 387]]

this section applies to taxable years beginning on or after January 1, 
2014.
    (2) Application of this section to leasehold improvements placed in 
service after December 31, 1986, in taxable years beginning before 
January 1, 2014. For leasehold improvements placed in service after 
December 31, 1986, in taxable years beginning before January 1, 2014, a 
taxpayer may--
    (i) Apply the provisions of this section; or
    (ii) Depreciate any leasehold improvement to which section 168 
applies under the provisions of section 168 and depreciate or amortize 
any leasehold improvement to which section 168 does not apply under the 
provisions of the Code that are applicable to the cost recovery of that 
leasehold improvement, without regard to the period of the lease.
    (3) Application of this section to leasehold improvements placed in 
service before January 1, 1987. Section 1.167(a)-4 as contained in 26 
CFR part 1 edition revised as of April 1, 2011, applies to leasehold 
improvements placed in service before January 1, 1987.
    (4) Change in method of accounting. Except as provided in Sec.  
1.446-1(e)(2)(ii)(d)(3)(i), a change to comply with this section for 
depreciable assets placed in service in a taxable year ending on or 
after December 30, 2003, is a change in method of accounting to which 
the provisions of section 446(e) and the regulations under section 
446(e) apply. Except as provided in Sec.  1.446-1(e)(2)(ii)(d)(3)(i), a 
taxpayer also may treat a change to comply with this section for 
depreciable assets placed in service in a taxable year ending before 
December 30, 2003, as a change in method of accounting to which the 
provisions of section 446(e) and the regulations under section 446(e) 
apply.

[T.D. 9636, 78 FR 57706, Sept. 19, 2013]



Sec.  1.167(a)-5  Apportionment of basis.

    In the case of the acquisition on or after March 1, 1913, of a 
combination of depreciable and nondepreciable property for a lump sum, 
as for example, buildings and land, the basis for depreciation cannot 
exceed an amount which bears the same proportion to the lump sum as the 
value of the depreciable property at the time of acquisition bears to 
the value of the entire property at that time. In the case of property 
which is subject to both the allowance for depreciation and 
amortization, depreciation is allowable only with respect to the portion 
of the depreciable property which is not subject to the allowance for 
amortization and may be taken concurrently with the allowance for 
amortization. After the close of the amortization period or after 
amortization deductions have been discontinued with respect to any such 
property, the unrecovered cost or other basis of the depreciable portion 
of such property will be subject to depreciation. For adjustments to 
basis, see section 1016 and other applicable provisions of law. For the 
adjustment to the basis of a structure in the case of a donation of a 
qualified conservation contribution under section 170(h), see Sec.  
1.170A-14(h)(3)(iii).

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960, as 
amended by T.D. 8069, 51 FR 1498, Jan. 14, 1986]



Sec.  1.167(a)-5T  Application of section 1060 to section 167 (temporary).

    In the case of an acquisition of a combination of depreciable and 
nondepreciable property for a lump sum in an applicable asset 
acquisition to which section 1060 applies, the basis for depreciation of 
the depreciable property cannot exceed the amount of consideration 
allocated to that property under section 1060 and Sec.  1.1060-1T.

[T.D. 8215, 53 FR 27043, July 18, 1988]



Sec.  1.167(a)-6  Depreciation in special cases.

    (a) Depreciation of patents or copyrights. The cost or other basis 
of a patent or copyright shall be depreciated over its remaining useful 
life. Its cost to the patentee includes the various Government fees, 
cost of drawings, models, attorneys' fees, and similar expenditures. For 
rules applicable to research and experimental expenditures, see sections 
174 and 1016 and the regulations thereunder. If a patent or copyright 
becomes valueless in any year before its expiration the unrecovered cost 
or other basis may be deducted in that year. See Sec.  1.167(a)-14(c)(4) 
for depreciation of a separately acquired interest in a patent or 
copyright described in

[[Page 388]]

section 167(f)(2) acquired after January 25, 2000. See Sec.  1.197-2 for 
amortization of interests in patents and copyrights that constitute 
amortizable section 197 intangibles.
    (b) Depreciation in case of farmers. A reasonable allowance for 
depreciation may be claimed on farm buildings (except a dwelling 
occupied by the owner), farm machinery, and other physical property but 
not including land. Livestock acquired for work, breeding, or dairy 
purposes may be depreciated unless included in an inventory used to 
determine profits in accordance with section 61 and the regulations 
thereunder. Such depreciation should be determined with reference to the 
cost or other basis, salvage value, and the estimated useful life of the 
livestock. See also section 162 and the regulations thereunder relating 
to trade or business expenses, section 165 and the regulations 
thereunder relating to losses of farmers, and section 175 and the 
regulations thereunder relating to soil or water conservation 
expenditures.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960, as 
amended by T.D. 8867, 65 FR 3825, Jan. 25, 2000]



Sec.  1.167(a)-7  Accounting for depreciable property.

    (a) Depreciable property may be accounted for by treating each 
individual item as an account, or by combining two or more assets in a 
single account. Assets may be grouped in an account in a variety of 
ways. For example, assets similar in kind with approximately the same 
useful lives may be grouped together. Such an account is commonly known 
as a group account. Another appropriate grouping might consist of assets 
segregated according to use without regard to useful life, for example, 
machinery and equipment, furniture and fixtures, or transportation 
equipment. Such an account is commonly known as a classified account. A 
broader grouping, where assets are included in the same account 
regardless of their character or useful lives, is commonly referred to 
as a composite account. For example, all the assets used in a business 
may be included in a single account. Group, classified, or composite 
accounts may be further broken down on the basis of location, dates of 
acquisition, cost, character, use, etc.
    (b) When group, classified, or composite accounts are used with 
average useful lives and a normal retirement occurs, the full cost or 
other basis of the asset retired, unadjusted for depreciation or 
salvage, shall be removed from the asset account and shall be charged to 
the depreciation reserve. Amounts representing salvage ordinarily are 
credited to the depreciation reserve. Where an asset is disposed of for 
reasons other than normal retirement, the full cost or other basis of 
the asset shall be removed from the asset account, and the depreciation 
reserve shall be charged with the depreciation applicable to the retired 
asset. For rules with respect to losses on normal retirements, see Sec.  
1.167 (a)-8.
    (c) A taxpayer may establish as many accounts for depreciable 
property as he desires. Depreciation allowances shall be computed 
separately for each account. Such depreciation preferably should be 
recorded in a depreciation reserve account; however, in appropriate 
cases it may be recorded directly in the asset account. Where 
depreciation reserves are maintained, a separate reserve account shall 
be maintained for each asset account. The regular books of account or 
permanent auxiliary records shall show for each account the basis of the 
property, including adjustments necessary to conform to the requirements 
of section 1016 and other provisions of law relating to adjustments to 
basis, and the depreciation allowances for tax purposes. In the event 
that reserves for book purposes do not correspond with reserves 
maintained for tax purposes, permanent auxiliary records shall be 
maintained with the regular books of accounts reconciling the 
differences in depreciation for tax and book purposes because of 
different methods of depreciation, bases, rates, salvage, or other 
factors. Depreciation schedules filed with the income tax return shall 
show the accumulated reserves computed in accordance with the allowances 
for income tax purposes.
    (d) In classified or composite accounts, the average useful life and 
rate shall be redetermined whenever additions, retirements, or 
replacements

[[Page 389]]

substantially alter the relative proportion of types of assets in the 
accounts. See example (2) in paragraph (b) of Sec.  1.167(b)-1 for 
method of determining the depreciation rate for a classified or 
composite account.
    (e) Applicability. Paragraphs (a), (b), and (d) of this section 
apply to property for which depreciation is determined under section 167 
(but not under section 168, section 1400I, section 1400L(c), section 168 
prior to its amendment by the Tax Reform Act of 1986, Public Law 99-514 
(100 Stat. 2121 (1986)), or under an additional first year depreciation 
deduction provision of the Internal Revenue Code (for example, section 
168(k) through (n), 1400L(b), or 1400N(d))). Paragraph (c) of this 
section does not apply to general asset accounts as provided by section 
168(i)(4), Sec.  1.168(i)-1, Sec.  1.168(i)-1T and Prop. Reg. Sec.  
1.168(i)-1 (September 19, 2013).
    (f) Effective/applicability date--(1) In general. This section 
applies to taxable years beginning on or after January 1, 2014. Except 
as provided in paragraphs (f)(2) and (f)(3) of this section, Sec.  
1.167(a)-7 as contained in 26 CFR part 1 edition revised as of April 1, 
2011, applies to taxable years beginning before January 1, 2014.
    (2) Early application of Sec.  1.167(a)-7(e). A taxpayer may choose 
to apply paragraph (e) of this section to taxable years beginning on or 
after January 1, 2012.
    (3) Optional application of TD 9564. A taxpayer may choose to apply 
Sec.  1.167(a)-7T as contained in TD 9564 (76 FR 81060) December 27, 
2011, to taxable years beginning on or after January 1, 2012, and before 
January 1, 2014.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960, as 
amended by T.D. 9564, 76 FR 81085, Dec. 27, 2011; T.D. 9636, 78 FR 
57707, Sept. 19, 2013]



Sec.  1.167(a)-8  Retirements.

    (a) Gains and losses on retirements. For the purposes of this 
section the term ``retirement'' means the permanent withdrawal of 
depreciable property from use in the trade or business or in the 
production of income. The withdrawal may be made in one of several ways. 
For example, the withdrawal may be made by selling or exchanging the 
asset, or by actual abandonment. In addition, the asset may be withdrawn 
from such productive use without disposition as, for example, by being 
placed in a supplies or scrap account. The tax consequences of a 
retirement depend upon the form of the transaction, the reason therefor, 
the timing of the retirement, the estimated useful life used in 
computing depreciation, and whether the asset is accounted for in a 
separate or multiple asset account. Upon the retirement of assets, the 
rules in this section apply in determining whether gain or loss will be 
recognized, the amount of such gain or loss, and the basis for 
determining gain or loss:
    (1) Where an asset is retired by sale at arm's length, recognition 
of gain or loss will be subject to the provisions of sections 1002, 
1231, and other applicable provisions of law.
    (2) Where an asset is retired by exchange, the recognition of gain 
or loss will be subject to the provisions of sections 1002, 1031, 1231, 
and other applicable provisions of law.
    (3) Where an asset is permanently retired from use in the trade or 
business or in the production of income but is not disposed of by the 
taxpayer or physically abandoned (as, for example, when the asset is 
transferred to a supplies or scrap account), gain will not be 
recognized. In such a case loss will be recognized measured by the 
excess of the adjusted basis of the asset at the time of retirement over 
the estimated salvage value or over the fair market value at the time of 
such retirement if greater, but only if--
    (i) The retirement is an abnormal retirement, or
    (ii) The retirement is a normal retirement from a single asset 
account (but see paragraph (d) of this section for special rule for item 
accounts), or
    (iii) The retirement is a normal retirement from a multiple asset 
account in which the depreciation rate was based on the maximum expected 
life of the longest lived asset contained in the account.
    (4) Where an asset is retired by actual physical abandonment (as, 
for example, in the case of a building condemned as unfit for further 
occupancy or other use), loss will be recognized

[[Page 390]]

measured by the amount of the adjusted basis of the asset abandoned at 
the time of such abandonment. In order to qualify for the recognition of 
loss from physical abandonment, the intent of the taxpayer must be 
irrevocably to discard the asset so that it will neither be used again 
by him nor retrieved by him for sale, exchange, or other disposition.

Experience with assets which have attained an exceptional or unusual age 
shall, with respect to similar assets, be disregarded in determining the 
maximum expected useful life of the longest lived asset in a multiple 
asset account. For example, if a manufacturer establishes a proper 
multiple asset account for 50 assets which are expected to have an 
average life of 30 years but which will remain useful to him for varying 
periods between 20 and 40 years, the maximum expected useful life will 
be 40 years, even though an occasional asset of this kind may last 60 
years.
    (b) Definition of normal and abnormal retirements. For the purpose 
of this section the determination of whether a retirement is normal or 
abnormal shall be made in the light of all the facts and circumstances. 
In general, a retirement shall be considered a normal retirement unless 
the taxpayer can show that the withdrawal of the asset was due to a 
cause not contemplated in setting the applicable depreciation rate. For 
example, a retirement is considered normal if made within the range of 
years taken into consideration in fixing the depreciation rate and if 
the asset has reached a condition at which, in the normal course of 
events, the taxpayer customarily retires similar assets from use in his 
business. On the other hand, a retirement may be abnormal if the asset 
is withdrawn at an earlier time or under other circumstances, as, for 
example, when the asset has been damaged by casualty or has lost its 
usefulness suddenly as the result of extraordinary obsolescence.
    (c) Basis of assets retired. The basis of an asset at the time of 
retirement for computing gain or loss shall be its adjusted basis for 
determining gain or loss upon a sale or other disposition as determined 
in accordance with the provisions of section 1011 and the following 
rules:
    (1) In the case of a normal retirement of an asset from a multiple 
asset account where the depreciation rate is based on average expected 
useful life, the term ``adjusted basis'' means the salvage value 
estimated in determining the depreciation deduction in accordance with 
the provisions in paragraph (c) of Sec.  1.167(a)-1.
    (2) In the case of a normal retirement of an asset from a multiple 
asset account on which the depreciation rate was based on the maximum 
expected life of the longest lived asset in the account, the adjustment 
for depreciation allowed or allowable shall be made at the rate which 
would have been proper if the asset had been depreciated in a single 
asset account (under the method of depreciation used for the multiple 
asset account) using a rate based upon the maximum expected useful life 
of that asset, and
    (3) In the case of an abnormal retirement from a multiple asset 
account the adjustment for depreciation allowed or allowable shall be 
made at the rate which would have been proper had the asset been 
depreciated in a single asset account (under the method of depreciation 
used for the multiple asset account) and using a rate based upon either 
the average expected useful life or the maximum expected useful life of 
the asset, depending upon the method of determining the rate of 
depreciation used in connection with the multiple asset account.
    (d) Special rule for item accounts. (1) As indicated in paragraph 
(a)(3)(ii) and (iii) of this section, a loss is recognized upon the 
normal retirement of an asset from a single asset account but a loss on 
the normal retirement of an asset in a multiple asset account is not 
allowable where the depreciation rate is based upon the average useful 
life of the assets in the account. Where a taxpayer with more than one 
depreciable asset chooses to set up a separate account for each such 
asset and the depreciation rate is based on the average useful life of 
such assets (so that he uses the same life for each account), the 
question arises whether his depreciation deductions in substance are the 
equivalent of those which would result

[[Page 391]]

from the use of multiple asset accounts and, therefore, he should be 
subject to the rules governing losses on retirements of assets from 
multiple asset accounts. Where a taxpayer has only a few depreciable 
assets which he chooses to account for in single asset accounts, 
particularly where such assets cover a relatively narrow range of lives, 
it cannot be said in the usual case that the allowance of losses on 
retirements from such accounts clearly will distort income. This results 
from the fact that where a taxpayer has only a few depreciable assets it 
is usually not possible clearly to determine that the depreciation rate 
is based upon the average useful life of such assets. Accordingly, it 
cannot be said that the taxpayer is in effect clearly operating with a 
multiple asset account using an average life rate so that losses should 
not be allowed on normal retirements. Therefore, losses normally will be 
allowed upon retirement of assets from single asset accounts where the 
taxpayer has only a few depreciable assets. On the other hand, when a 
taxpayer who has only a few depreciable assets chooses to account for 
them in single asset accounts, using for each account a depreciation 
rate based on the average useful life of such assets, and the assets 
cover a wide range of lives, the likelihood that income will be 
distorted is greater than where the group of assets covers a relatively 
narrow range of lives. In those cases where the allowance of losses 
would distort income, the rules with respect to the allowance of losses 
on normal retirement shall be applied to such assets in the same manner 
as though the assets had been accounted for in multiple asset accounts 
using a rate based upon average expected useful life.
    (2) Where a taxpayer has a large number of depreciable assets and 
depreciation is based on the average useful life of such assets, then, 
whether such assets are similar or dissimilar and regardless of whether 
they are accounted for in individual asset accounts or multiple asset 
accounts the allowance of losses on the normal retirement of such assets 
would distort income. Such distortion would result from the fact that 
the use of average useful life (and, accordingly, average rate) assumes 
that while some assets normally will be retired before the expiration of 
the average life, others normally will be retired after expiration of 
the average life. Accordingly, if instead of accounting for a large 
number of similar or dissimilar depreciable assets in multiple asset 
accounts, the taxpayer chooses to account separately for such assets, 
using a rate based upon the average life of such assets, the rules with 
respect to the allowances of losses on normal retirements will be 
applied to such assets in the same manner as though the assets were 
accounted for in multiple asset accounts using a rate based upon average 
expected useful life.
    (3) Where a taxpayer who does not have a large number of depreciable 
assets (and who therefore is not subject to subparagraph (2) of this 
paragraph) chooses to set up a separate account for each such asset, and 
has sought to compute an average life for such assets on which to base 
his depreciation deductions (so that he uses the same life for each 
account), the allowance of losses on normal retirements from such 
accounts may in some situations substantially distort income. Such 
distortion would result from the fact that the use of average useful 
life (and, accordingly, average rate) assumes that while some assets 
normally will be retired before expiration of the average life, others 
normally will be retired after expiration of the average life. 
Accordingly, where a taxpayer chooses to account separately for such 
assets instead of accounting for them in multiple asset accounts, and 
the result is to substantially distort his income, the rules with 
respect to the allowance of losses on normal retirements shall be 
applied to such assets in the same manner as though the assets had been 
accounted for in multiple asset accounts using a rate based upon average 
expected useful life.
    (4) Whenever a taxpayer is treated under this paragraph as though 
his assets were accounted for in a multiple asset account using an 
average life rate, and, therefore, he is denied a loss on retirements, 
the unrecovered cost less salvage of each asset which was accounted for 
separately may be amortized in accordance with the regulation

[[Page 392]]

stated in paragraph (e)(1)(ii) of this section.
    (e) Accounting treatment of asset retirements. (1) In the case of a 
normal retirement where under the foregoing rules no loss is recognized 
and where the asset is retired without disposition or abandonment, (i) 
if the asset was contained in a multiple asset account, the full cost of 
such asset, reduced by estimated salvage, shall be charged to the 
depreciation reserve, or (ii) if the asset was accounted for separately, 
the unrecovered cost or other basis, less salvage, of the asset may be 
amortized through annual deductions from gross income in amounts equal 
to the unrecovered cost or other basis of such asset, divided by the 
average expected useful life (not the remaining useful life) applicable 
to the asset at the time of retirement. For example, if an asset is 
retired after six years of use and at the time of retirement 
depreciation was being claimed on the basis of an average expected 
useful life of ten years, the unrecovered cost or other basis less 
salvage would be amortized through equal annual deductions over a period 
of ten years from the time of retirement.
    (2) Where multiple asset accounts are used and acquisitions and 
retirements are numerous, if a taxpayer, in order to avoid unnecessarily 
detailed accounting for individual retirements, consistently follows the 
practice of charging the reserve with the full cost or other basis of 
assets retired and of crediting it with all receipts from salvage, the 
practice may be continued so long as, in the opinion of the 
Commissioner, it clearly reflects income. Conversely, where the taxpayer 
customarily follows a practice of reporting all receipts from salvage as 
ordinary taxable income such practice may be continued so long as, in 
the opinion of the Commissioner, it clearly reflects income.
    (f) Cross reference. For special rules in connection with the 
retirement of the last assets of a given year's acquisitions under the 
declining balance method, see example (2) in paragraph (b) of Sec.  
1.167 (b)-2.
    (g) Applicability. This section applies to property for which 
depreciation is determined under section 167 (but not under section 168, 
section 1400I, section 1400L(c), section 168 prior to its amendment by 
the Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 2121(1986)), or 
under an additional first year depreciation deduction provision of the 
Internal Revenue Code (for example, section 168(k) through (n), 
1400L(b), or 1400N(d))).
    (h) Effective/applicability date--(1) In general. This section 
applies to taxable years beginning on or after January 1, 2014. Except 
as provided in paragraphs (h)(2) and (h)(3) of this section, Sec.  
1.167(a)-8 as contained in 26 CFR part 1 edition revised as of April 1, 
2011, applies to taxable years beginning before January 1, 2014.
    (2) Early application of Sec.  1.167(a)-8(g). A taxpayer may choose 
to apply paragraph (g) of this section to taxable years beginning on or 
after January 1, 2012.
    (3) Optional application of TD 9564. A taxpayer may choose to apply 
Sec.  1.167(a)-8T as contained in TD 9564 (76 FR 81060) December 27, 
2011, to taxable years beginning on or after January 1, 2012, and before 
January 1, 2014.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960, as 
amended by T.D. 9564, 76 FR 81085, Dec. 27, 2011; T.D. 9636, 78 FR 
57707, Sept. 19, 2013]



Sec.  1.167(a)-9  Obsolescence.

    The depreciation allowance includes an allowance for normal 
obsolescence which should be taken into account to the extent that the 
expected useful life of property will be shortened by reason thereof. 
Obsolescence may render an asset economically useless to the taxpayer 
regardless of its physical condition. Obsolescence is attributable to 
many causes, including technological improvements and reasonably 
foreseeable economic changes. Among these causes are normal progress of 
the arts and sciences, supersession or inadequacy brought about by 
developments in the industry, products, methods, markets, sources of 
supply, and other like changes, and legislative or regulatory action. In 
any case in which the taxpayer shows that the estimated useful life 
previously used should be shortened by reason of obsolescence greater 
than had been assumed in computing such estimated useful life, a change 
to a new and shorter estimated useful life

[[Page 393]]

computed in accordance with such showing will be permitted. No such 
change will be permitted merely because in the unsupported opinion of 
the taxpayer the property may become obsolete. For rules governing the 
allowance of a loss when the usefulness of depreciable property is 
suddenly terminated, see Sec.  1.167(a)-8. If the estimated useful life 
and the depreciation rates have been the subject of a previous 
agreement, see section 167(d) and Sec.  1.167(d)-1.



Sec.  1.167(a)-10  When depreciation deduction is allowable.

    (a) A taxpayer should deduct the proper depreciation allowance each 
year and may not increase his depreciation allowances in later years by 
reason of his failure to deduct any depreciation allowance or of his 
action in deducting an allowance plainly inadequate under the known 
facts in prior years. The inadequacy of the depreciation allowance for 
property in prior years shall be determined on the basis of the 
allowable method of depreciation used by the taxpayer for such property 
or under the straight line method if no allowance has ever been claimed 
for such property. The preceding sentence shall not be construed as 
precluding application of any method provided in section 167(b) if 
taxpayer's failure to claim any allowance for depreciation was due 
solely to erroneously treating as a deductible expense an item properly 
chargeable to capital account. For rules relating to adjustments to 
basis, see section 1016 and the regulations thereunder.
    (b) The period for depreciation of an asset shall begin when the 
asset is placed in service and shall end when the asset is retired from 
service. A proportionate part of one year's depreciation is allowable 
for that part of the first and last year during which the asset was in 
service. However, in the case of a multiple asset account, the amount of 
depreciation may be determined by using what is commonly described as an 
``averaging convention'', that is, by using an assumed timing of 
additions and retirements. For example, it might be assumed that all 
additions and retirements to the asset account occur uniformly 
throughout the taxable year, in which case depreciation is computed on 
the average of the beginning and ending balances of the asset account 
for the taxable year. See example (3) under paragraph (b) of Sec.  
1.167(b)-1. Among still other averaging conventions which may be used is 
the one under which it is assumed that all additions and retirements 
during the first half of a given year were made on the first day of that 
year and that all additions and retirements during the second half of 
the year were made on the first day of the following year. Thus, a full 
year's depreciation would be taken on additions in the first half of the 
year and no depreciation would be taken on additions in the second half. 
Moreover, under this convention, no depreciation would be taken on 
retirements in the first half of the year and a full year's depreciation 
would be taken on the retirements in the second half. An averaging 
convention, if used, must be consistently followed as to the account or 
accounts for which it is adopted, and must be applied to both additions 
and retirements. In any year in which an averaging convention 
substantially distorts the depreciation allowance for the taxable year, 
it may not be used.



Sec.  1.167(a)-11  Depreciation based on class lives and asset 
depreciation ranges for property placed in service after December 31, 1970.

    (a) In general--(1) Summary. This section provides an asset 
depreciation range and class life system for determining the reasonable 
allowance for depreciation of designated classes of assets placed in 
service after December 31, 1970. The system is designed to minimize 
disputes between taxpayers and the Internal Revenue Service as to the 
useful life of property, and as to salvage value, repairs, and other 
matters. The system is optional with the taxpayer. The taxpayer has an 
annual election. Generally, an election for a taxable year must apply to 
all additions of eligible property during the taxable year of election, 
but does not apply to additions of eligible property in any other 
taxable year. The taxpayer's election, made with the return

[[Page 394]]

for the taxable year, may not be revoked or modified for any property 
included in the election. Generally, the taxpayer must establish vintage 
accounts for all eligible property included in the election, must 
determine the allowance for depreciation of such property in the taxable 
year of election, and in subsequent taxable years, on the basis of the 
asset depreciation period selected and must apply the first-year 
convention specified in the election to determine the allowance for 
depreciation of such property. This section also contains special 
provisions for the treatment of salvage value, retirements, and the 
costs of the repair, maintenance, rehabilitation or improvement of 
property. In general, a taxpayer may not apply any provision of this 
section unless he makes an election and thereby consents to, and agrees 
to apply, all the provisions of this section. A taxpayer who elects to 
apply this section does, however, have certain options as to the 
application of specified provisions of this section. A taxpayer may 
elect to apply this section for a taxable year only if for such taxable 
year he complies with the requirements of paragraph (f)(4) of this 
section.
    (2) Definitions. For the meaning of certain terms used in this 
section, see paragraphs (b)(2) (``eligible property''), (b)(3) 
(``vintage account'' and ``vintage''), (b)(4) (``asset depreciation 
range'', ``asset guideline class'', ``asset guideline period'', and 
``asset depreciation period''), (b)(5)(iii)(c) (``used property''), 
(b)(6)(i) (``public utility property''), (c)(1)(iv) (``original use''), 
(c)(1)(v) (``unadjusted basis'' and ``adjusted basis''), (c)(2)(ii) 
(``modified half-year convention''), (c)(2)(iii) (``half-year 
convention''), (d)(1)(i) (``gross salvage value''), (d)(1)(ii) 
(``salvage value''), (d)(2)(iii) (``repair allowance'', ``repair 
allowance percentage'', and ``repair allowance property''), (d)(2)(vi) 
(``excluded addition''), (d)(2)(vii) (``property improvement''), 
(d)(3)(ii) (``ordinary retirement'' and ``extraordinary retirement''), 
(d)(3)(vi) (``special basis vintage account''), and (e)(1) (``first 
placed in service'') of this section.
    (b) Reasonable allowance using asset depreciation ranges--(1) In 
general. The allowance for depreciation of eligible property (as defined 
in subparagraph (2) of this paragraph) to which the taxpayer elects to 
apply this section shall be determined as provided in paragraph (c) of 
this section and shall constitute the reasonable allowance for 
depreciation of such property under section 167(a).
    (2) Definition of eligible property. For purposes of this section, 
the term ``eligible property'' means tangible property which is subject 
to the allowance for depreciation provided by section 167(a) but only 
if--
    (i) An asset guideline class and asset guideline period are in 
effect for such property for the taxable year of election (see 
subparagraph (4) of this paragraph);
    (ii) The property is first placed in service (as described in 
paragraph (e) (1) of this section) by the taxpayer after December 31, 
1970 (but see subparagraph (7) of this paragraph for special rule where 
there is a mere change in the form of conducting a trade or business); 
and
    (iii) The property is either--
    (a) Section 1245 property as defined in section 1245(a) (3), or
    (b) Section 1250 property as defined in section 1250(c).

See, however, subparagraph (6) of this paragraph for special rule for 
certain public utility property as defined in section 167(l)(3)(A). 
Property which meets the requirements of this subparagraph is eligible 
property even if depreciation with respect to such property, determined 
in accordance with this section, is allocated to or otherwise required 
to be reflected in the cost of a capitalized item. The term ``eligible 
property'' includes any property which meets the requirements of this 
subparagraph, whether such property is new property, ``used property'' 
(as described in subparagraph (5)(iii)(c) of this paragraph), a 
``property improvement'' (as described in paragraph (d)(2)(vii) of this 
section), or an ``excluded addition'' (as described in paragraph 
(d)(2)(vi) of this section). For the treatment of expenditures for the 
repair, maintenance, rehabilitation or improvement of certain property, 
see paragraph (d) (2) of this section.

[[Page 395]]

    (3) Requirement of vintage accounts--(i) In general. For purposes of 
this section, a ``vintage account'' is a closed-end depreciation account 
containing eligible property to which the taxpayer elects to apply this 
section, first placed in service by the taxpayer during the taxable year 
of election. The ``vintage'' of an account refers to the taxable year 
during which the eligible property in the account is first placed in 
service by the taxpayer. Such an account will consist of an asset, or a 
group of assets, within a single asset guideline class established 
pursuant to subparagraph (4) of this paragraph and may contain only 
eligible property. Each item of eligible property to which the taxpayer 
elects to apply this section, first placed in service by the taxpayer 
during the taxable year of election (determined without regard to a 
convention described in paragraph (c)(2) of this section) shall be 
placed in a vintage account of the taxable year of election. For rule 
regarding ``special basis vintage accounts'' for certain property 
improvements, see paragraph (d)(2)(viii) and (3)(vi) of this section. 
Any number of vintage accounts of a taxable year may be established. 
More than one account of the same vintage may be established for 
different assets of the same asset guideline class. See paragraph 
(d)(3)(xi) of this section for special rule for treatment of certain 
multiple asset and item accounts.
    (ii) Special rule. Section 1245 property may not be placed in a 
vintage account with section 1250 property. Property the original use of 
which does not commence with the taxpayer may not be placed in a vintage 
account with property the original use of which commences with the 
taxpayer. Property described in section 167(f)(2) may not be placed in a 
vintage account with property not described in section 167(f)(2). 
Property described in section 179(d)(1) for which the taxpayer elects 
the allowance for the first taxable year in accordance with section 
179(c) may not be placed in a vintage account with property not 
described in section 179(d)(1) or for which the taxpayer does not elect 
such allowance for the first taxable year. For special rule for property 
acquired in a transaction to which section 381(a) applies, see paragraph 
(e)(3)(i) of this section. For additional rules with respect to 
accounting for eligible property, see paragraph (e) of this section.
    (4) Asset depreciation ranges and periods--(i) Selection of asset 
depreciation period. The taxpayers books and records must specify for 
each vintage account of the taxable year of election--
    (a) In the case of vintage account for property in an asset 
guideline class for which no asset depreciation range is in effect for 
the taxable year, the asset depreciation period (which shall be equal to 
the asset guideline period for the assets in such account), or
    (b) In the case of a vintage account for property in an asset 
guideline class for which an asset depreciation range is in effect for 
the taxable year, the asset depreciation period selected by the taxpayer 
from the asset depreciation range for the assets in such account.

Unless otherwise expressly provided in the establishment thereof, for 
purposes of this section, the term ``asset guideline class'' means a 
category of assets (including ``subsidiary assets'') for which a 
separate asset guideline period is in effect for the taxable year as 
provided in subdivision (ii) of this subparagraph. The ``asset 
depreciation range'' is a period of years which extends from 80 percent 
of the asset guideline period to 120 percent of such period, determined 
in each case by rounding any fractional part of a year to the nearer of 
the nearest whole or half year. Except as provided in paragraph 
(e)(3)(iv) of this section, in the case of an asset guideline class for 
which an asset depreciation range is in effect, any period within the 
asset depreciation range for the assets in a vintage account which is a 
whole number of years or a whole number of years plus a half year, may 
be selected. The term ``asset depreciation period'' means the period 
selected from the asset depreciation range, or if no asset depreciation 
range is in effect for the class, the asset guideline period. The 
``asset guideline period'' is established in accordance with subdivision 
(ii) of this subparagraph and is the class life

[[Page 396]]

under section 167(m). See Revenue Procedure 72-10 for special rules for 
section 1250 property and property predominately used outside the United 
States. In general, an asset guideline period, but no asset depreciation 
range, is in effect for such property.
    (ii) Establishment of asset guideline classes and periods. The asset 
guideline classes and the asset guideline periods, and the asset 
depreciation ranges determined from such periods, in effect for taxable 
years ending before the effective date of the first supplemental asset 
guideline classes, asset guideline periods, and asset depreciation 
ranges, established pursuant to this section are set forth in Revenue 
Procedure 72-10. Asset guideline classes and periods, and asset 
depreciation ranges, will from time to time be established, 
supplemented, and revised with express reference to this section, and 
will be published in the Internal Revenue Bulletin. The asset guideline 
classes, the asset guideline periods, and the asset depreciation ranges 
determined from such periods in effect as of the last day of a taxable 
year of election shall apply to all vintage accounts of such taxable 
year, except that neither the asset guideline period nor the lower limit 
of the asset depreciation range for any such account shall be longer 
than the asset guideline period or the lower limit of the asset 
depreciation range, as the case may be, for such account in effect as of 
the first day of the taxable year (or as of such later time in such year 
as an asset guideline class first established during such year becomes 
effective). Generally, the reasonable allowance for depreciation of 
property for any taxable year in a vintage account shall not be changed 
to reflect any supplement or revision of the asset guideline classes or 
periods, and asset depreciation ranges, for the taxable year in which 
the account is established, which occurs after the end of such taxable 
year. However, if expressly provided in such a supplement or revision, 
the taxpayer may, at his option in the manner specified therein, apply 
the revised or supplemented asset guideline classes or periods and asset 
depreciation ranges to such property for such taxable year and 
succeeding taxable years.
    (iii) Applicable guideline classes and periods in special 
situations. (a) An electric or gas utility which would in accordance 
with Revenue Procedure 64-21 be entitled to use a composite guideline 
class basis for applying Revenue Procedure 62-21 may, solely with 
respect to property for which an asset depreciation range is in effect 
for the taxable year, elect to apply this section on the basis of a 
composite asset guideline class and asset guideline period determined by 
applying the provisions of Revenue Procedure 64-21 to such property. The 
asset depreciation range for such a composite asset guideline class 
shall be determined by reference to the composite asset guideline period 
at the beginning of the first taxable year to which the taxpayer elects 
to apply this section and shall not be changed until such time as major 
variations in the asset mix or the asset guideline classes or periods 
justify some other composite asset guideline period. Except as provided 
in paragraph (d)(2)(iii) of this section with respect to buildings and 
other structures, for the purposes of this section, all property in the 
composite asset guideline class shall be treated as included in a single 
asset guideline class. If the taxpayer elects to apply this subdivision, 
the election shall be made on the tax return filed for the first taxable 
year for which the taxpayer elects to apply this section. An election to 
apply this subdivision for any taxable year shall apply to all 
succeeding taxable years to which the taxpayer elects to apply this 
section, except to the extent the election to apply this subdivision is 
with the consent of the Commissioner terminated with respect to a 
succeeding taxable year and all taxable years thereafter.
    (b) For purposes of this section, property shall be included in the 
asset guideline class for the activity in which the property is 
primarily used. See paragraph (e)(3)(iii) of this section for rule for 
leased property. Property shall be classified according to primary use 
even though the activity in which such property is primarily used is 
insubstantial in relation to all the taxpayer's activities. No change in 
the classification of property shall be made because of a change in 
primary use

[[Page 397]]

after the end of the taxable year in which property is first placed in 
service, including a change in use which results in section 1250 
property becoming section 1245 property.
    (c) An incorrect classification or characterization by the taxpayer 
of property for the purposes of this section (such as under (b) of this 
subdivision or under subparagraph (2) or (3) (ii) of this paragraph) 
shall not cause or permit a revocation of the election to apply this 
section for the taxable year in which such property was first placed in 
service. The classification or characterization of such property shall 
be corrected. All adjustments necessary to the correction shall be made, 
including adjustments of unadjusted basis, adjusted basis, salvage 
value, the reserve for depreciation of all vintage accounts affected, 
and the amount of depreciation allowable for all taxable years for which 
the period for assessment of tax prescribed in section 6501 has not 
expired. If because of incorrect classification or characterization 
property included in an election to apply this section was not placed in 
a vintage account and no asset depreciation period was selected for the 
property or the property was placed in a vintage account but an asset 
depreciation period was selected from an incorrect asset depreciation 
range, the taxpayer shall place the property in a vintage account and 
select an asset depreciation period for the account from the correct 
asset depreciation range.
    (d) Generally, except as provided in subparagraph (5)(v)(a) of this 
paragraph, a taxpayer may not compute depreciation for eligible property 
first placed in service during the taxable year under a method of 
depreciation not described in section 167(b) (1), (2), or (3). (If the 
taxpayer computes depreciation with respect to such property under 
section 167(k), or amortizes such property, the property must be 
excluded from the election to apply this section.) (See subparagraph 
(5)(v)(b) of this paragraph.) However, if the taxpayer establishes to 
the satisfaction of the Commissioner that a method of depreciation not 
described in section 167(b) (1), (2), (3), or (k) was adopted for 
property in the asset guideline class on the basis of a good faith 
mistake as to the proper asset guideline class for the property, then, 
unless the requirements of subparagraph (5)(v)(a) of this paragraph are 
met, the taxpayer must terminate (as of the beginning of the taxable 
year) such method of depreciation with respect to all eligible property 
in the asset guideline class which was first placed in service during 
the taxable year. In such event, the taxpayer's election to apply this 
section shall include eligible property in the asset guideline class 
without regard to subparagraph (5)(v)(a) of this paragraph. The 
provisions of (c) of this subdivision shall apply to the correction in 
the classification of the property.
    (e) If the provisions of section 167(j) apply to require a change in 
the method of depreciation with respect to an item of section 1250 
property in a multiple asset vintage account, the asset shall be removed 
from the account and placed in a separate item vintage account. The 
unadjusted basis of the asset shall be removed from the unadjusted basis 
of the vintage account as of the first day of the taxable year in which 
the change in method of depreciation is required and the depreciation 
reserve established for the account shall be reduced by the depreciation 
allowable for the property computed in the manner prescribed in 
paragraph (c)(1)(v)(b) of this section for determination of the adjusted 
basis of property. See paragraph (d)(3)(vii)(e) of this section for 
treatment of salvage value when property is removed from a vintage 
account.
    (iv) Examples. The principles of this subparagraph may be 
illustrated by the following examples:

    Example 1. Corporation X purchases a bulldozer for the use in its 
construction business. The bulldozer is first placed in service in 1972. 
Since the bulldozer is tangible property for which an asset guideline 
class and period have been established, the bulldozer is eligible 
property. The bulldozer is in asset guideline class 15.1 of Revenue 
Procedure 72-10, and the asset depreciation range is 4-6 years.
    Example 2. In 1972, corporation Y first places in service a factory 
building. Since the factory building is tangible property for which an 
asset guideline class and period have been established, it is eligible 
property. The factory building is in asset guideline class 65.11 of 
Revenue Procedure 72-10. Since no asset depreciation range is in effect 
for

[[Page 398]]

the asset guideline class, the asset depreciation period is the asset 
guideline period of 45 years. (See subparagraph (5)(vi) of this 
paragraph for election to exclude certain section 1250 property during 
transition period.)
    Example 3. In January of 1971, corporation Y, a calendar year 
taxpayer, pays or incurs $2,000 for the rehabilitation and improvement 
of machine A which was first placed in service in 1969. On January 1, 
1971, corporation Y first placed in service machines B and C, each with 
an unadjusted basis of $10,000. Machines B and C are eligible property. 
Machine A would be eligible property but for the fact it was first 
placed in service prior to January 1, 1971 (that is, machine A is 
eligible property determined without regard to subparagraph (2)(ii) of 
this paragraph). Corporation Y elects to apply this section for the 
taxable year, and adopts the modified half-year convention described in 
paragraph (c)(2)(ii) of this section, but does not elect to apply the 
asset guideline class repair allowance described in paragraph 
(d)(2)(iii) of this section. Machines A, B, and C are in asset guideline 
class 24.4 under Revenue Procedure 72-10 for which the asset 
depreciation range is 8 to 12 years. The $2,000 expended on machine A 
substantially increases its capacity and is a capital expenditure under 
sections 162 and 263. The $2,000 is a property improvement (as defined 
in paragraph (d)(2)(vii)(b) of this section) which is eligible property. 
However, corporation Y by mistake treats the property improvement of 
$2,000 as a deductible repair. Also by mistake, corporation Y includes 
machine B in asset guideline class 24.3 under Revenue Procedure 72-10 
for which the asset depreciation range is 5 to 7 years. Corporation Y 
establishes vintage accounts for 1971, and computes depreciation for 
1971 and 1972 as follows:

------------------------------------------------------------------------
                                                  Dec. 31,     Dec. 31,
                                                    1972,        1972,
                                                 reserve for   adjusted
                                                depreciation     basis
------------------------------------------------------------------------
Vintage account for machine B, with an asset         $4,000       $6,000
 depreciation period of 5 years and an
 unadjusted basis of $10,000 for which
 corporation Y adopts the straight line method
Vintage account for machine C, with an asset          2,500        7,500
 depreciation period of 8 years and an
 unadjusted basis of $10,000 for which
 corporation Y adopts the straight line method
------------------------------------------------------------------------


After audit in 1973 of corporation Y's taxable years 1971 and 1972, it 
is determined that the $2,000 paid in 1971 for the rehabilitation and 
improvement of machine A is a capital expenditure and that machine B is 
in asset guideline class 24.4. The incorrect classification is 
corrected. Corporation Y places machine B and the property improvement 
in a vintage account of 1971 and on its tax return filed for 1973 
selects an asset depreciation period of 8 years for that account. Giving 
effect to the correction in classification of the property in accordance 
with subdivision (iii) (c) of this subparagraph, at the end of 1972 the 
unadjusted basis, reserve for depreciation, and adjusted basis of the 
vintage account for machine B and the property improvement with respect 
to machine A are $12,000, $3,000, and $9,000, respectively. Corporation 
Y's deduction of the $2,000 property improvement in 1971 as a repair 
expense under section 162 is disallowed. For 1971 and 1972 depreciation 
deductions are disallowed in the amount of $500 each year (that is, $750 
excess annual depreciation on machine B minus $250 annual depreciation 
on the property improvement).
    Example 4. (a) In 1971, Corporation X, a calendar year taxpayer, 
first places in service machines A through M, all of which are eligible 
property. All the machines except machine A are in asset guideline class 
24.3 under Revenue Procedure 72-10. Machine A is in asset guideline 
class 24.4 under Revenue Procedure 72-10. Machine B has an unadjusted 
basis equal to 80 percent of the total unadjusted basis of machines B 
through M. By good faith mistake as to proper classification, 
corporation X includes both machine A and machine B in asset guideline 
class 24.4. Corporation X consistently uses the machine hour method of 
depreciation on all property in asset guideline class 24.4, and for 1971 
computes depreciation for machines A and B under that method. 
Corporation X elects to apply this section for 1971 on the assumption 
that the election includes machines C through M which are in asset 
guideline class 24.3. In 1973, upon audit of corporation X's taxable 
years 1971 and 1972, it is determined that machine B is included in 
asset guideline class 24.3 and that since for 1971 corporation X 
computed depreciation on machine B under the machine hour method, in 
accordance with subparagraph (5)(v)(a) of this paragraph, all property 
in asset guideline class 24.3 (machines B through M) is excluded from 
corporation X's election to apply this section for 1971. Although 
corporation X has consistently used the machine hour method for asset 
guideline class 24.4, corporation X has not in the past used the machine 
hour method for machines of the type and function of machines C through 
M which are in asset guideline class 24.3. Both machine A and machine B 
are used in connection with the manufacture of wood products. There is 
reasonable basis for corporation X having assumed that machine B is in 
asset guideline class 24.4 along with machine A to which it is similar. 
Corporation X establishes to the satisfaction of the Commissioner that 
it used the machine hour method for machine B on the basis of a good 
faith

[[Page 399]]

mistake as to the proper classification of the machine. Corporation X 
may, at its option (see subparagraph (5)(v) of this paragraph), 
terminate the machine hour method of depreciation for machine B as of 
the beginning of 1971, and in that event corporation X's election to 
apply this section for 1971 will apply to machines B through M without 
regard to subparagraph (5)(v)(a) of this paragraph. The adjustments 
provided in subdivision (iii)(c) of this subparagraph will be made as a 
result of the correction in classification of property. If corporation X 
does not terminate the machine hour method with respect to machine B, 
machines B through M must be excluded from the election to apply this 
section (see subparagraph (5)(v) of this paragraph).
    (b) The facts are the same as in (a) of this example except that 
machine B has an unadjusted basis equal to only 65 percent of the total 
unadjusted basis of machines B through M.
    In this case, corporation X must either terminate the machine hour 
method of depreciation with respect to asset B (since the provisions of 
subparagraph (5)(v) of this paragraph do not permit the exclusion of the 
property from the election to apply this section) or otherwise comply 
with the provisions of subparagraph (5)(v) of this paragraph. (See 
paragraph (c)(1)(iv) for limitation on methods which may be adopted for 
property included in the election to apply this section.)

    (5) Requirements of election--(i) In general. Except as otherwise 
provided in paragraph (d)(2) of this section dealing with expenditures 
for the repair, maintenance, rehabilitation or improvement of certain 
property, no provision of this section shall apply to any property other 
than eligible property to which the taxpayer elects in accordance with 
this section, to apply this section. For the time and manner of 
election, and certain conditions to an election, see paragraph (f) of 
this section. Except as otherwise provided in subparagraph (4)(iii) of 
this paragraph, subdivision (v) of this subparagraph and in subparagraph 
(6)(iii) of this paragraph, a taxpayer's election to apply this section 
may not be revoked or modified after the last day prescribed for filing 
the election. Thus, for example, after such day, a taxpayer may not 
cease to apply this section to property included in the election, 
establish different vintage accounts for the taxable year of election, 
select a different period from the asset depreciation range for any such 
account, or adopt a different first-year convention for any such 
account.
    (ii) Property required to be included in election. Except as 
otherwise provided in subdivision (iii) of this subparagraph dealing 
with certain ``used property'', in subdivision (iv) of this subparagraph 
dealing with ``section 38 property'', in subdivision (v) of this 
subparagraph dealing with property subject to special depreciation or 
amortization, in subdivision (vi) of this subparagraph dealing with 
certain section 1250 property, in subdivision (vii) of this subparagraph 
dealing with certain subsidiary assets, and in paragraph (e)(3) (i) and 
(iv) of this section dealing with transactions to which section 381(a) 
applies, if the taxpayer elects to apply this section to any eligible 
property first placed in service by the taxpayer during the taxable year 
of election, the election shall apply to all such eligible property, 
whether placed in service in a trade or business or held for production 
of income.
    (iii) Special 10 percent used property rule. (a) If (1) the 
unadjusted basis of eligible used section 1245 property (as defined in 
(c) of this subdivision) first placed in service by the taxpayer during 
the taxable year of election, for which no specific used property asset 
guideline class (as defined in (c) of this subdivision) is in effect for 
the taxable year, exceeds (2) 10 percent of the unadjusted basis of all 
eligible section 1245 property first placed in service during the 
taxable year of election, the taxpayer may exclude all (but not less 
than all) the property described in (a)(1) of this subdivision from the 
election to apply this section.
    (b) If (1) the unadjusted basis of eligible used section 1250 
property first placed in service by the taxpayer during the taxable year 
of election, for which no specific used property asset guideline class 
is in effect for the taxable year, exceeds (2) 10 percent of the 
unadjusted basis of all eligible section 1250 property first placed in 
service during the taxable year of election, the taxpayer may exclude 
all (but not less than all) the property described in (b)(1) of this 
subdivision from the election to apply this section.

[[Page 400]]

    (c) For the purposes of this section, the term ``used property'' 
means property the original use of which does not commence with the 
taxpayer. Solely for the purpose of determining whether the 10 percent 
rule of this subdivision is satisfied, (1) eligible used property first 
placed in service during the taxable year and excluded from the election 
to apply this section pursuant to subdivision (v)(a) of this 
subparagraph and (2) eligible property acquired during the taxable year 
in a transaction to which section 381(a) applies, shall all be treated 
as used property regardless of whether such property would be treated as 
new property under section 167(c) and the regulations thereunder. The 
term ``specific used property asset guideline class'' means a class 
established in accordance with subparagraph (4) of this paragraph solely 
for used property primarily used in connection with the activity to 
which the class relates.
    (iv) Property subject to investment tax credit. The taxpayer may 
exclude from an election to apply this section all, or less than all, 
units of eligible property first placed in service during the taxable 
year which is--
    (a) ``Section 38 property'' as defined in section 48(a) which meets 
the requirements of section 49 and which is not property described in 
section 50, or
    (b) Property to which section 47(a)(5)(B) applies which would be 
section 38 property but for section 49 and which is placed in service to 
replace section 38 property (other than property described in section 
50) disposed of prior to August 15, 1971.
    (v) Property subject to special method of depreciation or 
authorization. (a) In the case of eligible property first placed in 
service in a taxable year of election (and not otherwise properly 
excluded from an election to apply this section) the taxpayer may not 
compute depreciation for any of such property in the asset guideline 
class under a method not described in section 167(b) (1), (2), (3), or 
(k) unless he (1) computes depreciation under a method or methods not so 
described for eligible property first placed in service in the taxable 
year in the asset guideline class with an unadjusted basis at least 
equal to 75 percent of the unadjusted basis of all eligible property 
first placed in service in the taxable year in the asset guideline class 
and (2) agrees to continue to depreciate such property under such method 
or methods until the consent of the Commissioner is obtained to a change 
in method. The consent of the Commissioner must be obtained by filing 
Form 3115 with the Commissioner of Internal Revenue, Washington, D.C. 
20224, within the first 180 days of the taxable year for which the 
change is desired. If for the taxable year of election the taxpayer 
computes depreciation under any method not described in section 167(b) 
(1), (2), (3), or (k) for any eligible property (other than property 
otherwise properly excluded from an election to apply this section) 
first placed in service during the taxable year, an election to apply 
this section for the taxable year shall not include such property or any 
other eligible property in the same asset guideline class as such 
property. With respect to a taxable year beginning before January 1, 
1973, if the taxpayer has adopted a method of depreciation which is not 
permitted under this subdivision, the taxpayer may under this section 
adopt a method of depreciation permitted under this subdivision or 
otherwise comply with the provisions of this subdivision.
    (b) An election to apply this section shall not include eligible 
property for which, for the taxable year of election, the taxpayer 
computes depreciation under section 167(k), or computes amortization 
under section 169, 184, 185, 187, 188, or paragraph (b) of Sec.  1.162-
11. If the taxpayer has elected to apply this section to eligible 
property described in section 167(k), 169, 184, 185, or 187 and the 
taxpayer thereafter computes depreciation or amortization for such 
property for any taxable year in accordance with section 167(k), 169, 
184, 185, or 187, then the election to apply this section to such 
property shall terminate as of the beginning of the taxable year for 
which depreciation or amortization is computed under such section. 
Application of this section to the property for any period prior to the 
termination date will not be affected by the termination. The unadjusted 
basis of the property shall be removed as of the termination date from 
the

[[Page 401]]

unadjusted basis of the vintage account. The depreciation reserve 
established for the account shall be reduced by the depreciation 
allowable for the property, computed in the manner prescribed in 
paragraph (c)(1)(v)(b) of this section for determination of the adjusted 
basis of the property. See paragraph (d)(3)(vii)(e) of this section for 
treatment of salvage value when property is removed from a vintage 
account.
    (vi) Certain section 1250 property. (a) The taxpayer may exclude 
from an election to apply this section all, or less than all, items of 
eligible section 1250 property first placed in service during the 
taxable year of election provided that--
    (1) The item is first placed in service before the earlier of the 
effective date of the first supplemental asset guideline class including 
such property established in accordance with subparagraph (4)(ii) of 
this paragraph, or January 1, 1974, and
    (2) The taxpayer establishes that a useful life shorter than the 
asset guideline period in effect on January 1, 1971, for such item of 
property is justified for such taxable year.

A useful life shorter than the asset guideline period in effect on 
January 1, 1971, will be considered justified only if such life is 
justified in accordance with the provisions of Revenue Procedure 62-21 
(including all modifications, amendments or supplements thereto as of 
January 1, 1971), determined without application of the minimal 
adjustment rule in section 4, part II, of Revenue Procedure 65-13. If an 
item of section 1250 property is excluded from an election to apply this 
section pursuant to this subdivision, any elevator or escalator which is 
a part of such item shall also be excluded from the election.
    (b) If the taxpayer excludes an item of section 1250 property from 
an election to apply this section in accordance with this subdivision, 
the useful life justified under Revenue Procedure 62-21 in accordance 
with this subdivision for the taxable year of exclusion will be treated 
as justified for such item of section 1250 property for the taxable year 
of the exclusion and all subsequent taxable years.
    (vii) Subsidiary assets. The taxpayer may exclude from an election 
to apply this section all (but not less than all) subsidiary assets 
first placed in service during the taxable year of election in an asset 
guideline class, provided that--
    (a) The unadjusted basis of eligible subsidiary assets first placed 
in service during the taxable year in the class is as much as 3 percent 
of the unadjusted basis of all eligible property first placed in service 
during the taxable year in the class, and
    (b) Such subsidiary assets are first placed in service by the 
taxpayer before the earlier of (1) the effective date of the first 
supplemental asset guideline class including such subsidiary assets 
established in accordance with subparagraph (4)(ii) of this paragraph, 
or (2) January 1, 1974.

For purposes of this subdivision the term ``subsidiary assets'' includes 
jigs, dies, molds, returnable containers, glassware, silverware, textile 
mill cam assemblies, and other equipment included in group 1, class 5, 
of Revenue Procedure 62-21. which is usually and property accounted for 
separately from other property and under a method of depreciation not 
expressed in terms of years.
    (6) Special rule for certain public utility property--(i) 
Requirement of normalization in certain cases. Under section 167(1), in 
the case of public utility property (as defined in section 
167(1)(3)(A)), if the taxpayer--
    (a) Is entitled to use a method of depreciation other than a 
``subsection (1) method'' of depreciation (as defined in section 
167(1)(3)(F)) only if it uses the ``normalization method of accounting'' 
(as defined in section 167(1)(3)(G)) with respect to such property, or
    (b) Is entitled for the taxable year to use only a ``subsection (1) 
method'' of depreciation, such property shall be eligible property (as 
defined in subparagraph (2) of this paragraph) only if the taxpayer 
normalizes the tax deferral resulting from the election to apply this 
section.
    (ii) Normalization. The taxpayer will be considered to normalize the 
tax deferral resulting from the election to apply this section only if 
it computes

[[Page 402]]

its tax expense for purposes of establishing its cost of service for 
ratemaking purposes and for reflecting operating results in its 
regulated books of account using a period for depreciation no less than 
the lesser of--
    (a) 100 percent of the asset guideline period in effect in 
accordance with subparagraph (4)(ii) of this paragraph for the first 
taxable year to which this section applies, or
    (b) The period for computing its depreciation expense for ratemaking 
purposes and for reflecting operating results in its regulated books of 
account, and makes adjustments to a reserve to reflect the deferral of 
taxes resulting from the election to apply this section. A determination 
whether the taxpayer is considered to normalize (within the meaning of 
the preceding sentence) the tax deferral resulting from the election to 
apply this section shall be made in a manner consistent with the 
principles for determining whether a taxpayer is using the 
``normalization method of accounting'' (within the meaning of section 
167(1)(3)(G)). [Removed] See Sec.  1.167(1)-1(h).
    (iii) Failure to normalize. If a taxpayer, which has elected to 
apply this section to any eligible public utility property and is 
required under subdivision (i) of this subparagraph to normalize the tax 
deferral resulting from the election to apply this section to such 
property, fails to normalize such tax deferral, the election to apply 
this section to such property shall terminate as of the beginning of the 
taxable year for which the taxpayer fails to normalize such tax 
deferral. Application of this section to such property for any period 
prior to the termination date will not be affected by the termination. 
The unadjusted basis of the property shall be removed as of the 
termination date from the unadjusted basis of the vintage account. The 
depreciation reserve established for the account shall be reduced by the 
depreciation allowable for the property, computed in the manner 
prescribed in paragraph (c)(1)(v)(b) of this section for determination 
of the adjusted basis of the property. See paragraph (d)(3)(vii)(e) of 
this section for treatment of salvage value when property is removed 
from a vintage account.
    (iv) Examples. The principles of this subparagraph may be 
illustrated by the following examples:

    Example 1. Corporation A is a gas pipeline company, subject to the 
jurisdiction of the Federal Power Commission, which is entitled under 
section 167(1) to use a method of depreciation other than a ``subsection 
(1) method'' of depreciation (as defined in section 167(1) (3) (F)) only 
if it uses the ``normalization method of accounting'' (as defined in 
section 167(1)(3)(G)). Corporation A elects to apply this section for 
1972 with respect to all eligible property. In 1972, corporation A 
places in service eligible property with an unadjusted basis of $2 
million. One hundred percent of the asset guideline period for such 
property is 22 years and the asset depreciation range is from 17.5 years 
to 26.5 years. The taxpayer uses the double declining balance method of 
depreciation, selects an asset depreciation period of 17.5 years and 
applies the half-year convention (described in paragraph (c)(2)(iii) of 
this section). The depreciation allowable under this section with 
respect to such property in 1972 is $114,285. The taxpayer will be 
considered to normalize the tax deferral resulting from the election to 
apply this section and to use the ``normalization method of accounting'' 
(within the meaning of section 167(1)(3)(G)) if it computes its tax 
expense for purposes of determining its cost of service for rate making 
purposes and for reflecting operating results in its regulated books of 
account using a ``subsection (1) method'' of depreciation, such as the 
straight line method, determined by using a depreciation period of 22 
years (that is, 100 percent of the asset guideline period). A 
depreciation allowance computed in this manner is $45,454. The 
difference in the amount determined under this section ($114,285) and 
the amount used in computing its tax expense for purposes of estimating 
its cost of service for rate making purposes and for reflecting 
operating results in its regulated books of account ($45,454) is 
$68,831. Assuming a tax rate of 48 percent, the deferral of taxes 
resulting from an election to apply this section and using a different 
method of depreciation for tax purposes from that used for establishing 
its cost of service for rate making purposes and for reflecting 
operating results in its regulated books of account is 48 percent of 
$68,831, or $33,039, which amount should be added to a reserve to 
reflect the deferral of taxes resulting from the election to apply this 
section and from the use of a different method of depreciation in 
computing the allowance for depreciation under section 167 from that 
used in computing its depreciation expense for purposes of establishing 
its cost of service for rate making purposes and for reflecting 
operating results in its regulated books of account.

[[Page 403]]

    Example 2. Corporation B, a telephone company subject to the 
jurisdiction of the Federal Communications Commission used a ``flow-
through method of accounting'' (as defined in section 167(1)(3)(H)) for 
its ``July 1969 accounting period'' (as defined in section 167(1)(3)(I)) 
with respect to all of its pre-1970 public utility property and did not 
make an election under section 167(1)(4)(A). Thus, corporation B is 
entitled under section 167(1) to use a method of depreciation other than 
a ``subsection (1) method'' with respect to certain property without 
using the ``normalization method of accounting.'' In 1972, corporation B 
makes an election to apply this section with respect to all eligible 
property. Corporation B is not required to normalize the tax deferral 
resulting from the election to apply this section in the case of 
property for which it is not required to use the ``normalization method 
of accounting'' under section 167(1).
    Example 3. Assume the same facts as in example (2) except that 
corporation B made a timely election under section 167(1)(4)(A) that 
section 167(1)(2)(C) not apply with respect to property which increases 
the productive or operational capacity of the taxpayer. Corporation B 
must normalize the tax deferral resulting from the election to apply 
this section with respect to such property.

    (7) Mere change in form of conducting a trade or business. Property 
which was first placed in service by the transferor before January 1, 
1971, shall not be eligible property if such property is first placed in 
service by the transferee after December 31, 1970, by reason of a mere 
change in the form of conducting a trade or business in which such 
property is used. A mere change in the form of conducting a trade or 
business in which such property is used will be considered to have 
occurred if--
    (i) The transferor (or in a case where the transferor is a 
partnership, estate, trust, or corporation, the partners, beneficiaries, 
or shareholders) of such property retains a substantial interest in such 
trade or business, or
    (ii) The basis of such property in the hands of the transferee is 
determined in whole or in part by reference to the basis of such 
property in the hands of the transferor.

For purposes of this subparagraph, a transferor (or in a case where the 
transferor is a partnership, estate, trust, or corporation, the 
partners, beneficiaries, or shareholders) shall be considered as having 
retained a substantial interest in the trade or business only if, after 
the change in form, his (or their) interest in such trade or business is 
substantial in relation to the total interest of all persons in such 
trade or business. This subparagraph shall apply to property first 
placed in service prior to January 1, 1971, held for the production of 
income (within the meaning of section 167(a)(2)) as well as to property 
used in a trade or business. The principles of this subdivision may be 
illustrated by the following examples:

    Example 1. Corporation X and corporation Y are includible 
corporations in an affiliated group as defined in section 1504(a). In 
1971 corporation X sells property to corporation Y for cash. The 
property would meet the requirements of subparagraph (2) of this 
paragraph for eligible property except that it was first placed in 
service by corporation X in 1970. After the transfer, the property is 
first placed in service by corporation Y in 1971. The property is not 
eligible property because of the mere change in the form of conducting a 
trade or business.
    Example 2. In 1971, in a transaction to which section 351 applies, 
taxpayer B transfers to corporation W property which would meet the 
requirements of subparagraph (2) of this paragraph for eligible property 
except that the property was first placed in service by B in 1969. 
Corporation W first places the property in service in 1971. The property 
is not eligible property because of the mere change in the form of 
conducting a trade or business.

    (c) Manner of determining allowance--(1) In general--(i) Computation 
of allowance. (a) The allowance for depreciation of property in a 
vintage account shall be determined in the manner specified in this 
paragraph by using the method of depreciation adopted by the taxpayer 
for the account and a rate based upon the asset depreciation period for 
the account. (For limitations on methods of depreciation permitted with 
respect to property, see section 167 (c) and (j) and subdivision (iv) of 
this subparagraph.) In applying the method of depreciation adopted by 
the taxpayer, the annual allowance for depreciation of a vintage account 
shall be determined without adjustment for the salvage value of the 
property in such account except that no account may be depreciated below 
the reasonable salvage value of the account. (For rules regarding 
estimation and treatment of salvage value, see paragraph (d)(1) and

[[Page 404]]

(3) (vii) and (viii) of this section.) Regardless of the method of 
depreciation adopted by the taxpayer, the depreciation allowable for a 
taxable year with respect to a vintage account may not exceed the amount 
by which (as of the beginning of the taxable year) the unadjusted basis 
of the account exceeds (1) the reserve for depreciation established for 
the account plus (2) the salvage value of the account. The unadjusted 
basis of a vintage account is defined in subdivision (v) of this 
subparagraph. The adjustments to the depreciation reserve are described 
in subdivision (ii) of this subparagraph.
    (b) The annual allowance for depreciation of a vintage account using 
the straight line method of depreciation shall be determined by dividing 
the unadjusted basis of the vintage account (without reduction for 
salvage value) by the number of years in the asset depreciation period 
selected for the account. See subdivision (iii)(b) of this subparagraph 
for the manner of computing the depreciation allowance following a 
change from the declining balance method or the sum of the years-digits 
method to the straight line method.
    (c) In the case of the sum of the years-digits method, the annual 
allowance for depreciation of a vintage account shall be computed by 
multiplying the unadjusted basis of the vintage account (without 
reduction for salvage value) by a fraction, the numerator of which 
changes each year to a number which corresponds to the years remaining 
in the asset depreciation period for the account (including the year for 
which the allowance is being computed) and the denominator of which is 
the sum of all the year's digits corresponding to the asset depreciation 
period for the account. See subdivision (iii)(c) of this subparagraph 
for the manner of computing the depreciation allowance following a 
change from the declining balance method to the sum of the years-digits 
method.
    (d) The annual allowance for depreciation of a vintage account using 
a declining balance method is determined by applying a uniform rate to 
the excess of the unadjusted basis of the vintage account over the 
depreciation reserve established for that account. The rate under the 
declining balance method may not exceed twice the straight line rate 
based upon the asset depreciation period for the vintage account.
    (e) The allowance for depreciation under this paragraph shall 
constitute the amount of depreciation allowable under section 167. See 
section 179 for additional first-year allowance for certain property.
    (ii) Establishment of depreciation reserve. The taxpayer must 
establish a depreciation reserve for each vintage account. The amount of 
the reserve for a guideline class must be stated on each income tax 
return on which depreciation with respect to such class is determined 
under this section. The depreciation reserve for a vintage account 
consists of the accumulated depreciation allowable under this section 
with respect to the vintage account, increased by the adjustments for 
ordinary retirements prescribed by paragraph (d)(3)(iii) of this 
section, by the adjustments for reduction of the salvage value of a 
vintage account prescribed by paragraph (d)(3)(vii)(d) of this section, 
and by the adjustments for transfers to supplies or scrap prescribed by 
paragraph (d)(3)(viii)(b) of this section, and decreased by the 
adjustments for extraordinary retirements and certain special 
retirements as prescribed by paragraph (d)(3) (iv) and (v) of this 
section, by the adjustments for the amount of the reserve in excess of 
the unadjusted basis of a vintage account prescribed by paragraph 
(d)(3)(ix)(a) of this section, and by the adjustments for property 
removed from a vintage account prescribed by paragraphs (b)(4)(iii)(e), 
(5)(v)(b) and (6)(iii) of this section. The adjustments to the 
depreciation reserve for ordinary retirements during the taxable year 
shall be made as of the beginning of the taxable year. The adjustments 
to the depreciation reserve for extraordinary retirements shall be made 
as of the date the retirement is treated as having occurred in 
accordance with the first-year convention (described in subparagraph (2) 
of this paragraph) adopted by the taxpayer for the vintage account. The 
adjustment to the depreciation reserve for reduction of salvage value 
and for transfers to supplies or scrap shall, in the case of an ordinary 
retirement,

[[Page 405]]

be made as of the beginning of the taxable year, and in the case of an 
extraordinary retirement the adjustment for reduction of salvage value 
shall be made as of the date the retirement is treated as having 
occurred in accordance with the first-year convention (described in 
subparagraph (2) of this paragraph) adopted by the taxpayer for the 
vintage account. The adjustment to the depreciation reserve for property 
removed from a vintage account in accordance with paragraph 
(b)(4)(iii)(e), (5)(v)(b) and (6)(iii) of this section shall be made as 
of the beginning of the taxable year. The depreciation reserve of a 
vintage account may not be decreased below zero.
    (iii) Consent to change in method of depreciation. (a) During the 
asset depreciation period for a vintage account, the taxpayer is 
permitted to change under this section from a declining balance method 
of depreciation to the sum of the years-digits method of depreciation 
and from a declining balance method of depreciation or the sum of the 
years-digits method of depreciation to the straight line method of 
depreciation with respect to such account. Except as provided in section 
167(j)(2)(1), and paragraph (e)(3)(i) of this section, no other changes 
in the method of depreciation adopted for a vintage account will be 
permitted. The provisions of Sec.  1.167(e)-1 shall not apply to any 
change in depreciation method permitted under this section. The change 
in method applies to all property in the vintage account and must be 
adhered to for the entire taxable year of the change.
    (b) When a change is made to the straight line method of 
depreciation, the annual allowance for depreciation of the vintage 
account shall be determined by dividing the adjusted basis of the 
vintage account (without reduction for salvage value) by the number of 
years remaining (at the time as of which the change is made) in the 
asset depreciation period selected for the account. However, the 
depreciation allowable for any taxable year following a change to the 
straight line method may not exceed an amount determined by dividing the 
unadjusted basis of the vintage account (without reduction for salvage 
value) by the number of years in the asset depreciation period selected 
for the account.
    (c) When a change is made from the declining balance method of 
depreciation to the sum of the years-digits method of depreciation, the 
annual allowance for depreciation of a vintage account shall be 
determined by multiplying the adjusted basis of the account (without 
reduction for salvage value) at the time as of which the change is made 
by a fraction, the numerator of which changes each year to a number 
which corresponds to the number of years remaining in the asset 
depreciation period selected for the account (including the year for 
which the allowance is being computed), and the denominator of which is 
the sum of all the year's digits corresponding to the number of years 
remaining in the asset depreciation period at the time as of which the 
change is made.
    (d) The number of years remaining in the asset depreciation period 
selected for an account is equal to the asset depreciation period less 
the number of years of depreciation previously allowed. For this 
purpose, regardless of the first year convention adopted by the 
taxpayer, it will be assumed that depreciation was allowed for one-half 
of a year in the first year.
    (e) The taxpayer shall furnish a statement setting forth the vintage 
accounts for which the change is made with the income tax return filed 
for the taxable year of the change.
    (f) The principles of this subdivision may be illustrated by the 
following examples:

    Example 1. A, a calendar year taxpayer, places new section 1245 
property in service in a trade or business as follows:

------------------------------------------------------------------------
                                                   Unadjusted  Estimated
             Asset              Placed in service     basis     salvage
------------------------------------------------------------------------
X.............................  Mar. 15, 1971....       $400        $20
Y.............................  June 13, 1971....        500         50
Z.............................  July 30, 1971....        100          0
------------------------------------------------------------------------


The property is eligible property and is properly included in a single 
vintage account. The asset depreciation range for such property is 5 to 
7 years and the taxpayer selects an asset depreciation period of 5\1/2\ 
years and adopts the 200-percent declining balance method of 
depreciation. The taxpayer adopts

[[Page 406]]

the half-year convention described in subparagraph (2)(iii) of this 
paragraph. After 3 years, A changes from the 200-percent declining 
balance method to the straight line method of depreciation. Depreciation 
allowances would be as follows:

----------------------------------------------------------------------------------------------------------------
                                    Unadjusted
              Year                     basis           Rate        Depreciation       Reserve     Adjusted basis
----------------------------------------------------------------------------------------------------------------
1971............................          $1,000         0.18182         $181.82         $181.82         $818.18
1972............................           1,000          .36363          297.52          479.34          520.66
1973............................           1,000          .36363          189.33          668.67          331.33
1974............................           1,000      \1\ .33333          110.44          779.11          220.89
1975............................           1,000          .33333          110.44          889.56          110.44
1976............................           1,000          .33333       \2\ 40.44          930.00           70.00
----------------------------------------------------------------------------------------------------------------
\1\ Rate applied to adjusted basis of the account (without reduction by salvage) at the time as of which the
  change is made to the straight line method.
\2\ The allowable depreciation is limited by estimated salvage.

    Example 2. The facts are the same as in example (1) except that A 
elects to use the modified half-year convention described in 
subparagraph (2)(ii) of this paragraph. The depreciation allowances 
would be as follows:

----------------------------------------------------------------------------------------------------------------
                                    Unadjusted
              Year                     basis           Rate        Depreciation       Reserve     Adjusted basis
----------------------------------------------------------------------------------------------------------------
1971............................          $1,000     \1\ 0.36363         $327.27         $327.27         $672.73
1972............................           1,000          .36363          244.63          571.90          428.10
1973............................           1,000          .36363          155.67          727.57          272.43
1974............................           1,000          .33333           90.81          818.38          181.62
1975............................           1,000          .33333           90.81          909.19           90.81
1976............................           1,000          .33333       \2\ 20.81          930.00           70.00
----------------------------------------------------------------------------------------------------------------
\1\ Rate applied to $900, the amount of assets placed in service during the first half of the taxable year.
\2\ The allowable depreciation is limited by estimated salvage.

    Example 3. The facts are the same as in example (1) except that A 
adopted the sum of the years-digits method of depreciation and does not 
change to the straight line method of depreciation. The depreciation 
allowances would be as follows:

----------------------------------------------------------------------------------------------------------------
                                    Unadjusted
              Year                     basis           Rate        Depreciation       Reserve     Adjusted basis
----------------------------------------------------------------------------------------------------------------
1971............................          $1,000     \1\ 2.75/18         $152.78         $152.78         $847.22
1972............................           1,000            5/18          277.78          430.56          569.44
1973............................           1,000            4/18          222.22          652.78          347.22
1974............................           1,000            3/18          166.67          819.45          180.55
1975............................           1,000            2/18      \2\ 110.55          930.00           70.00
1976............................           1,000            1/18            0.00          930.00           70.00
1977............................           1,000         0.25/18            0.00          930.00           70.00
----------------------------------------------------------------------------------------------------------------
\1\ Rate is equal to one-half of 5.5/18. The denominator is equal to 5.5 + 4.5 + 3.5 + 2.5 + 1.5 + 0.5.
\2\ The allowable depreciation is limited by estimated salvage.

    Example 4. The facts are the same as in example (3) except that A 
elects to use the modified half-year convention described in 
subparagraph (2) (ii) of this paragraph. The depreciation allowances 
would be as follows:

----------------------------------------------------------------------------------------------------------------
                                    Unadjusted
              Year                     basis           Rate        Depreciation       Reserve     Adjusted basis
----------------------------------------------------------------------------------------------------------------
1971............................          $1,000      \1\ 5.5/18         $275.00         $275.00         $725.00
1972............................           1,000            5/18          277.78          552.78          447.22
1973............................           1,000            4/18          222.22          775.00          225.00
1974............................           1,000            3/18      \2\ 155.00          930.00           70.00
1975............................           1,000            2/18            0.00          930.00           70.00
1976............................           1,000            1/18            0.00          930.00           70.00
1977............................           1,000         0.25/18            0.00          930.00           70.00
----------------------------------------------------------------------------------------------------------------
\1\ Rate applied to $900, the amount of assets placed in service during the first half of the taxable year.
\2\ The allowable depreciation is limited by estimated salvage.


[[Page 407]]

    Example 5. The facts are the same as in example (2) except that 
after 2 years A changes from the 200-percent declining balance method to 
the sum of the years-digits method of depreciation. The depreciation 
allowances would be as follows:

----------------------------------------------------------------------------------------------------------------
                                    Unadjusted
              Year                     basis           Rate        Depreciation       Reserve     Adjusted basis
----------------------------------------------------------------------------------------------------------------
1971............................          $1,000         0.36363         $327.27         $327.27         $672.73
1972............................           1,000          .36363          244.63          571.90          428.10
1973............................           1,000            4/10          171.24          743.14          256.86
1974............................           1,000            3/10          128.43          871.57          128.43
1975............................           1,000            2/10       \1\ 58.43          930.00           70.00
1976............................           1,000            1/10            0.00          930.00           70.00
----------------------------------------------------------------------------------------------------------------
\1\ The allowable depreciation is limited by estimated salvage.

    (iv) Limitation on methods. (a) The same method of depreciation must 
be adopted for all property in a single vintage account. Generally, the 
method of depreciation which may be adopted is subject to the 
limitations contained in section 167 (c), (j) and (l).
    (b) Except as otherwise provided in section 167(j) with respect to 
certain eligible section 1250 property--
    (1) In the case of a vintage account for which the taxpayer has 
selected an asset depreciation period of 3 years or more and which only 
contains property the original use of which commences with the taxpayer, 
any method of depreciation described in section 167(b) (1), (2), or (3) 
may be adopted, but if the vintage account contains property the 
original use of which does not commence with the taxpayer, or if the 
asset depreciation period for the account is less than 3 years, a method 
of depreciation described in section 167(b) (2) or (3) may not be 
adopted for the account, and
    (2) The declining balance method using a rate not in excess of 150 
percent of the straight line rate based upon the asset depreciation 
period for the vintage account may be adopted for the account even if 
the original use of the property does not commence with the taxpayer 
provided the asset depreciation period for the account is at least 3 
years.
    (c) The term ``original use'' means the first use to which the 
property is put, whether or not such use corresponds to the use of such 
property by the taxpayer. (See Sec.  1.167(c)-1).
    (v) Unadjusted and adjusted basis. (a) For purposes of this section, 
the unadjusted basis of an asset (including an ``excluded addition'' and 
a ``property improvement'' as described, respectively, in paragraph 
(d)(2) (vi) and (vii) of this section) is its cost or other basis 
without any adjustment for depreciation or amortization (other than 
depreciation under section 179) but with other adjustments required 
under section 1016 or other applicable provisions of law. The unadjusted 
basis of a vintage account is the total of the unadjusted bases of all 
the assets in the account. The unadjusted basis of a ``special basis 
vintage account'' as described in paragraph (d)(3)(vi) of this section 
is the amount of the property improvement determined in paragraph 
(d)(2)(vii)(a) of this section.
    (b) The adjusted basis of a vintage account is the amount by which 
the unadjusted basis of the account exceeds the reserve for depreciation 
for the account. The adjusted basis of an asset in a vintage account is 
the amount by which the unadjusted basis of the asset exceeds the amount 
of depreciation allowable for the asset under this section computed by 
using the method of depreciation and the rate applicable to the account. 
For purposes of this subdivision, the depreciation allowable for an 
asset shall include, to the extent identifiable, the amount of proceeds 
previously added to the depreciation reserve in accordance with 
paragraph (d)(3)(iii) of this section upon the retirement of any portion 
of such asset. (See paragraph (d)(3)(vi) of this section for election 
under certain circumstances to allocate adjusted basis of an amount of 
property improvement determined under paragraph (d)(2)(vii)(a) of this 
section.)
    (2) Conventions applied to additions and retirements--(i) In 
general. The allowance for depreciation of a vintage account (whether an 
item account or a

[[Page 408]]

multiple asset account) shall be determined by applying one of the 
conventions described in subdivisions (ii) and (iii) of this 
subparagraph. (For the manner of applying a convention in the case of 
taxable years beginning before and ending after December 31, 1970, see 
subparagraph (3) of this paragraph.) The same convention must be adopted 
for all vintage accounts of a taxable year, but the same convention need 
not be adopted for the vintage accounts of another taxable year. An 
election to apply this section must specify the convention adopted. (See 
paragraph (f) of this section for information required in making the 
election.) The convention adopted by the taxpayer is a method of 
accounting for purposes of section 446, but the consent of the 
Commissioner will be deemed granted to make an annual adoption of either 
of the conventions described in subdivisions (ii) and (iii) of this 
subparagraph.
    (ii) Modified half-year convention. The depreciation allowance for a 
vintage account for which the taxpayer adopts the ``modified half-year 
convention'' shall be determined by treating: (a) All property in such 
account which is placed in service during the first half of the taxable 
year as placed in service on the first day of the taxable year; and (b) 
all property in such account which is placed in service during the 
second half of the taxable year as placed in service on the first day of 
the succeeding taxable year. The depreciation allowance for a vintage 
account for a taxable year in which there is an extraordinary retirement 
(as defined in paragraph (d) (3) (ii) of this section) of property first 
placed in service during the first half of the taxable year is 
determined by treating all such retirements from such account during the 
first half of the taxable year as occurring on the first day of the 
taxable year and all such retirements from such account during the 
second half of the taxable year as occurring on the first day of the 
second half of the taxable year. The depreciation allowance for a 
vintage account for a taxable year in which there is an extraordinary 
retirement (as defined in paragraph (d)(3)(ii) of this section) of 
property first placed in service during the second half of the taxable 
year is determined by treating all such retirements from such account 
during the first half of the taxable year as occurring on the first day 
of the second half of the taxable year and all such retirements in the 
second half of the taxable year as occurring on the first day of the 
succeeding taxable year.
    (iii) Half-year convention. The depreciation allowance for a vintage 
account for which the taxpayer adopts the ``half-year convention'' shall 
be determined by treating all property in the account as placed in 
service on the first day of the second half of the taxable year and by 
treating all extraordinary retirements (as defined in paragraph 
(d)(3)(ii) of this section) from the account as occurring on the first 
day of the second half of the taxable year.
    (iv) Rules of application. (a) The first-year convention adopted for 
a vintage account must be consistently applied to all additions to and 
all extraordinary retirements from such account. See paragraph (d)(3) 
(ii) and (iii) of this section for definition and treatment of ordinary 
retirements.
    (b) If the actual number of months in a taxable year is other than 
12 full calendar months, depreciation is allowed only for such actual 
number of months and the term ``taxable year'', for purposes of this 
subparagraph, shall mean only such number of months. In such event, the 
first half of such taxable year shall be deemed to expire at the close 
of the last day of a calendar month which is the closest such last day 
to the middle of such taxable year and the second half of such taxable 
year shall be deemed to begin the day after the expiration of the first 
half of such taxable year. If a taxable year consists of a period which 
includes only 1 calendar month, the first half of the taxable year shall 
be deemed to expire on the first day which is nearest to the midpoint of 
the month, and the second half of the taxable year shall begin the day 
after the expiration of the first half of the month.
    (c) For purposes of this subparagraph, for property placed in 
service after November 14, 1979, other than depreciable property 
described in paragraph (c)(2)(iv)(e) of this section, the taxable year 
of the person placing such property in service does not include any

[[Page 409]]

month before the month in which the person begins engaging in a trade or 
business or holding depreciable property for the production of income.
    (d) For purposes of paragraph (c)(2) (iv)(c) of this section--
    (1) For property placed in service after February 21, 1981, an 
employee is not considered engaged in a trade or business by virtue of 
employment.
    (2) If a person engages in a small amount of trade or business 
activity after February 21, 1981, for the purpose of obtaining a 
disproportionately large depreciation deduction for assets for the 
taxable year in which they are placed in service, and placing those 
assets in service represents a substantial increase in the person's 
level of business activity, then for purposes of depreciating those 
assets the person will not be treated as beginning a trade or business 
until the increased amount of business activity begins. For property 
held for the production of income, the principle of the preceding 
sentence applies.
    (3) A person may elect to apply the rules of Sec.  1.167(a)-11 
(c)(2)(iv)(d) as set forth in T.D. 7763 (``(d) rules in T.D. 7763''). 
This election shall be made by reflecting it under paragraph (f)(4) of 
this section in the books and records. If necessary, amended returns 
shall be filed.
    (4) If an averaging convention was adopted in reliance on or in 
anticipation of the (d) rules in T.D. 7763, that convention may be 
changed without regard to paragraph (f)(3) of this section. Similarly, 
if an election is made under paragraph (c)(2)(iv)(d)(3) of this section 
to apply to the (d) rules in T.D. 7763, the averaging convention adopted 
for the taxable years for which the election is made may be changed. The 
change shall be made by filing a timely amended return for the taxable 
year for which the convention was adopted. Notwithstanding the three 
preceding sentences, if an averaging convention was adopted in reliance 
on or in anticipation of the (d) rules in T.D. 7763, and if an election 
is made to apply those rules, the averaging convention adopted cannot be 
changed except as provided in paragraph (f) of this section.
    (e) The rules in paragraph (c)(2)(iv)(c) of this section do not 
apply to depreciable property placed in service after November 14, 1979, 
and the rules in paragraph (c)(2)(iv)(d) of this section do not apply to 
depreciable property placed in service after February 21, 1981, with 
respect to which substantial expenditures were paid or incurred prior to 
November 15, 1979. For purposes of the preceding sentence, expenditures 
will not be considered substantial unless they exceed the lesser of 30 
percent of the final cost of the property or $10 million. Expenditures 
that are not includible in the basis of the depreciable property will be 
considered expenditures with respect to property if they are directly 
related to a specific project involving such property. For purposes of 
determining whether expenditures were paid or incurred prior to November 
15, 1979, expenditures made by a person (transferor) other than the 
person placing the property in service (transferee) will be taken into 
account only if the basis of the property in the hands of the transferee 
is determined in whole or in part by reference to the basis in the hands 
of the transferor. The principle of the preceding sentence also applies 
if there are multiple transfers.
    (v) Mass assets. In the case of mass assets, if extraordinary 
retirements of such assets in a guideline class during the first half of 
the taxable year are allocated to a particular vintage year for which 
the taxpayer applied the modified half-year convention, then that 
portion of the mass assets so allocated which bears the same ratio to 
the total number of mass assets so allocated as the mass assets in the 
same vintage and assets guideline class placed in service during the 
first half of that vintage year bear to the total mass assets in the 
same vintage and asset guideline class shall be treated as retired on 
the first day of the taxable year. The remaining mass assets which are 
subject to extraordinary retirement during the first half of the taxable 
year and which are allocated to that vintage year and assets guideline 
class shall be treated as retired on the first days of the second half 
of the taxable year. If extraordinary retirements of mass assets in a 
guideline class occur in the second half of the taxable year and are 
allocated to a particular vintage year for which the

[[Page 410]]

taxpayer applied the modified half-year convention, then that portion of 
the mass assets so allocated which bears the same ratio to the total 
number of mass assets so allocated as the mass assets in the same 
vintage and asset guideline class first placed in service during the 
first half of that vintage year bear to the total mass assets in the 
same vintage and asset guideline class shall be treated as retired on 
the first day of the second half of the taxable year. The remaining mass 
assets which are subject to extraordinary retirements during the second 
half of the taxable year and which are allocated to that same vintage 
and asset guideline class shall be treated as retired on the first day 
of the succeeding taxable year. If the taxpayer has applied the half-
year convention for the vintage year to which the extraordinary 
retirements are allocated, the mass assets shall be treated as retired 
on the first day of the second half of the taxable year.
    (3) Taxable years beginning before and ending after December 31, 
1970. In the case of a taxable year which begins before January 1, 1971, 
and ends after December 31, 1970, property first placed in service after 
December 31, 1970, but treated as first placed in service before January 
1, 1971, by application of a convention described in subparagraph (2) of 
this paragraph shall be treated as provided in this subparagraph. The 
depreciation allowed (or allowable) for the taxable year shall consist 
of the depreciation allowed (or allowable) for the period before January 
1, 1971, determined without regard to this section plus the amount 
allowable for the period after December 31, 1970, determined under this 
section. However, neither the modified half-year convention described in 
subparagraph (2)(ii) of this paragraph, nor the half-year convention 
described in subparagraph (2)(iii) of this paragraph may for any such 
taxable year be applied with respect to property placed in service after 
December 31, 1970, to allow depreciation for any period prior to January 
1, 1971, unless such convention is consistent with the convention 
applied by the taxpayer with respect to property placed in service in 
such taxable year prior to January 1, 1971.
    (4) Examples. The principles of this paragraph may be illustrated by 
the following examples:

    Example 1. Taxpayer A, a calendar year taxpayer, places new property 
in service in a trade or business as follows:

------------------------------------------------------------------------
                                                              Unadjusted
                Asset                    Placed in service       basis
------------------------------------------------------------------------
W...................................  Apr. 1, 1971..........     $5,000
X...................................  June 30, 1971.........      8,000
Y...................................  July 15, 1971.........     12,000
------------------------------------------------------------------------


Taxpayer A adopts the modified half-year convention described in 
subparagraph (2) (ii) of this paragraph. Assets W, X, and Y are placed 
in a multiple asset account for which the asset depreciation range is 8 
to 12 years. A selects 8 years, the minimum asset depreciation period 
with respect to such assets, and adopts the declining balance method of 
depreciation using a rate twice the straight line rate (computed without 
reduction for salvage). The annual rate under this method using a period 
of 8 years is 25 percent. The depreciation allowance for assets W and X 
for 1971 is $3,250, a full year's depreciation under the modified half-
year convention (that is, basis of $13,000 (unreduced by salvage) 
multiplied by 25 percent). The depreciation allowance for asset Y for 
1971 is zero under the modified half-year convention.
    Example 2. The facts are the same as in example (1), except that the 
taxpayer adopts the half-year convention described in subparagraph (2) 
(iii) of this paragraph. The depreciation allowance with respect to 
asset Y is $1,500 (that is the basis of $12,000 multiplied by 25 
percent, then multiplied by \1/2\). Assets W and X are also entitled to 
a depreciation allowance for only a half year. Thus, the depreciation 
allowance for assets W and X for 1971 is $1,625 (that is, \1/2\ of the 
$3,250 allowance computed in example (1)).
    Example 3. Asset Z is placed in service by a calendar year taxpayer 
on December 1, 1971. The taxpayer places asset Z in an item account and 
adopts the sum of the years-digits method and the half year convention 
described in subparagraph (2) (iii) of this paragraph. The asset 
depreciation range for such asset is 4 to 6 years and the taxpayer 
selects an asset depreciation period of 5 years. The depreciation 
allowance for asset Z in 1971 is $10,000 (that is, basis of $60,000 
(unreduced by salvage) multiplied by \5/15\, the appropriate fraction 
using the sum of the years-digits method then multiplied by \1/2\, since 
only one half year's depreciation is allowable under the convention).
    Example 4. A is a calendar year taxpayer. All taxpayer A's assets 
are placed in service

[[Page 411]]

in the first half of 1971. If the taxpayer selects the modified half-
year convention described in subparagraph (2) (ii) of this paragraph, a 
full year's depreciation is allowable for all assets.
    Example 5. (i) The taxpayer during his taxable year which begins 
April 1, 1970, and ends March 31, 1971, places new property in service 
in a trade or business as follows:

------------------------------------------------------------------------
                                                              Unadjusted
                Asset                    Placed in service       basis
------------------------------------------------------------------------
A...................................  Apr. 30, 1970.........    $10,000
B...................................  Dec. 15, 1970.........     10,000
C...................................  Jan. 1, 1971..........     10,000
------------------------------------------------------------------------


The taxpayer adopted a convention under Sec.  1.167(a)-10(b) with 
respect to assets placed in service prior to January 1, 1971, which 
treats assets placed in service during the first half of the year as 
placed in service on the first day of such year and assets placed in 
service in the second half of the year as placed in service on the first 
day of the following year. If the taxpayer selects the half-year 
convention described in subparagraph (2) (iii) of this paragraph, one 
year's depreciation is allowable on asset A determined without regard to 
this section. No depreciation is allowable for asset B. No depreciation 
is allowable for asset C for the period prior to January 1, 1971. One-
fourth year's depreciation is allowable on asset C determined under this 
section.
    (ii) The facts are the same as in (i) of this example except that 
the taxpayer adopts the modified half-year convention described in 
subparagraph (2) (ii) of this paragraph for 1971. No depreciation is 
allowable for assets B and C which were placed in service in the second 
half of the taxable year.
    Example 6. The taxpayer during his taxable year which begins August 
1, 1970, and ends July 31, 1971, places new property in service in a 
trade or business as follows:

------------------------------------------------------------------------
                  Asset                          Placed in service
------------------------------------------------------------------------
  A......................................  Aug. 1, 1970.
  B......................................  Jan. 15, 1971.
  C......................................  June 30, 1971.
------------------------------------------------------------------------


The taxpayer adopted a convention under Sec.  1.167(a)-10(b) with 
respect to assets placed in service prior to January 1, 1971, which 
treats all assets as placed in service at the mid-point of the taxable 
year. If the taxpayer selects the half-year convention described in 
subparagraph (2) (iii) of this paragraph, one-half year's depreciation 
is allowable for asset A determined without regard to this section. One-
half year's depreciation is allowable for assets B and C determined 
under this section.
    Example 7. X, a calendar year corporation, is incorporated on July 
1, 1978, and begins engaging in a trade or business in September 1979. X 
purchases asset A and places it in service on November 20, 1979. 
Substantial expenditures were not paid or incurred by X with respect to 
asset A prior to November 15, 1979. For purposes of applying the 
conventions under this section to determine depreciation for asset A, 
the 1979 taxable year is treated as consisting of 4 months. The first 
half of the taxable year ends on October 31, 1979, and the second half 
begins on November 1, 1979. X adopts the half-year convention. Asset A 
is treated as placed in service on November 1, 1979.
    Example 8. On January 20, 1982, A, B, and C enter an agreement to 
form partnership P for the purpose of purchasing and leasing a ship to a 
third party, Z. P uses the calendar year as its taxable year. On 
December 15, 1982, P acquires the ship and leases it to Z. For purposes 
of applying the conventions, P begins its leasing business in December 
1982, and its taxable year begins on December 1, 1982. Assuming that P 
elects to apply this section and adopts the modified half-year 
convention, P depreciates the ship placed in service in 1982 for the 1-
month period beginning December 1, 1982, and ending December 31, 1982.
    Example 9. A and B form partnership P on December 15, 1981, to 
conduct a business of leasing small aircraft. P uses the calendar year 
as its taxable year. On January 15, 1982, P acquires and places in 
service a $25,000 aircraft. P begins engaging in business with only one 
aircraft for the purpose of obtaining a disproportionately large 
depreciation deduction for aircraft that P plans to acquire at the end 
of the year. On December 10, 1982, P acquires and places in service 4 
aircraft, the total purchase price of which is $250,000. For purposes of 
applying the conventions to the aircraft acquired in December, P begins 
its leasing business in December 1982, and P's taxable year begins 
December 1, 1982, and ends December 31, 1982. Assuming that P elects to 
apply this section and adopts the modified half-year convention, P 
depreciates the aircraft placed in service in December 1982, for the 1-
month period beginning December 1, 1982, and ending December 31, 1982. P 
depreciates the aircraft placed in service in January 1982, for the 12-
month period beginning January 1, 1982, and ending December 31, 1982.

    (d) Special rules for salvage, repairs and retirements--(1) Salvage 
value--(i) Definition of gross salvage value. ``Gross salvage'' value is 
the amount which is estimated will be realized upon a sale or other 
disposition of the property in the vintage account when it is no longer 
useful in the taxpayer's trade or business or in the production of his 
income and is to be retired from service, without reduction for the cost 
of removal,

[[Page 412]]

dismantling, demolition or similar operations. If a taxpayer customarily 
sells or otherwise disposes of property at a time when such property is 
still in good operating condition, the gross salvage value of such 
property is the amount expected to be realized upon such sale or 
disposition, and under certain circumstances, as where such property is 
customarily sold at a time when it is still relatively new, the gross 
salvage value may constitute a relatively large proportion of the 
unadjusted basis of such property.
    (ii) Definition of salvage value. ``Salvage value'' means gross 
salvage value less the amount, if any, by which the gross salvage value 
is reduced by application of section 167(f). Generally, as provided in 
section 167(f), a taxpayer may reduce the amount of gross salvage value 
of a vintage account by an amount which does not exceed 10 percent of 
the unadjusted basis of the personal property (as defined in section 
167(f)(2)) in the account. See paragraph (b)(3)(ii) of this section for 
requirement of separate vintage accounts for personal property described 
in section 167(f)(2).
    (iii) Estimation of salvage value. The salvage value of each vintage 
account of the taxable year shall be estimated by the taxpayer at the 
time the election to apply this section is made, upon the basis of all 
the facts and circumstances existing at the close of the taxable year in 
which the account is established. The taxpayer shall specify the amount, 
if any, by which gross salvage value taken into account is reduced by 
application of section 167(f). See paragraph (f)(2) of this section for 
requirement that the election specify the estimated salvage value for 
each vintage account of the taxable year of election. The salvage value 
estimated by the taxpayer will not be redetermined merely as a result of 
fluctuations in price levels or as a result of other facts and 
circumstances occurring after the close of the taxable year of election. 
Salvage value for a vintage account need not be established or increased 
as a result of a property improvement as described in subparagraph (2) 
(vii) of this paragraph. The taxpayer shall maintain records reasonably 
sufficient to determine facts and circumstances taken into account in 
estimating salvage value.
    (iv) Salvage as limitation on depreciation. In no case may a vintage 
account be depreciated below a reasonable salvage value after taking 
into account any reduction in gross salvage value permitted by section 
167(f).
    (v) Limitation on adjustment of reasonable salvage value. The 
salvage value established by the taxpayer for a vintage account will not 
be redetermined if it is reasonable. Since the determination of salvage 
value is a matter of estimation, minimal adjustments will not be made. 
The salvage value established by the taxpayer will be deemed to be 
reasonable unless there is sufficient basis in the facts and 
circumstances existing at the close of the taxable year in which the 
account is established for a determination of an amount of salvage value 
for the account which exceeds the salvage value established by the 
taxpayer for the account by an amount greater than 10 percent of the 
unadjusted basis of the account at the close of the taxable year in 
which the account is established. If the salvage value established by 
the taxpayer for the account is not within the 10 percent range, or if 
the taxpayer follows the practice of understating his estimates of gross 
salvage value to take advantage of this subdivision, and if there is a 
determination of an amount of salvage value for the account which 
exceeds the salvage value established by the taxpayer for the account, 
an adjustment will be made by increasing the salvage value established 
by the taxpayer for the account by an amount equal to the difference 
between the salvage value as determined and the salvage value 
established by the taxpayer for the account. For the purposes of this 
subdivision, a determination of salvage value shall include all 
determinations at all levels of audit and appellate proceedings, and as 
well as all final determinations within the meaning of section 1313(a) 
(1). This subdivision shall apply to each such determination. (See 
example (3) of subdivision (vi) of this subparagraph.)
    (vi) Examples. The principles of this subparagraph may be 
illustrated by the

[[Page 413]]

following examples in which it is assumed that the taxpayer has not 
followed a practice of understating his estimates of gross salvage 
value:

    Example 1. Taxpayer B elects to apply this section to assets Y and 
Z, which are placed in a multiple asset vintage account of 1971 for 
which the taxpayer selects an asset depreciation period of 8 years. The 
unadjusted basis of asset Y is $50,000 and the unadjusted basis of asset 
Z is $30,000. B estimates a gross salvage value of $55,000. The property 
qualifies under section 167(f) (2) and B reduces the amount of salvage 
taken into account by $8,000 (that is, 10 percent of $80,000 under 
section 167(f)). Thus, B establishes a salvage value of $47,000 for the 
account. Assume that there is not sufficient basis for determining a 
salvage value for the account greater than $52,000 (that is, $60,000 
minus the $8,000 reduction under section 167(f)). Since the salvage 
value of $47,000 established by B for the account is within the 10 
percent range, it is reasonable. Salvage value for the account will not 
be redetermined.
    Example 2. The facts are the same as in example (1) except that B 
estimates a gross salvage value of $50,000 and establishes a salvage 
value of $42,000 for the account (that is, $50,000 minus the $8,000 
reduction under section 167(f)). There is sufficient basis for 
determining an amount of salvage value greater than $50,000 (that is, 
$58,000 minus the $8,000 reduction under section 167(f)). The salvage 
value of $42,000 established by B for the account can be redetermined 
without regard to the limitation in subdivision (v) of this 
subparagraph, since it is not within the 10 percent range. Upon audit of 
B's tax return for a taxable year for which the redetermination would 
affect the amount of depreciation allowable for the account, salvage 
value is determined to be $52,000 after taking into account the 
reduction under section 167(f). Salvage value for the account will be 
adjusted to $52,000.
    Example 3. The facts are the same as in example (1) except that upon 
audit of B's tax return for a taxable year the examining officer 
determines the salvage value to be $58,000 (that is, $66,000 minus the 
$8,000 reduction under section 167(f)), and proposes to adjust salvage 
value for the vintage account to $58,000 which will result in 
disallowing an amount of depreciation for the taxable year. B does not 
agree with the finding of the examining officer. After receipt of a 
``30-day letter'', B waives a district conference and initiates 
proceedings before the Appellate Division. In consideration of the case 
by the Appellate Division it is concluded that there is not sufficient 
basis for determining an amount of salvage value for the account in 
excess of $55,000 (that is $63,000 minus the $8,000 reduction under 
section 167(f)). Since the salvage of $47,000 established by B for the 
account is within the 10 percent range, it is reasonable. Salvage value 
for the account will not be redetermined.
    Example 4. Taxpayer C elects to apply this section to factory 
building X which is placed in an item vintage account of 1971. The 
unadjusted basis of factory building X is $90,000. C estimates a gross 
salvage value for the account of $10,000. The property does not qualify 
under section 167(f)(2). C establishes a salvage value of $10,000 for 
the account. Assume that there is not sufficient basis for determining a 
salvage value for the account greater than $18,000. Since the salvage 
value of $10,000 established by B for the account is within the 10 
percent range, it is reasonable. Salvage value for the account will not 
be redetermined.

    (2) Treatment of repairs--(i) In general. (a) Sections 162, 212, and 
263 provide general rules for the treatment of certain expenditures for 
the repair, maintenance, rehabilitation or improvement of property. In 
general, under those sections, expenditures which substantially prolong 
the life of an asset, or are made to increase its value or adapt it to a 
different use are capital expenditures. If an expenditure is treated as 
a capital expenditure under section 162, 212, or 263, it is subject to 
the allowance for depreciation. On the other hand, in general, 
expenditures which do not substantially prolong the life of an asset or 
materially increase its value or adapt it for a substantially different 
use may be deducted as an expense in the taxable year in which paid or 
incurred. Expenditures, or a series of expenditures, may have 
characteristics both of deductible expenses and capital expenditures. 
Other expenditures may have the characteristics of capital expenditures, 
as in the case of an ``excluded addition'' (as defined in subdivision 
(vi) of this subparagraph). This subparagraph provides a simplified 
procedure for determining whether expenditures with respect to certain 
property are to be treated as deductible expenses or capital 
expenditures.
    (b) [Reserved]
    (ii) Election of repair allowance. In the case of an asset guideline 
class which consists of ``repair allowance property'' as defined in 
subdivision (iii) of this subparagraph, subject to the provisions of 
subdivision (v) of this subparagraph, the taxpayer may elect to apply 
the asset guideline class repair allowance described in subdivision 
(iii) of this

[[Page 414]]

subparagraph for any taxable year ending after December 31, 1970, for 
which the taxpayer elects to apply this section.
    (iii) Repair allowance for an asset guideline class. For a taxable 
year for which the taxpayer elects to apply this section, the ``repair 
allowance'' for an asset guideline class which consists of ``repair 
allowance property'' is an amount equal to--
    (a) The average of (1) the unadjusted basis of all ``repair 
allowance property'' in the asset guideline class at the beginning of 
the taxable year, less in the case of such property in a vintage account 
the unadjusted basis of all such property retired in an ordinary 
retirement (as described in subparagraph (3)(ii) of this paragraph) in 
prior taxable years, and (2) the unadjusted basis of all ``repair 
allowance property'' in the asset guideline class at the end of the 
taxable year, less in the case of such property in a vintage account the 
unadjusted basis of all such property retired in an ordinary retirement 
(including ordinary retirements during the taxable year), multiplied 
by--
    (b) The repair allowance percentage in effect for the asset 
guideline class for the taxable year.

In applying the assets guideline class repair allowance to buildings 
which are section 1250 property, for the purpose of this subparagraph 
each building shall be treated as in a separate asset guideline class. 
If two or more buildings are in the same asset guideline class 
determined without regard to the preceding sentence and are operated as 
an integrated unit (as evidenced by their actual operation, management, 
financing and accounting), they shall be treated as a single building 
for this purpose. The ``repair allowance percentages'' in effect for 
taxable years ending before the effective date of the first supplemental 
repair allowance percentages established pursuant to this section are 
set forth in Revenue Procedure 72-10. Repair allowance percentages will 
from time to time be established, supplemented and revised with express 
reference to this section. These repair allowance percentages will be 
published in the Internal Revenue Bulletin. The repair allowance 
percentages in effect on the last day of the taxable year shall apply 
for the taxable year, except that the repair allowance percentage for a 
particular taxable year shall not be less than the repair allowance 
percentage in effect on the first day of such taxable year (or as of 
such later time in such year as a repair allowance percentage first 
established during such year becomes effective). Generally, the repair 
allowance percentages for a taxable year shall not be changed to reflect 
any supplement or revision of the repair allowance percentages after the 
end of such taxable year. However, if expressly provided in such a 
supplement or revision of the repair allowance percentages, the taxpayer 
may, at his option in the manner specified therein, apply the revised or 
supplemented repair allowance percentages for such taxable year and 
succeeding taxable years. For the purposes of this section, ``repair 
allowance property'' means eligible property determined without regard 
to paragraph (b)(2)(ii) of this section (that is, without regard to 
whether such property was first placed in service by the taxpayer before 
or after December 31, 1970) in an asset guideline class for which a 
repair allowance percentage is in effect for the taxable year. The 
determination whether property is repair allowance property shall be 
made without regard to whether such property is excluded, under 
paragraph (b)(5) of this section, from an election to apply this 
section. Property in an asset guideline class for which the taxpayer 
elects to apply the asset guideline class repair allowance described in 
this subdivision, which results from expenditures in the taxable year of 
election for the repair, maintenance, rehabilitation, or improvement of 
property in an asset guideline class shall not be ``repair allowance 
property'' for such taxable year but shall be for each succeeding 
taxable year provided such property is a property improvement as 
described in subdivision (vii) (a) of this subparagraph and is in an 
asset guideline class for which a repair allowance percentage is in 
effect for such succeeding taxable year.
    (iv) Application of asset guideline class repair allowance. In 
accordance with the principles of sections 162, 212, and 263, if the 
taxpayer pays or incurs any

[[Page 415]]

expenditures during the taxable year for the repair, maintenance, 
rehabilitation or improvement of eligible property (determined without 
regard to paragraph (b)(2)(ii) of this section), the taxpayer must 
either--
    (a) If such property is repair allowance property and if the 
taxpayer elects to apply the repair allowance for the asset guideline 
class, treat an amount of all such expenditures in such taxable year 
with respect to all such property in the asset guideline class which 
does not exceed in total the repair allowance for that asset guideline 
class as deductible repairs, and treat the excess of all such 
expenditures with respect to all such property in the asset guideline 
class in the manner described for a property improvement in subdivision 
(viii) of this subparagraph, or
    (b) If such property is not repair allowance property or if the 
taxpayer does not elect to apply the repair allowance for the asset 
guideline class, treat each of such expenditures in such taxable year 
with respect to all such property in the asset guideline class as either 
a capital expenditure or as a deductible repair in accordance with the 
principles of sections 162, 212, and 263 (without regard to (a) of this 
subdivision), and treat the expenditures which are required to be 
capitalized under sections 162, 212, and 263 (without regard to (a) of 
this subdivision) in the manner described for a property improvement in 
subdivision (viii) of this subparagraph.

For the purposes of (a) of this subdivision, expenditures for the 
repair, maintenance, rehabilitation or improvement of property do not 
include expenditures for an excluded addition or for which a deduction 
is allowed under section 167(k). (See subdivision (viii) of this 
subparagraph for treatment of an excluded addition.) The taxpayer shall 
elect each taxable year whether to apply the repair allowance and treat 
expenditures under (a) of this subdivision, or to treat expenditures 
under (b) of this subdivision. The treatment of expenditures under this 
subdivision for a taxable year for all asset guideline classes shall be 
specified in the books and records of the taxpayer for the taxable year. 
The taxpayer may treat expenditures under (a) of this subdivision with 
respect to property in one asset guideline class and treat expenditures 
under (b) of this subdivision with respect to property in some other 
asset guideline class. In addition, the taxpayer may treat expenditures 
with respect to property in an asset guideline class under (a) of this 
subdivision in one taxable year, and treat expenditures with respect to 
property in that asset guideline class under (b) of this subdivision in 
another taxable year.
    (v) Special rules for repair allowance. (a) The asset guideline 
class repair allowance described in subdivision (iii) of this 
subparagraph shall apply only to expenditures for the repair, 
maintenance, rehabilitation or improvement of repair allowance property 
(as described in subdivision (iii) of this subparagraph). The taxpayer 
may apply the asset guideline class repair allowance for the taxable 
year only if he maintains books and records reasonably sufficient to 
determine:
    (1) The amount of expenditures paid or incurred during the taxable 
year for the repair, maintenance, rehabilitation or improvement of 
repair allowance property in the asset guideline class, and
    (2) The expenditures (and the amount thereof) with respect to such 
property which are for excluded additions (such as whether the 
expenditure is for an additional identifiable unit of property, or 
substantially increases the productivity or capacity of an existing 
identifiable unit of property or adapts it for a substantially different 
use).

In general, such books and records shall be sufficient to identify the 
amount and nature of expenditures with respect to specific items of 
repair allowance property or groups of similar properties in the same 
asset guideline class. However, in the case of such expenditures with 
respect to property, part of which is in one asset guideline class and 
part in another, or part of which is repair allowance property and part 
of which is not, and in comparable circumstances involving property in 
the same asset guideline class, to the extent books and records are not 
maintained identifying such expenditures with specific items of property 
or groups of similar properties and it is

[[Page 416]]

not practicable to do so, the total amount of such expenditures which is 
not specifically identified may be allocated by any reasonable method 
consistently applied. In any case, the cost of repair, maintenance, 
rehabilitation or improvement of property performed by production 
personnel may be allocated by any reasonable method consistently applied 
and if performed incidental to production and not substantial in amount, 
no allocation to repair, maintenance, rehabilitation or improvement need 
be made. The types of expenditures for which specific identification 
would ordinarily be made include: Substantial expenditures such as for 
major parts or major structural materials for which a work order is or 
would customarily be written; expenditures for work performed by an 
outside contractor; or expenditures under a specific down time program. 
Types of expenditures for which specific identification would ordinarily 
be impractical include: General maintenance costs of machinery, 
equipment, and plant in the case of a taxpayer having assets in more 
than one class (or different types of assets in the same class) which 
are located together and generally maintained by the same work crew; 
small supplies which are used with respect to various classes or types 
of property; labor costs of personnel who work on property in different 
classes, or different types of property in the same class, if the work 
is performed on a routine, as needed, basis and the only identification 
of the property repaired is by the personnel. Factors which will be 
taken into account in determining the reasonableness of the taxpayer's 
allocation of expenditures include prior experience of the taxpayer; 
relative bases of the assets in the guideline class; types of assets 
involved; and relationship to specifically identified expenditures.
    (b) If for the taxable year the taxpayer elects to deduct under 
section 263(e) expenditures with respect to repair allowance property 
consisting of railroad rolling stock (other than a locomotive) in a 
particular asset guideline class, the taxpayer may not, for such taxable 
year, use the asset guideline class repair allowance described in 
subdivision (iii) of this subparagraph for any property in such asset 
guideline class.
    (c)(1) If the taxpayer repairs, rehabilitates or improves property 
for sale or resale to customers, the asset guideline class repair 
allowance described in subdivision (iii) of this subparagraph shall not 
apply to expenditures for the repair, maintenance, rehabilitation or 
improvement of such property, or (2) if a taxpayer follows the practice 
of acquiring for his own use property (in need of repair, rehabilitation 
or improvement to be suitable for the use intended by the taxpayer) and 
of making expenditures to repair, rehabilitate or improve such property 
in order to take advantage of this subparagraph, the asset guideline 
class repair allowance described in subdivision (iii) of this 
subparagraph shall not apply to such expenditures. In either event, such 
property shall not be ``repair allowance property'' as described in 
subdivision (iii) of this subparagraph.
    (vi) Definition of excluded addition. The term ``excluded addition'' 
means--
    (a) An expenditure which substantially increases the productivity of 
an existing identifiable unit of property over its productivity when 
first acquired by the taxpayer;
    (b) An expenditure which substantially increases the capacity of an 
existing identifiable unit of property over its capacity when first 
acquired by the taxpayer;
    (c) An expenditure which modifies an existing identifiable unit of 
property for a substantially different use;
    (d) An expenditure for an identifiable unit of property if (1) such 
expenditure is for an additional identifiable unit of property or (2) 
such expenditure (other than an expenditure described in (e) of this 
subdivision) is for replacement of an identifiable unit of property 
which was retired;
    (e) An expenditure for replacement of a part in or a component or 
portion of an existing identifiable unit of property (whether or not 
such part, component or portion is also an identifiable unit of 
property) if such part, component or portion is for replacement of a 
part, component or portion which was retired in a retirement upon which 
gain or loss is recognized (or would be

[[Page 417]]

recognized but for a special nonrecognition provision of the Code or 
Sec.  1.1502-13).
    (f) In the case of a building or other structure (in addition to 
(b), (c), (d), and (e) of this subdivision which also apply to such 
property), an expenditure for additional cubic or linear space; and
    (g) In the case of those units of property of pipelines, electric 
utilities, telephone companies, and telegraph companies consisting of 
lines, cables and poles (in addition to (a) through (e) of this 
subdivision which also apply to such property), an expenditure for 
replacement of a material portion of the unit of property.

Except as provided in (d) and (e) of this subdivision, notwithstanding 
any other provision of this subdivision, the term ``excluded addition'' 
does not include any expenditure in connection with the repair, 
maintenance, rehabilitation or improvement of an identifiable unit of 
property which does not exceed $100. For this purpose all related 
expenditures with respect to the unit of property shall be treated as a 
single expenditure. For the purposes of (a), and (b) of this 
subdivision, an increase in productivity or capacity is substantial only 
if the increase is more than 25 percent. An expenditure which merely 
extends the productive life of an identifiable unit of property is not 
an increase in productivity within the meaning of (a) of this 
subdivision. Under (g) of this subdivision a replacement is material 
only if the portion replaced exceeds 5 percent of the unit of property 
with respect to which the replacement is made. For the purposes of this 
subdivision, a unit of property generally consists of each operating 
unit (that is, each separate machine or piece of equipment) which 
performs a discrete function and which the taxpayer customarily acquires 
for original installation and retires as a unit. The taxpayer's 
accounting classification of units of property will generally be 
accepted for purposes of this subdivision provided the classifications 
are reasonably consistent with the preceding sentence and are 
consistently applied. In the case of a building the unit of property 
generally consists of the building as well as its structural components; 
except that each building service system (such as an elevator, an 
escalator, the electrical system, or the heating and cooling system) is 
an identifiable unit for the purpose of (a), (b), (c), and (d) of this 
subdivision. However, both in the case of machinery and equipment and in 
the case of a building, for the purpose of applying (d)(1) of this 
subdivision a unit of property may consist of a part in or a component 
or portion of a larger unit of property. In the case of property 
described in (g) of this subdivision (such as a pipeline), a unit of 
property generally consists of each segment which performs a discrete 
function either as to capacity, service, transmission or distribution 
between identifiable points. Thus, for example, under this subdivision 
in the case of a vintage account of five automobiles each automobile is 
an identifiable unit of property (which is not merely a part in or a 
component or portion of larger unit of property within the meaning of 
(e) of this subdivision). Accordingly, the replacement of one of the 
automobiles (which is retired) with another automobile is an excluded 
addition under (d)(2) of this subdivision. Also the purchase of a sixth 
automobile is an expenditure for an additional identifiable unit of 
property and is an excluded addition under (d)(1) of this subdivision. 
An automobile air conditioner is also an identifiable unit of property 
for the purposes of (d)(1) of this subdivision, but not for the purposes 
of (d)(2) of this subdivision. Accordingly, the addition of an air 
conditioner to an automobile is an excluded addition under (d)(1) of 
this subdivision, but the replacement of an existing air conditioner in 
an automobile is not an excluded addition under (d)(2) of this 
subdivision (since it is merely the replacement of a part in an existing 
identifiable unit of property). The replacement of the air conditioner 
may, however, be an excluded addition under (e) of this subdivision, if 
the air conditioner replaced was retired in a retirement upon which gain 
or loss was recognized. The principles of this subdivision may be 
further illustrated by the following examples in which it is assumed 
(unless otherwise stated) that (e) of this subdivision does not apply:


[[Page 418]]


    Example 1. For the taxable year, B pays or incurs only the following 
expenditures: (1) $5,000 for general maintenance of repair allowance 
property (as described in subdivision (iii) of this subparagraph) such 
as inspection, oiling, machine adjustments, cleaning, and painting; (2) 
$175 for replacement of bearings and gears in an existing lathe; (3) 
$125 for replacement of an electric starter (of the same capacity) and 
certain electrical wiring in an automatic drill press; (4) $300 for 
modification of a metal fabricating machine (including replacement of 
certain parts) which substantially increases its capacity; (5) $175 for 
repair of the same metal fabricating machine which does not 
substantially increase its capacity; (6) $800 for the replacement of an 
existing lathe with a new lathe; and (7) $65 for the repair of a drill 
press. Expenditures (1) through (3) are expenditures for the repair, 
maintenance, rehabilitation or improvement of property to which B can 
elect to apply the asset guideline class repair allowance described in 
subdivision (iii) of this subparagraph. Expenditure (4) is an excluded 
addition under (b) of this subdivision. Expenditure (5) is not an 
excluded addition. Expenditure (6) is an excluded addition under (d)(2) 
of this subdivision. Without regard to (a), (b), and (c) of this 
subdivision, expenditure (7) is not an excluded addition since the 
expenditure does not exceed $100.
    Example 2. Corporation M operates a steel plant which produces 
rails, blooms, billets, special bar sections, reinforcing bars, and 
large diameter line pipe. During the taxable year, corporation M: (1) 
relines an openhearth furnace; (2) places in service 20 new ingot molds; 
(3) replaces one reversing roll in the blooming mill; (4) overhauls the 
rail and billet mill with no increase in capacity; (5) replaces a roll 
stand in the 20-inch bar mill; and (6) overhauls the 11-inch bar mill 
and reducing stands increasing billet speed from 1,800 feet per minute 
to 2,300 feet per minute. Assume that each expenditure exceeds $100. 
Expenditure (1) is not an excluded addition. Expenditure (2) is an 
excluded addition under (d)(1) of this subdivision. Expenditure (3) is 
not an excluded addition since the expenditure for the reversing roll 
merely replaces a part in an existing identifiable unit of property. 
Expenditure (4) is not an excluded addition. Expenditure (5) is an 
excluded addition under (d)(2) of this subdivision since the roll stand 
is not merely a part of an existing identifiable unit of property. 
Expenditure (6) is an excluded addition under (a) of this subdivision 
since it increases the billet speed by more than 25 percent.
    Example 3. For the taxable year, corporation X pays or incurs the 
following expenditures: (1) $1,000 for two new temporary partition walls 
in the company's offices; (2) $1,400 for repainting the exterior of a 
terminal building; (3) $300 for repair of the roof of a warehouse; (4) 
$150 for replacement of two window frames and panes in the warehouse; 
and (5) $100 for plumbing repair. Expenditure (1) is an excluded 
addition under (d)(1) of this subdivision. None of the other 
expenditures are excluded additions.
    Example 4. For the taxable year, corporation Y pays or incurs the 
following expenditures: (1) $10,000 for expansion of a loading dock from 
600 square feet to 750 square feet; (2) $600 for replacement of two roof 
girders in a factory building; and (3) $9,500 for replacement of columns 
and girders supporting the floor of a second story loft storage area 
within the factory building in order to permit storage of supplies with 
a gross weight 50 percent greater than the previous capacity of the 
loft. Expenditure (1) is an excluded addition under (f) of this 
subdivision. Expenditure (2) is not an excluded addition. Expenditure 
(3) is an excluded addition under (b) of this subdivision.
    Example 5. Corporation A has an office building with an unadjusted 
basis of $10 million. The building has 10 elevators, five of which are 
manually operated and five of which are automatic. During 1971, 
corporation A:
    (1) Replaces the five manually operated elevators with highspeed 
automatic elevators at a cost of $400,000;
    (2) Replaces the cable in one of the existing automatic elevators at 
a cost of $1,700. The replacements of the elevators are excluded 
additions under (d)(2) of this subdivision. The replacement of the cable 
is not an excluded addition.
    Example 6. Taxpayer W, a cement manufacturer, engages in the 
following modification and maintenance activities during the taxable 
year: (1) Replaces eccentric-bearing, spindle, and wearing surface in a 
gyratory crusher; (2) places in service a new apron feeder and hammer 
mill; (3) replaces four buckets on a chain bucket elevator; (4) relines 
refractory surface in the burning zone of a rotary kiln; (5) installs 
additional new dust collectors; and (6) Replaces two 16-inch x 90-foot 
belts on his conveyer system. Assume that there is no increase in 
productivity or capacity and that each expenditure exceeds $100. 
Expenditure (1) is not an excluded addition. Expenditure (2) an excluded 
addition under (d)(1) of this subdivision. Expenditures (3) and (4) are 
not excluded additions. Expenditures (5) is an excluded addition under 
(d)(1) of this subdivision. Expenditure (6) is not an excluded addition.
    Example 7. Corporation X, a gas pipeline company, has, in addition 
to others, the following units of property: (1) A gathering pipeline for 
a field consisting of 25 gas wells; (2) the main transmission line 
between compressor stations (that is, in the case of a 500-mile main 
transmission line with a compressor station every 100 miles, each one 
hundred miles section between compressor

[[Page 419]]

stations is a separate unit of property); (3) a lateral transmission 
line from the main transmission line to a city border station; (4) a 
medium pressure distribution line to the northern portion of the city; 
and (5) a low pressure distribution line serving a group of 
approximately 200 residential customers off the medium pressure 
distribution line. In 1971, corporation X pays or incurs the following 
expenditures in connection with the repair, maintenance, rehabilitation 
or improvement of repair allowance property: (1) replaces a meter on a 
gas well; (2) in connection with the repair and rehabilitation of a unit 
of property consisting of a 2-mile gathering pipeline, replaces a 3,000-
foot section of the gathering line; (3) in connection with the repair of 
leaks in a unit of property consisting of a 100-mile gas transmission 
line (that is, the 100 miles between compressor stations), replaces a 
2,000-foot section of pipeline at one point; and (4) at another point 
replaces a 7-mile section of the same 100-mile gas transmission line. 
Assume that none of these expenditures substantially increases capacity 
and that each expenditure exceeds $100. Expenditure (1) is an excluded 
addition under (d) of this subdivision. Expenditure (2) is an excluded 
addition under (g) of this subdivision since the portion replaced is 
more than 5 percent of the unit of property. Expenditure (3) is not an 
excluded addition. Expenditure (4) is an excluded addition under (g) of 
this subdivision.
    Example 8. Taxpayer Y, an electric utility company, has in addition 
to others, the following units of property: (1) A high voltage 
transmission circuit from the switching station (at the generating 
station) to the transmission station; (2) a series of 100 poles (fully 
dressed) supporting the circuit in (1); (3) a high voltage circuit from 
the transmission station to the distribution substation; (4) a high 
voltage distribution circuit (either radial or looped) from the 
distribution substation; (5) a transformer on a distribution pole; (6) a 
circuit breaker on a distribution pole; and (7) all 220 (and lower) volt 
circuit (including customer service connections) off the distribution 
circuit in (4). In 1971, taxpayer Y pays or incurs the following 
expenditures for the repair, maintenance, rehabilitation or improvement 
of repair allowance property: (1) Replaces 25 adjacent poles in a unit 
of property consisting of the 300 poles supporting a radial distribution 
circuit from a distribution substation; (2) replaces a transformer on 
one of the poles in (1); (3) replaces a cross-arm on one of the poles in 
(1); (4) replaces a 200-foot section of a 2-mile radial distribution 
circuit serving 100 residential customers; and (5) replaces a 2,000-foot 
section on a 10-mile high voltage circuit from a transmission station to 
a distribution substation which was destroyed by a casualty which 
taxpayer Y treated as an extraordinary retirement under paragraph 
(d)(3)(ii) of this section. Expenditure (1) is an excluded addition 
under (g) of this subdivision. Expenditure (2) is an excluded addition 
under (d)(2) of this subdivision. Expenditures (3) and (4) are not 
excluded additions. Expenditure (5) is an excluded addition under (e) of 
this subdivision.
    Example 9. Corporation Z, a telephone company, has in addition to 
others, the following units of property: (1) A buried feeder cable 3 
miles in length off a local switching station; (2) a buried subfeeder 
cable 1 mile in length off the feeder cable in (1); (3) all the 
distribution cable (and customer service drops) off the subfeeder cable 
in (2); (4) the 300 poles (fully dressed) supporting the distribution 
cable in (3); (5) a 10-mile local trunk cable which interconnects two 
local tandem switching stations; (6) a toll connecting trunk cable from 
a local tandem switching station to a long distance tandem switching 
station; (7) a toll trunk cable 50 miles in length from the access point 
at one city to the access point at another city. In 1971, corporation Z 
pays or incurs the following expenditures in connection with the repair, 
maintenance, rehabilitation or improvement of repair allowance property: 
(1) replaces 100 feet of distribution cable in a unit of property 
consisting of 8 miles of local distribution cable (plus customer service 
drops); (2) replaces an amplifier in the distribution system; and (3) 
replaces 10 miles of a unit of property consisting of a toll trunk cable 
50 miles in length. Expenditure (1) is not an excluded addition. 
Expenditure (2) is an excluded addition under (d)(2) of this 
subdivision. Expenditure (3) is an excluded addition under (g) of this 
subdivision.

    (vii) Definition of property improvement. The term ``property 
improvement'' means--
    (a) If the taxpayer treats expenditures for the asset guideline 
class under subdivision (iv) (a) of this subparagraph, the amount of all 
expenditures paid or incurred during the taxable year for the repair, 
maintenance, rehabilitation or improvement of repair allowance property 
in the asset guideline class, which exceeds the asset guideline class 
repair allowance for the taxable year; and
    (b) If the taxpayer treats expenditures for the asset guideline 
class under subdivision (iv) (b) of this subparagraph, the amount of 
each expenditure paid or incurred during the taxable year for the 
repair, maintenance, rehabilitation or improvement of property which is 
treated under sections 162, 212, and 263 as a capital expenditure.


[[Page 420]]



The term ``property improvement'' does not include any expenditure for 
an excluded addition.
    (viii) Treatment of property improvements and excluded additions. If 
for the taxable year there is a property improvement as described in 
subdivision (vii) of this subparagraph or an excluded addition as 
described in subdivision (vi) of this subparagraph, the following rules 
shall apply--
    (a) The total amount of any property improvement for the asset 
guideline class determined under subdivision (vii)(a) of this 
subparagraph shall be capitalized in a single ``special basis vintage 
account'' of the taxable year in accordance with the taxpayer's election 
to apply this section for the taxable year (applied without regard to 
paragraph (b)(5)(v)(a) of this section). See subparagraph (3)(vi) of 
this paragraph for definition and treatment of a ``special basis vintage 
account''.
    (b) Each property improvement determined under subdivision (vii)(b) 
of this subparagraph, if it is eligible property, shall be capitalized 
in a vintage account of the taxable year in accordance with the 
taxpayer's election to apply this section for the taxable year (applied 
without regard to paragraph (b)(5)(v)(a) of this section).
    (c) Each excluded addition, if it is eligible property, shall be 
capitalized in a vintage account of the taxable year in accordance with 
the taxpayer's election to apply this section for the taxable year.

For rule as to date on which a property improvement or an excluded 
addition is first placed in service, see paragraph (e)(1) (iii) and (iv) 
of this section.
    (ix) Examples. The principles of this subparagraph may be 
illustrated by the following examples:

    Example 1. For the taxable year 1972, B elects to apply this 
section. B has repair allowance property (as described in subdivision 
(iii) of this subparagraph) in asset guideline class 20.2 under Revenue 
Procedure 72-10 with an average unadjusted basis determined as provided 
in subdivision (iii) (a) of this subparagraph of $100,000 and repair 
allowance property in asset guideline class 24.4 with an average 
unadjusted basis of $300,000. The repair allowance percentage for asset 
guideline class 20.2 is 4.5 percent and for asset guideline class 24.4 
is 6.5 percent. The two asset guideline class repair allowances for 1972 
are $4,500 and $19,500, respectively, determined as follows:

                       Asset Guideline Class 20.2
 
$100,000 average unadjusted basis multiplied by 4.5 percent.      $4,500
 
                       Asset Guideline Class 24.4
 
$300,000 average unadjusted basis multiplied by 6.5 percent.     $19,500
 

    Example 2. The facts are the same as in example (1). During the 
taxable year 1972, B pays or incurs the following expenditures for the 
repair, maintenance, rehabilitation or improvement of repair allowance 
property in asset guideline class 20.2

General maintenance (including primarily labor costs)..........   $3,000
Replacement of parts in several machines (including labor costs    4,000
 of $1,650)....................................................
                                                                --------
                                                                   7,000
 


In addition, in connection with the rehabilitation and improvement of 
two other machines B pays or incurs $6,000 (including labor costs of 
$2,000) which is treated as an excluded addition because the capacity of 
the machines was substantially increased. For 1972, B elects to apply 
this section and to apply the asset guideline class repair allowance to 
asset guideline class 20.2. Since the asset guideline class repair 
allowance is $4,500, B can deduct $4,500 in accordance with subdivision 
(iv) (a) of this subparagraph. B must capitalize $2,500 in a special 
basis vintage account in accordance with subdivisions (vii) (a) and 
(viii) (a) of this subparagraph. Since the excluded addition is a 
capital item and is eligible property, B must also capitalize $6,000 in 
a vintage account in accordance with subdivision (viii) (c) of this 
subparagraph. B selects from the asset depreciation range an asset 
depreciation period of 17 years for the special basis vintage account. B 
includes the excluded addition in a vintage account of 1972 for which he 
also selects an asset depreciation period of 17 years.

    (3) Treatment of retirements--(i) In general. The rules of this 
subparagraph specify the treatment of all retirements from vintage 
accounts. The rules of Sec.  1.167(a)-8 shall not apply to any 
retirement from a vintage account. An asset in a vintage account is 
retired when such asset is permanently withdrawn from use in a trade or 
business or in the production of income by the taxpayer. A retirement 
may occur as a result of a sale or exchange, by other act of the 
taxpayer amounting to a permanent disposition of an asset, or by 
physical abandonment of an asset. A retirement may also occur by 
transfer of an asset to supplies or scrap.

[[Page 421]]

    (ii) Definitions of ordinary and extraordinary retirements. The term 
``ordinary retirement'' means any retirement of section 1245 property 
from a vintage account which is not treated as an ``extraordinary 
retirement'' under this subparagraph. The retirement of an asset from a 
vintage account in a taxable year is an ``extraordinary retirement'' 
if--
    (a) The asset is section 1250 property;
    (b) The asset is section 1245 property which is retired as the 
direct result of fire, storm, shipwreck, or other casualty and the 
taxpayer, at his option consistently applied (taking into account type, 
frequency, and the size of such casualties) treats such retirements as 
extraordinary; or
    (c)(1) The asset is section 1245 property which is retired (other 
than by transfer to supplies or scrap) in a taxable year as the direct 
result of a cessation, termination, curtailment, or disposition of a 
business, manufacturing, or other income producing process, operation, 
facility or unit, and (2) the unadjusted basis (determined without 
regard to subdivision (vi) of this subparagraph) of all such assets so 
retired in such taxable year from such account as a direct result of the 
event described in (c)(1) of this subdivision exceeds 20 percent of the 
unadjusted basis of such account immediately prior to such event.

For the purposes of (c) of this subdivision, all accounts (other than a 
special basis vintage account as described in subdivision (vi) of this 
subparagraph) containing section 1245 property of the same vintage in 
the same asset guideline class, and from which a retirement as a direct 
result of such event occurs within the taxable year, shall be treated as 
a single vintage account. See subdivision (xi) of this subparagraph for 
special rule for item accounts. The principles of this subdivision may 
be illustrated by the following examples:

    Example 1. Taxpayer A is a processor and distributor of dairy 
products. Part of taxpayer A's operation is a bottle washing facility 
consisting of machines X, Y, and Z, each of which is in an item vintage 
account of 1971. Each item vintage account has an unadjusted basis of 
$1,000. Taxpayer A also has a 1971 multiple asset vintage account 
consisting of machines E, S, and C. Machines E and S, used in processing 
butter, each has an unadjusted basis of $10,000. Machine C used in 
capping bottles has an unadjusted basis of $1,000. In 1975, taxpayer A 
changes to the use of paper milk cartons and disposes of all bottle 
washing machines (X, Y, and Z) as well as machine C which was used in 
capping bottles. The sales of machine C, X, Y, and Z are the direct 
result of the termination of a manufacturing process. However, since the 
total unadjusted basis of the eligible section 1245 property retired as 
a direct result of such event is only $4,000 (which is less than 20 
percent of the total unadjusted basis of machines E, S, C, X, Y, and Z, 
$24,000) the sales are ordinary retirements. All the assets are in the 
same asset guideline class and are of the same vintage. Accordingly, 
machines E, S, C, X, Y, and Z are for this purpose treated as being in a 
single vintage account.
    Example 2. The facts are the same as in example (1) except that in 
1976, taxpayer A sells six of his 12 milk delivery trucks as a direct 
result of eliminating home deliveries to customers in the suburbs. 
Deliveries within the city require only six trucks. Each of the trucks 
has an unadjusted basis of $3,000. Six of the taxpayer's delivery trucks 
are in a multiple asset vintage account of 1974 and six are in a 
multiple asset vintage account of 1972. Neither account contains any 
other property. Four trucks are retired from the 1972 vintage account 
and two trucks are retired from the 1974 vintage account. The sales 
result from the curtailment of taxpayer A's home delivery operation. The 
unadjusted basis of the four trucks retired from the 1972 vintage 
exceeds 20 percent of the total unadjusted basis of the affected 
account. The same is true for the two trucks retired from the 1974 
vintage account. The sales of the trucks are extraordinary retirements.

    (d) The asset is section 1245 property which is retired after 
December 30, 1980 by a charitable contribution for which a deduction is 
allowable under section 170.
    (iii) Treatment of ordinary retirements. No loss shall be recognized 
upon an ordinary retirement. Gain shall be recognized only to the extent 
specified in this subparagraph. All proceeds from ordinary retirements 
shall be added to the depreciation reserve of the vintage account from 
which the retirement occurs. See subdivision (vi) of this subparagraph 
for optional allocation of basis in the case of a special basis vintage 
account. See subdivision (ix) of this subparagraph for recognition of 
gain when the depreciation reserve exceeds the unadjusted basis of the 
vintage account. The amount of salvage

[[Page 422]]

value for a vintage account shall be reduced (but not below zero) as of 
the beginning of the taxable year by the excess of (a) the depreciation 
reserve for the account, after adjustment for depreciation allowable for 
such taxable year and all other adjustments prescribed by this section 
(other than the adjustment prescribed by subdivision (ix) of this 
subparagraph), over (b) the unadjusted basis of the account less the 
amount of salvage value for the account before such reduction. Thus, in 
the case of a vintage account with an unadjusted basis of $1,000 and a 
salvage value of $100, to the extent that proceeds from ordinary 
retirements increase the depreciation reserve above $900, the salvage 
value is reduced. If the proceeds increase the depreciation reserve for 
the account to $1,000, the salvage value is reduced to zero. The 
unadjusted basis of the asset retired in an ordinary retirement is not 
removed from the account and the depreciation reserve for the account is 
not reduced by the depreciation allowable for the retired asset. The 
previously unrecovered basis of the retired asset will be recovered 
through the allowance for depreciation with respect to the vintage 
account. See subdivision (v)(a) of this subparagraph for treatment of 
retirements on which gain or loss is not recognized in whole or in part. 
See subdivision (v)(b) of this subparagraph for treatment of retirements 
by disposition to a member of an affiliated group as defined in section 
1504(a). See subdivision (v)(c) of this subparagraph for treatment of 
transfers between members of an affiliated group of corporations or 
other related parties as extraordinary retirements.
    (iv) Treatment of extraordinary retirements. (a) Unless the 
transaction is governed by a special nonrecognition section of the Code 
such as 1031 or 337 or is one to which subdivision (v)(b) of this 
subparagraph applies, gain or loss shall be recognized upon an 
extraordinary retirement in the taxable year in which such retirement 
occurs subject to section 1231, section 165, and all other applicable 
provisions of law such as sections 1245 and 1250. If the asset which is 
retired in an extraordinary retirement is the only or last asset in the 
account, the account shall terminate and no longer be an account to 
which this section applies. In all other cases, the unadjusted basis of 
the retired asset shall be removed from the unadjusted basis of the 
vintage account, and the depreciation reserve established for the 
account shall be reduced by the depreciation allowable for the retired 
asset computed in the manner prescribed in paragraph (c) (1)(v)(b) of 
this section for determination of the adjusted basis of the asset. See 
subdivision (ix) of this subparagraph for recognition of gain in the 
case of an account containing section 1245 property when the 
depreciation reserve exceeds the unadjusted basis of the vintage 
account. See subdivision (iii) of this subparagraph for reduction of 
salvage value for such an account when the depreciation reserve exceeds 
the unadjusted basis of the account minus salvage value. See subdivision 
(v)(b) of this subparagraph for treatment of retirements by disposition 
to a member of an affiliated group as defined in section 1504(a).
    (b) The principles of this subdivision may be illustrated by the 
following examples:

    Example 1. Corporation X has a multiple asset vintage account of 
1971 consisting of assets K, R, A, and P all of which are section 1245 
property. The unadjusted basis of the account is $40,000. The unadjusted 
basis of asset A is $10,000. When the reserve for depreciation for the 
account is $20,000, asset A is sold in an extraordinary retirement for 
$8,000 in cash. The $10,000 unadjusted basis of asset A is removed from 
the account and the $5,000 depreciation allowable for asset A is removed 
from the reserve for depreciation. Gain in the amount of $3,000 (to 
which section 1245 applies) is recognized upon the sale of asset A.
    Example 2. Corporation X has an item vintage account of 1972 
consisting of residential apartment unit A. Unit A is section 1250 
property. It is residential rental property and meets the requirements 
of section 167(j)(2). Corporation X adopts the declining balance method 
of depreciation using a rate twice the straight line rate. The asset 
depreciation period is 40 years. Unit A has an unadjusted basis of 
$200,000. On June 30, 1974, when the reserve for depreciation for the 
account is $19,500, unit A is sold for $220,000. Since unit A is section 
1250 property, the sale is an extraordinary retirement in accordance 
with subdivision (ii)(a) of this subparagraph (without regard to 
subdivision

[[Page 423]]

(ii)(b) or (c) of this subparagraph). The adjusted basis of unit A is 
$180,500. Gain in the amount of $39,500 is recognized. The ``additional 
depreciation'' (as defined in section 1250(b)) for unit A is $9,500. 
Accordingly, $9,500 is in accordance with section 1250 treated as gain 
from the sale or exchange of an asset which is neither a capital asset 
nor property described in section 1231. The $30,000 balance of the gain 
from the sale of unit A may be gain to which section 1231 applies.

    (v) Special rule for certain retirements. (a) In the case of an 
ordinary retirement on which gain or loss is in whole or in part not 
recognized because of a special nonrecognition section of the Code, such 
as 1031 or 337, no part of the proceeds from such retirement shall be 
added to the depreciation reserve of the vintage account in accordance 
with subdivision (iii) of this subparagraph. Instead, such retirement 
shall for all purposes of this section be treated as an extraordinary 
retirement.
    (b) The provisions of Sec.  1.1502-13 shall apply to a retirement. 
In the case of an ordinary retirement to which the provisions of Sec.  
1.1502-13 apply, no part of the proceeds from such retirement shall be 
added to the depreciation reserve of the vintage account in accordance 
with subdivision (iii) of this subparagraph. Instead, such retirement 
shall for all purposes of this section be treated as an extraordinary 
retirement.
    (c) In a case in which property is transferred, in a transaction 
which would without regard to this subdivision be treated as an ordinary 
retirement, during the taxable year in which first placed in service to 
a person who bears a relationship described in section 179(d)(2) (A) or 
(B), such transfer shall for all purposes of this section be treated as 
an extraordinary retirement.
    (d)(1) If, in the case of mass assets, it is impracticable for the 
taxpayer to maintain records from which he can establish the vintage of 
such assets as retirements occur, and if he adopts other reasonable 
recordkeeping practices, then the vintage of mass asset retirements may 
be determined by use of an appropriate mortality dispersion table. Such 
a mortality dispersion table may be based upon an acceptable sampling of 
the taxpayer's actual experience or other acceptable statistical or 
engineering techniques. Alternatively, the taxpayer may use a standard 
mortality dispersion table prescribed by the Commissioner for this 
purpose. If the taxpayer uses such standard mortality dispersion table 
for any taxable year of election, it must be used for all subsequent 
taxable years of election unless the taxpayer obtains the consent of the 
Commissioner to change to another dispersion table or to actual 
identification of retirements. For information requirements regarding 
mass assets, see paragraph (f)(5) of this section.
    (2) For purposes of this section, the term ``mass assets'' has the 
same meaning as when used in paragraph (e)(4) of Sec.  1.47-1.
    (e) The principles of this subdivision may be illustrated by the 
following examples:

    Example 1. Corporation X has a vintage account of 1971 consisting of 
machines A, B, and C, each with an unadjusted basis of $1,000. The 
unadjusted basis of the account is $3,000 and at the end of 1977 the 
reserve for depreciation is $2,100. On January 1, 1978, machine A is 
transferred to corporation Y solely for stock in the amount of $1,400 in 
a transaction to which section 351 applies. Since the adjusted basis of 
machine A is $300, a gain of $1,100 is realized, but no gain is 
recognized under section 351. Even though machine A was transferred in 
an ordinary retirement in accordance with (a) of this subdivision the 
rules for an extraordinary retirement are applied. The proceeds are not 
added to the reserve for depreciation for the account. Machine A is 
removed from the account, the unadjusted basis of the account is reduced 
by $1,000, and the reserve for depreciation for the account is reduced 
by $700.
    Example 2. The facts are the same as in example (1) except that the 
consideration received for machine A is stock of corporation Y in the 
amount of $1,200 and cash in the amount of $200. The result is the same 
as in example (1) except that gain is recognized in the amount of $200 
all of which is gain to which section 1245 applies.
    Example 3. The facts are the same as in example (1) except that 
machine A is sold for $1,400 cash in an ordinary retirement and 
corporation X and corporation Y are includible corporations in an 
affiliated group as defined in section 1504(a) which files a 
consolidated return for 1978. Accordingly, (b) of this subdivision 
applies. The retirement is treated as an extraordinary retirement. 
Machine A is removed from the account, the unadjusted basis of the 
account is reduced by $1,000, and the reserve for depreciation for

[[Page 424]]

the account is reduced by $700. The gain of $1,100 is deferred gain to 
which Sec.  1.1502-13 applies.

    (vi) Treatment of special basis vintage accounts. A ``special basis 
vintage account'' is a vintage account for an amount of property 
improvement determined under subparagraph (2) (vii)(a) of this 
paragraph. In general, reference in this section to a ``vintage 
account'' shall include a special basis vintage account. The unadjusted 
basis of a special basis vintage account shall be recovered through the 
allowance for depreciation in accordance with this section over the 
asset depreciation period for the account. Except as provided in this 
subdivision, the unadjusted basis, adjusted basis and reserve for 
depreciation of such account shall not be allocated to any specific 
asset in the asset guideline class, and the provisions of this 
subparagraph shall not apply to such account. However, in the event of a 
sale, exchange or other disposition of ``repair allowance property'' (as 
described in subparagraph (2)(iii) of this paragraph) in an 
extraordinary retirement as described in subdivision (ii) of this 
subparagraph (or if the asset is not in a vintage account, in an 
abnormal retirement as described in Sec.  1.167(a)-8), the taxpayer may, 
if consistently applied to all such retirements in the taxable year and 
adequately identified in the taxpayer's books and records, elect to 
allocate the adjusted basis (as of the end of the taxable year) of all 
special basis vintage accounts for the asset guideline class to each 
such retired asset in the proportion that the adjusted basis of the 
retired asset (as of the beginning of the taxable year) bears to the 
adjusted basis of all repair allowance property in the asset guideline 
class at the beginning of the taxable year. The election to allocate 
basis in accordance with this subdivision shall be made on the tax 
return filed for the taxable year. The principles of this subdivision 
may be illustrated by the following example:

    Example. In addition to other property, the taxpayer has machines A, 
B, and C all in the same asset guideline class and each with an adjusted 
basis on January 1, 1977, of $10,000. The adjusted basis on January 1, 
1977, of all repair allowance property (as described in subparagraph 
(2)(iii) of this paragraph) in the asset guideline class is $90,000. The 
machines are sold in an extraordinary retirement in 1977. The taxpayer 
is entitled to and does elect to allocate basis in accordance with this 
subdivision. There is also a 1972 special basis vintage account for the 
asset guideline class, as follows:

------------------------------------------------------------------------
                                                                Dec. 31,
                                      Unadjusted   Reserve for    1977,
                                         basis    depreciation  adjusted
                                                                  basis
------------------------------------------------------------------------
1972 special basis vintage account,      $2,000       $1,100        $900
 for which the taxpayer selected an
 asset depreciation period of 10
 years, adopted the straight line
 method, and used the half-year
 convention.........................
------------------------------------------------------------------------


By application of this subdivision, the adjusted basis of machines A, B, 
and C is increased to $10,100 each (that is, $10,000 / $90,000 x $900 = 
$100). The unadjusted basis, reserve for depreciation and adjusted basis 
of the special basis vintage account are reduced, respectively, by one-
third (that is, $300 / $900=\1/3\) in order to reflect the allocation of 
basis from the special basis vintage account.

    (vii) Reduction in the salvage value of a vintage account. (a) A 
taxpayer may apply this section without reducing the salvage value for a 
vintage account in accordance with this subdivision or in accordance 
with subdivision (viii) of this subparagraph (relating to transfers to 
supplies or scrap). See subdivision (iii) of this subparagraph for 
reduction of salvage value in certain circumstances in the amount of 
proceeds from ordinary retirements.
    (b) However, the taxpayer may, at his option, follow the consistent 
practice of reducing, as retirements occur, the salvage value for a 
vintage account by the amount of salvage value attributable to the 
retired asset, or the taxpayer may consistently follow the practice of 
so reducing the salvage value for a vintage account as extraordinary 
retirements occur while not reducing the salvage value for the account 
as ordinary retirements occur. If the taxpayer does not reduce the 
salvage value for a vintage account as ordinary retirements occur, the 
taxpayer may be entitled to a deduction in the taxable year in which the 
last asset is retired from the account in accordance

[[Page 425]]

with subdivision (ix) (b) of this subparagraph.
    (c) For purposes of this subdivision, the portion of the salvage 
value for a vintage account attributable to a retired asset may be 
determined by multiplying the salvage value for the account by a 
fraction, the numerator of which is the unadjusted basis of the retired 
asset and the denominator of which is the unadjusted basis of the 
account, or any other method consistently applied which reasonably 
reflects that portion of the salvage value for the account originally 
attributable to the retired asset.
    (d) In the case of ordinary retirements the taxpayer may--
    (1) In the case of retirements (other than by transfer to supplies 
or scrap) follow the consistent practice of reducing the salvage value 
for the account by the amount of salvage value attributable to the 
retired asset and not adding the same amount to the depreciation reserve 
for the account, and
    (2) In the case of retirements by transfer to supplies or scrap, 
follow the consistent practice of reducing the salvage value for the 
account by the amount of salvage value attributable to the retired asset 
and not adding the same amount to the depreciation reserve for the 
account (in which case the basis in the supplies or scrap account of the 
retired asset will be zero) or follow the consistent practice of 
reducing the salvage value for the account by the amount of salvage 
value attributable to the retired asset and adding the same amount to 
the depreciation reserve for the account (up to an amount which does not 
increase the depreciation reserve to an amount in excess of the 
unadjusted basis of the account) in which case the basis in the supplies 
or scrap account of the retired asset will be the amount added to the 
depreciation reserve for the account.

Thus, for example, in the case of an ordinary retirement by transfer of 
an asset to supplies or scrap, the basis of the asset in the supplies or 
scrap account would either be zero or the amount added to the 
depreciation reserve of the vintage account from which the retirement 
occurred. When the depreciation reserve for the account equals the 
unadjusted basis of the account no further adjustment to salvage value 
for the account will be made. See subdivision (viii) of this 
subparagraph for special optional rule for reduction of salvage value in 
the case of an ordinary retirement by transfer of an asset to supplies 
or scrap.
    (e) In the event of a removal of property from a vintage account in 
accordance with paragraph (b)(4)(iii)(e), (5)(v)(b) or (6)(iii) of this 
section the salvage value for the account may be reduced by the amount 
of salvage value attributable to the asset removed determined as 
provided in (c) of this subdivision.
    (viii) Special optional adjustments for transfers to supplies or 
scrap. If the taxpayer does not follow the consistent practice of 
reducing, as ordinary retirements occur, the salvage value for a vintage 
account in accordance with subdivision (vii) of this subparagraph, the 
taxpayer may (in lieu of the method described in subdivision (vii) (c) 
and (d) of this subparagraph) follow the consistent practice of reducing 
salvage value as ordinary retirements occur by transfer of assets to 
supplies or scrap and of determining the basis (in the supplies or scrap 
account) as assets retired in an ordinary retirement by transfer to 
supplies or scrap, in the following manner--
    (a) The taxpayer may determine the value of the asset (not to exceed 
its unadjusted basis) by any reasonable method consistently applied 
(such as average cost, conditioned cost, or fair market value) if such 
method is adequately identified in the taxpayer's books and records.
    (b) The value attributable to the asset determined in accordance 
with (a) of this subdivision shall be subtracted from the salvage value 
for the account (to the extent thereof) and the greater of (1) the 
amount subtracted from the salvage value for the vintage account and (2) 
the value of the asset determined in accordance with (a) of this 
subdivision, shall be added to the reserve for depreciation of this 
vintage account.
    (c) The amount added to the reserve for depreciation of the vintage 
account in accordance with (b) of this subdivision shall be treated as 
the basis of the

[[Page 426]]

retired asset in the supplies or scrap account.

If the taxpayer makes the adjustments in accordance with this 
subdivision, the reserve for depreciation of the vintage account may 
exceed the unadjusted basis of the account, and in that event gain will 
be recognized in accordance with subdivision (ix) of this subparagraph.
    (ix) Recognition of gain or loss in certain situations. (a) In the 
case of a vintage account for section 1245 property, if at the end of 
any taxable year after adjustment for depreciation allowable for such 
taxable year and all other adjustments prescribed by this section, the 
depreciation reserve established for such account exceeds the unadjusted 
basis of the account, the entire amount of such excess shall be 
recognized as gain in such taxable year. Such gain--
    (1) Shall constitute gain to which section 1245 applies to the 
extent that it does not exceed the total amount of depreciation 
allowances in the depreciation reserve at the end of such taxable year, 
reduced by gain recognized pursuant to this subdivision with respect to 
the account previously treated as gain to which section 1245 applies, 
and
    (2) May constitute gain to which section 1231 applies to the extent 
that it exceeds such total amount as so reduced.

In such event, the depreciation reserve shall be reduced by the amount 
of gain recognized, so that after such reduction the amount of the 
depreciation reserve is equal to the unadjusted basis of the account.
    (b) In the case of an account for section 1245 property, if at the 
time the last asset in the vintage account is retired the unadjusted 
basis of the account exceeds the depreciation reserve for the account 
(after all adjustments prescribed by this section), the entire amount of 
such excess shall be recognized in such taxable year as a loss under 
section 165 or as a deduction for depreciation under section 167. If the 
retirement of such asset occurs by sale or exchange on which gain or 
loss is recognized, the amount of such excess may constitute a loss 
subject to section 1231. Upon retirement of the last asset in a vintage 
account, the account shall terminate and no longer be an account to 
which this section applies. See subdivision (xi) of this subparagraph 
for treatment of certain multiple asset and item accounts.
    (c) The principles of this subdivision may be illustrated by the 
following example:

    Example. The taxpayer has a vintage account for section 1245 
property with an unadjusted basis of $1,000 and a depreciation reserve 
of $700 (of which $600 represents depreciation allowances and $100 
represents the proceeds of ordinary retirements from the account). If 
$500 is realized during the taxable year from ordinary retirements of 
assets from the account, the reserve is increased to $1,200, gain is 
recognized to the extent of $200 (the amount by which the depreciation 
reserve before further adjustment exceeds $1,000) and the depreciation 
reserve is then decreased to $1,000. The $200 of gain constitutes gain 
to which section 1245 applies. If the amount realized from ordinary 
retirements during the year had been $1,100 instead of $500, the gain of 
$800 would have consisted of $600 of gain to which section 1245 applies 
and $200 of gain to which section 1231 may apply.

    (x) Dismantling cost. The cost of dismantling, demolishing, or 
removing an asset in the process of a retirement from the vintage 
account shall be treated as an expense deductible in the year paid or 
incurred, and such cost shall not be subtracted from the depreciation 
reserve for the account.
    (xi) Special rule for treatment of multiple asset and item accounts. 
For the purposes of subdivision (ix)(b) of this subparagraph, all 
accounts (other than a special basis vintage account as described in 
subdivision (vi) of this subparagraph) of the same vintage in the same 
asset guideline class for which the taxpayer has selected the same asset 
depreciation period and adopted the same method of depreciation, and 
which contain only section 1245 property permitted by paragraph 
(b)(3)(ii) of this section to be included in the same vintage account, 
shall be treated as a single multiple asset vintage account.
    (4) Examples. The principles of this paragraph may be illustrated by 
the following examples:

    Example 1. (a)Taxpayer A has a multiple asset vintage account for 
selection 1245 property with an unadjusted basis of $1,000. All

[[Page 427]]

the assets were first placed in service by A on January 15, 1971. This 
account contains all of A's assets in a single asset guideline class. A 
elects to apply this section for 1971 and adopts the modified half-year 
convention. A estimates a salvage value for the account of $100 and this 
estimate is determined to be reasonable. (See subparagraph (1)(v) of 
this paragraph for limitation on adjustment of reasonable salvage 
value.) A adopts the straight line method of depreciation with respect 
to the account and selects a 10-year asset depreciation period. A does 
not follow a practice of reducing the salvage value for the account in 
the amount of salvage value attributable to each retired asset in 
accordance with subparagraph (3)(vii) of this paragraph. The 
depreciation allowance for each of the first 4 years is $100, that is 
\1/10\ multiplied by the unadjusted basis of $1,000, with reduction for 
salvage.
    (b) In the fifth year of the asset depreciation period, three assets 
are sold in an ordinary retirement for $300. Under paragraph (c)(1)(ii) 
of this section and subparagraph (3)(iii) of this paragraph, the 
proceeds of the retirement are added to the depreciation reserve as of 
the beginning of the fifth year. Accordingly, the reserve as of the 
beginning of the fifth year is $700, that is, $400 of depreciation as of 
the beginning of the year plus $300 proceeds from ordinary retirements. 
The depreciation allowance for the fifth year is $100, that is \1/10\ 
multiplied by the unadjusted basis of $1,000, without reduction for 
salvage. Accordingly, the depreciation reserve at the end of the fifth 
year is $800.
    (c) In the sixth year, asset X is sold in an extraordinary 
retirement for $30 and gain or loss is recognized. Under the first-year 
convention used by the taxpayer, the unadjusted basis of X, $300, is 
removed from the unadjusted basis of the vintage account as of the 
beginning of the sixth year and the depreciation reserve as of the 
beginning of such year is reduced to $650 by removing the depreciation 
applicable to asset X, $150 (see subparagraph (3)(iv) of this 
paragraph). Since the depreciation reserve ($650) exceeds the unadjusted 
basis of the account ($700) minus salvage value ($100) by $50, under 
subparagraph (3)(iii) of this paragraph, salvage value is reduced by 
$50. No depreciation is allowable for the sixth year.
    (d) In the seventh year, an asset is sold in an ordinary retirement 
for $110. This would increase the reserve as of the beginning of the 
seventh year to $760 and under subparagraph (3)(iii) of this paragraph 
the salvage value is reduced to zero. Under subparagraph (3)(ix)(a) of 
this paragraph the depreciation reserve is then decreased to $700 (the 
unadjusted basis of the account) and $60 is reported as gain, without 
regard to the adjusted basis of the asset. No depreciation is allowable 
for the seventh year since the depreciation reserve ($700) equals the 
unadjusted basis of the account ($700).
    (e)(1) In the eighth year, A elects to apply this section and to 
treat expenditures during the year for repair, maintenance, 
rehabilitation or improvement under subparagraph (2)(iii) and (iv)(a) of 
this paragraph (the ``guideline class repair allowance''). This results 
in the treatment of $300 as a property improvement for the asset 
guideline class. (See subparagraph (2)(vii) of this paragraph for 
definition of a property improvement.) The property improvement is 
capitalized in a special basis vintage account of the eighth taxable 
year (see subparagraph (2)(viii)(a) of this paragraph). A selects an 
asset depreciation period of 10 years and adopts the straight line 
method for the special basis vintage account. A adopts the modified 
half-year convention for the eighth year.
    (2) In the eighth year, A sells asset Y in an ordinary retirement 
for $175. Under paragraph (c)(1)(ii) of this section and subparagraph 
(3)(iii) of this paragraph, $175 is added to the depreciation reserve 
for the account as of the beginning of the taxable year. Since the 
depreciation reserve for the account ($875) exceeds the unadjusted basis 
of the account ($700) by $175, that amount of gain is recognized under 
subparagraph (3)(ix) of this paragraph. Upon recognition of gain in the 
amount of $175, the depreciation reserve for the account is reduced to 
$700.
    (3) No depreciation is allowable in the eighth year for the vintage 
account since the depreciation reserve ($700) equals the unadjusted 
basis of the account ($700). The depreciation allowable in the eighth 
year for the special basis vintage account is $15, that is, unadjusted 
basis of $300, multiplied by \1/10\, the asset depreciation period 
selected for the special basis vintage account, but limited to $15 under 
the modified half-year convention. (See paragraph (e)(1)(iv) of this 
section for treatment of $150 of the property improvement as first 
placed in service in the first half of the taxable year and $150 of the 
property improvement as first placed in service in the last half of the 
taxable year.)
    Example 2. Taxpayer B has a 1971 multiple asset vintage account for 
section 1245 property with an unadjusted basis of $100,000. B selects 
from the asset depreciation range an asset depreciation period of 10 
years and adopts the straight line method of depreciation and the 
modified half-year convention. B establishes a salvage value for the 
account of $10,000. All the assets in the account are first placed in 
service on January 15, 1971. B follows the practice of reducing salvage 
value for the account as ordinary retirements occur in accordance with 
subparagraph (3)(vii) of this paragraph, but does not follow the 
optional practice of determining the basis of assets transferred to 
supplies or scrap in accordance with subparagraph (3)(vii) of this 
paragraph. No retirements

[[Page 428]]

occur during the first five years. The depreciation reserve at the 
beginning of the sixth year is $50,000. In the sixth year an asset with 
an unadjusted basis of $20,000 is transferred to supplies in an ordinary 
retirement. By application of subparagraph (3)(vii) (c) and (d)(2) of 
this paragraph B determines the reduction in salvage value for the 
account attributable to such asset to be $2,000 (that is, $20,000 / 
$100,000 x $10,000 = $2,000).

B reduces the salvage value for the account by $2,000 and adds 2,000 to 
the depreciation reserve for the account. The basis of the retired asset 
in the supplies account is $2,000. The depreciation allowable for the 
account for the sixth year is $10,000. The depreciation reserve for the 
account at the beginning of the seventh year is $62,000. At the mid-
point of the seventh year all the remaining assets in the account are 
sold in an ordinary retirement for $20,000, which is added to the 
depreciation reserve as of the beginning of the seventh year, thus 
increasing the reserve to $82,000. The $5,000 depreciation allowable for 
the account for the seventh year (one-half of a full-year's depreciation 
of $10,000) increases the depreciation reserve to $87,000. Under 
subparagraph (3)(ix)(b) of this paragraph, a loss of $13,000 subject to 
section 1231 is realized in the seventh year (that is, the excess of the 
unadjusted basis of $100,000 over the depreciation reserve of $87,000). 
No depreciation is allowable for the account after the mid-point of the 
seventh year since all the assets are retired and the account has 
terminated.

    (e) Accounting for eligible property--(1) Definition of first placed 
in service--(i) In general. The term ``first placed in service'' refers 
to the time the property is first placed in service by the taxpayer, not 
to the first time the property is placed in service. Property is first 
placed in service when first placed in a condition or state of readiness 
and availability for a specifically assigned function, whether in a 
trade or business, in the production of income, in a tax-exempt 
activity, or in a personal activity. In general, the provisions of 
paragraph (d)(1)(ii) and (d)(2) of Sec.  1.46-3 shall apply for the 
purpose of determining the date on which property is placed in service, 
but see subdivision (ii) of this subparagraph for special rule for 
certain replacement parts. In the case of a building which is intended 
to house machinery and equipment and which is constructed, 
reconstructed, or erected by or for the taxpayer and for the taxpayer's 
use, the building will ordinarily be placed in service on the date such 
construction, reconstruction, or erection is substantially complete and 
the building is in a condition or state of readiness and availability. 
Thus, for example, in the case of a factory building, such readiness and 
availability shall be determined without regard to whether the machinery 
or equipment which the building houses, or is intended to house, has 
been placed in service. However, in an appropriate case, as for example 
where the building is essentially an item of machinery or equipment, or 
the use of the building is so closely related to the use of the 
machinery or equipment that it clearly can be expected to be replaced or 
retired when the property it initially houses is replaced or retired, 
the determination of readiness or availability of the building shall be 
made by taking into account the readiness and availability of such 
machinery or equipment. The date on which depreciation begins under a 
convention used by the taxpayer or under a particular method of 
depreciation, such as the unit of production method or the retirement 
method, shall not determine the date on which the property is first 
placed in service. See paragraph (c)(2) of this section for application 
of a first-year convention to determine the allowance for depreciation 
of property in a vintage account.
    (ii) Certain replacement parts. Property (such as replacement parts) 
the cost or other basis of which is deducted as a repair expense in 
accordance with the asset guideline repair allowance described in 
paragraph (d)(2)(iii) of this section shall not be treated as placed in 
service.
    (iii) Property improvements and excluded additions. (a) Except as 
provided in (b) of this subdivision, a property improvement determined 
under paragraph (d)(2)(vii)(b) of this section, and an excluded addition 
(other than an excluded addition referred to in the succeeding sentence) 
is first placed in service when its cost is paid or incurred. The 
general rule in subdivision (i) of this subparagraph applies to an 
excluded addition described in paragraph (d) (2)(vi) (d), (e), (f), or 
(g) of this section.
    (b) If a property improvement or an excluded addition to which the 
first

[[Page 429]]

sentence of (a) of this subdivision applies is paid or incurred in part 
in one taxable year and in part in the succeeding taxable year (or in 
part in the first half of a taxable year and in part in the last half of 
the taxable year) the taxpayer may at his option consistently treat such 
property improvements and excluded additions under the general rule in 
subdivision (i) of this subparagraph.
    (iv) Certain property improvements. In the case of an amount of 
property improvement determined under paragraph (d)(2)(vii)(a) of this 
section, one-half of such amount is first placed in service in the first 
half of the taxable year in which the cost is paid or incurred and one-
half is first placed in service in the last half of such taxable year.
    (v) Special rules for clearing accounts. In the case of public 
utilities which consistently account for certain property through 
``clearing accounts,'' the date on which such property is first placed 
in service shall be determined in accordance with rules to be prescribed 
by the Commissioner.
    (2) Special rules for transferred property. If eligible property is 
first placed in service by the taxpayer during a taxable year of 
election, and the property is disposed of before the end of the taxable 
year, the election for such taxable year shall include such property 
unless such property is excluded in accordance with paragraph (b)(5) 
(iii), (iv, (v), (vi), or (vii) of this section.
    (3) Special rules in the case of certain transfers--(i) Transaction 
to which section 381(a) applies. (a) In general the acquiring 
corporation in a transaction to which section 381(a) applies is for the 
purposes of this section treated as if it were the distributor or 
transferor corporation.
    (b) If the distributor or transferor corporation (including any 
distributor or transferor corporation of any distributor or transferor 
corporation) has made an election to apply this section to eligible 
property transferred in a transaction to which section 381(a) applies, 
the acquiring corporation must segregate such eligible property (to 
which the distributor or transferor corporation elected to apply this 
section) into vintage accounts as nearly coextensive as possible with 
the vintage accounts created by the distributor or transferor 
corporation identified by reference to the year the property was first 
placed in service by the distributor or transferor corporation. The 
asset depreciation period for the vintage account in the hands of the 
distributor or transferor corporation must be used by the acquiring 
corporation. The method of depreciation adopted by the distributor or 
transferor corporation, shall be used by the acquiring corporation 
unless such corporation obtains the consent of the Commissioner to use 
another method of depreciation in accordance with paragraph (e) of Sec.  
1.446-1 or changes the method of depreciation under paragraph 
(c)(1)(iii) of this section.
    (c) The acquiring corporation may apply this section to the property 
so acquired only if the distributor or transferor corporation elected to 
apply this section to such property.
    (d) See paragraph (b)(7) of this section for special rule for 
certain property where there is a mere change in the form of conducting 
a trade or business.
    (ii) Partnerships, trusts, estates, donees, and corporations. Except 
as provided in subdivision (i) of this subparagraph with respect to 
transactions to which section 381(a) applies and subdivision (iv) of 
this subparagraph with respect to certain transfers between members of 
an affiliated group of corporations or other related parties, if 
eligible property is placed in service by an individual, trust, estate, 
partnership or corporation, the election to apply this section shall be 
made by the individual, trust, estate, partnership or corporation 
placing such property in service. For example, if a partnership places 
in service property contributed to the partnership by a partner, the 
partnership may elect to apply this section to such property. If the 
partnership does not make the election, this section will not apply to 
such property. See paragraph (b)(7) of this section for special rule for 
certain property where there is mere change in the form of conducting a 
trade or business.
    (iii) Leased property. The asset depreciation range and the asset 
depreciation period for eligible property subject

[[Page 430]]

to a lease shall be determined without regard to the period for which 
such property is leased, including any extensions or renewals of such 
period. See paragraph (b)(5)(v) of this section for exclusion of 
property amortized under paragraph (b) of Sec.  1.162-11 from an 
election to apply this section. In the case of a lessor of property, 
unless there is an asset guideline class in effect for lessors of such 
property, the asset guideline class for such property shall be 
determined as if the property were owned by the lessee. However, in the 
case of an asset guideline class based upon the type of property (such 
as trucks or railroad cars) as distinguished from the activity in which 
used, the property shall be classified without regard to the activity of 
the lessee. Notwithstanding the preceding sentence, if a lease with 
respect to property, which would be includible in an asset guideline 
class based upon the type of property under the preceding sentence (such 
as trucks or railroad cars), is entered into after March 12, 1971, and 
before April 23, 1973, or a written contract to execute such a lease is 
entered into during such period and such contract is binding on April 
23, 1973, and at all times thereafter, and if the rent or rate of return 
is based on a classification of such property as if it were owned by the 
lessee, then such property shall be classified as if it were owned by 
the lessee. However, the preceding sentence shall not apply if pursuant 
to the terms or conditions of the lease or binding contract the rent or 
rate of return may be adjusted to take account of a change in the period 
for depreciation with respect to the property resulting from inclusion 
of the property in an asset guideline class based upon the type of 
property rather than in an asset guideline class based upon the activity 
of the lessee. Similarly, where the terms of such a lease or contract 
provide that the obligation of the taxpayer to enter into the lease is 
subject to a condition that the property be included in an asset 
guideline class based upon the activity of the lessee, the contract or 
lease will not be considered as binding upon the taxpayer, for purposes 
of this subdivision. See paragraph (b)(4)(iii)(b) of this section for 
general rule for classification of property according to primary use.
    (iv) Treatment of certain transfers between members of affiliated 
groups or other related persons. If section 38 property in an asset 
guideline class (determined without regard to whether the taxpayer 
elects to apply this section) is transferred by the taxpayer to a person 
who bears a relationship described in section 179(d)(2) (A) or (B), such 
property is in the same asset guideline class in the hands of 
transferee, and the transfer is neither described in section 381(a) nor 
treated as a disposition or cessation within the meaning of section 47, 
then the asset guideline period for such property selected by the 
taxpayer under this section shall not be shorter than the period used 
for computing the qualified investment with respect to the property 
under section 46(c). In a case in which the asset depreciation range for 
the asset guideline class which includes such property does not include 
the period for depreciation used by the transferor in computing the 
qualified investment with respect to such property, the transferee will 
not be permitted to include such property in an election under this 
section. However, in such a case, the transferor of the property may 
recompute the qualified investment for the year the property was placed 
in service using a period for depreciation which falls within the asset 
depreciation range.
    (f) Election with respect to eligible property--(1) Time and manner 
of election--(i) In general. An election to apply this section to 
eligible property shall be made with the income tax return filed for the 
taxable year in which the property is first placed in service (see 
paragraph (e)(1) of this section) by the taxpayer. In the case of an 
affiliated group of corporations (as defined in section 1504(a)) which 
makes a consolidated return with respect to income tax in accordance 
with section 1502 and the regulations thereunder, each corporation which 
joins in the making of such return may elect to apply this section for a 
taxable year. An election to compute the allowance for depreciation 
under this section is a method of accounting but the consent of the 
Commissioner

[[Page 431]]

will be deemed granted to make an annual election. For election by a 
partnership see section 703 (b) and paragraph (e)(3)(ii) of this 
section. If the taxpayer does not file a timely return (taking into 
account extensions of the time for filing) for the taxable year in which 
the property is first placed in service, the election shall be filed at 
the time the taxpayer files his first return for that year. The election 
may be made with an amended return filed within the time prescribed by 
law (including extensions) for filing the original return for the 
taxable year of election. If an election is not made within the time and 
in the manner prescribed in this paragraph, no election may be made for 
such taxable year (by the filing of an amended return or in any other 
manner) with respect to any eligible property placed in service in the 
taxable year.
    (ii) Other elections under this section. All other elections under 
this section may be made only within the time and in the manner 
prescribed by subdivision (i) of this subparagraph with respect to an 
election to apply this section.
    (iii) Effective date. See paragraph (f)(6) of this section for the 
effective date of this paragraph.
    (2) Information required. A taxpayer who elects to apply this 
section must specify in the election:
    (i) That the taxpayer makes such election and consents to and agrees 
to apply, all the provisions of this section;
    (ii) The asset guideline class for each vintage account of the 
taxable year;
    (iii) The first-year convention adopted by the taxpayer for the 
taxable year of election;
    (iv) Whether the special 10 percent used property rule described in 
paragraph (b)(5)(iii) of this section has been applied to exclude used 
property from the election;
    (v) Whether the taxpayer elects to apply the asset guideline class 
repair allowance described in paragraph (d)(2)(iii) of this section;
    (vi) Whether the taxpayer elects for the taxable year to allocate 
the adjusted basis of a special basis vintage account in accordance with 
paragraph (d)(3)(vi) of this section;
    (vii) Whether any eligible property for which the taxpayer was not 
required or permitted to make an election was excluded because of the 
special rules of paragraph (b)(5)(v) or (6), or paragraph (e)(3)(i) or 
(iv) of this section;
    (viii) Whether any ``section 38 property'' was excluded under 
paragraph (b)(5)(iv) of this section from the election to apply this 
section;
    (ix) If the taxpayer is an electric or gas utility, whether the 
taxpayer elects to apply this section on the basis of a composite asset 
guideline class in accordance with paragraph (b)(4)(iii)(a) of this 
section; and
    (x) Such other information as may reasonably be required.

The information required under this subparagraph may be provided in 
accordance with rules prescribed by the Commissioner for reasonable 
grouping of assets or accounts. Form 4832 is provided for making an 
election and for submission of the information required. An election may 
be made and the information submitted only in accordance with Form 4832. 
An election to apply this section will not be rendered invalid under 
this subparagraph so long as there is substantial compliance, in good 
faith, with the requirements of this subparagraph.
    (3) Irrevocable election. An election to apply this section to 
eligible property for any taxable year may not be revoked or changed 
after the time for filing the election prescribed under subparagraph (1) 
of this paragraph has expired. No other election under this section may 
be revoked or changed after such time unless expressly provided for 
under this section. (See paragraph (b)(5)(v)(b) of this section for 
special rule.)
    (4) Special conditions to election to apply this section--(i) 
Maintenance of books and records. The taxpayer may not elect to apply 
this section for a taxable year unless the taxpayer maintains the books 
and records required under this section. In addition to any other 
information required under this section, the taxpayer's books and 
records must specify--
    (a) The asset depreciation period selected by the taxpayer for each 
vintage account;

[[Page 432]]

    (b) If the taxpayer applies the modified half-year convention, the 
total cost or other basis of all eligible property first placed in 
service in the first half of the taxable year and the total cost or 
other basis of all eligible property first placed in service in the last 
half of the taxable year;
    (c) The unadjusted basis and salvage value for each vintage account, 
and the amount, if any, by which gross salvage value was decreased under 
section 167 (f);
    (d) Each asset guideline class for which the taxpayer elects to 
apply the asset guideline class repair allowance described in paragraph 
(d)(2)(iii) of this section;
    (e) The amount of property improvement, determined under paragraph 
(d)(2)(vii)(a) of this section, for each asset guideline class for which 
the taxpayer elects to apply the asset guideline class repair allowance;
    (f) A reasonable description of property excluded from an election 
to apply this section and the basis for the exclusion;
    (g) The total unadjusted basis of all assets retired during the 
taxable year from each asset guideline class, and the proceeds realized 
during the taxable year from such retirements; and
    (h) The vintage (that is, the taxable year in which established) of 
the assets retired during the year from each asset guideline class.

For purposes of paragraph (f)(4)(i) (g) and (h) of this section, all 
accounts of the same vintage and asset guideline class may be treated as 
a single account. The taxpayer must specify the information required 
under paragraph (f)(4)(i) (g) and (h) without regard to the retirement 
of an asset by transfer to a supplies account for reuse.
    (ii) Response to survey. Taxpayers who elect to apply this section 
must respond to infrequent data surveys conducted by the Treasury 
Department. These periodic surveys, which will be conducted on the basis 
of scientifically sound sampling methods, are designed to obtain data 
(including industry asset acquisitions and retirements) used to keep the 
asset guideline classes and periods up to date.
    (iii) Effect of noncompliance. An election to apply this section 
will not be rendered invalid under this subparagraph so long as there is 
substantial compliance, in good faith, with the requirements of this 
subparagraph.
    (5) Mass assets. In the case of mass assets, if the taxpayer assigns 
retirements to vintage accounts in the manner provided in paragraph 
(d)(3)(v)(c) of this section, the following information must be supplied 
with form 4832:
    (i) Whether the taxpayer used the standard mortality dispersion 
curve or a curve based upon his own experience, and
    (ii) Such other reasonable information as may be required by the 
Commissioner.
    (6) Effective date. The rules in this paragraph apply to elections 
for taxable years ending on or after December 31, 1978. In the case of 
an election for a taxable year ending before December 31, 1978, the 
rules in paragraph (f) of this section, in effect before the amendments 
made by T.D. 7593 approved January 11, 1979, shall apply. See 26 CFR 
Sec.  1.167(a)-11(f) (1977) for paragraph (f) of this section as it 
appeared before the amendments made by T.D. 7593.
    (g) Relationship to other provisions--(1) Useful life--(i) In 
general. Except as provided in subdivision (ii) of this subparagraph, an 
election to apply this section to eligible property constitutes an 
agreement under section 167(d) and this section to treat the asset 
depreciation period for each vintage account as the useful life of the 
property in such account for all purposes of the Code, including 
sections 46, 47, 48, 57, 163(d), 167(c), 167(f)(2), 179, 312(m), 514(a), 
and 4940(c). For example, since section 167(c) requires a useful life of 
at least 3 years and the asset depreciation period selected is treated 
as the useful life for purposes of section 167(c), the taxpayer may 
adopt a method of depreciation described in section 167(b) (2) or (3) 
for an account only if the asset depreciation period selected for the 
account is at least 3 years.
    (ii) Special rules. (a) For the purposes of paragraph (d) of this 
section, the anticipated period of use (estimated at the close of the 
taxable year in which the asset is first placed in service) on

[[Page 433]]

the basis of which salvage value is estimated, shall be determined 
without regard to the asset depreciation period for the property.
    (b) For the purposes of sections 162 and 263 and the regulations 
thereunder, whether an expenditure prolongs the life of an asset shall 
be determined on the basis of the anticipated period of use of the asset 
(estimated at the close of the taxable year in which the asset is first 
placed in service) without regard to the asset depreciation period for 
such asset.
    (c) The determination whether a transaction with respect to 
qualified property constitutes a sale or a lease of such property shall 
be made without regard to the asset depreciation period for the 
property.
    (d) The principles of this subdivision may be illustrated by the 
following example:

    Example. Corporation X has assets in asset guideline class 32.3 
which are used in the manufacture of stone and clay products. The asset 
depreciation range for assets in asset guideline class 32.3 is from 12 
to 18 years. Assume that corporation X selects 14 years as the asset 
depreciation period for all assets in asset guideline class 32.3. Under 
paragraph (d)(1)(i) of this section, corporation X must estimate salvage 
value on the basis of the anticipated period of use of the property 
(determined as of the close of the taxable year in which the property is 
first placed in service). The anticipated period of use must also be 
used for purposes of sections 162 and 263 in determining whether an 
expenditure materially prolongs the useful life of an asset. The 
anticipated period of use of an asset is determined without regard to 
the asset depreciation period of 14 years. Corporation X has, among 
other assets in the asset guideline class, machines A, B, and C. 
Corporation X estimates the anticipated period of use of machines A, B, 
and C as 8 years, 14 years, and 22 years, respectively. These estimates 
are reasonable and will be used for estimating salvage value and for 
purposes of sections 162 and 263.

    (2) Section 167(d) agreements. If the taxpayer has, prior to January 
1, 1971, entered into a section 167(d) agreement which applies to any 
eligible property, the taxpayer will be permitted to withdraw the 
eligible property from the agreement provided that an election is made 
to apply this section to such property. The statement of intent to 
withdraw eligible property from such an agreement must be made in an 
election filed for the taxable year in which the property is first 
placed in service. The withdrawal, in accordance with this subparagraph, 
of any eligible property from a section 167(d) agreement shall not 
affect any other property covered by such an agreement.
    (3) Relationship to the straight line method--(i) In general. For 
purposes of determining the amount of depreciation which would be 
allowable under the straight line method of depreciation, such amount 
shall be computed with respect to any property in a vintage account 
using the straight line method in the manner described in paragraph 
(c)(1)(i) of this section and a rate based upon the period for the 
vintage account selected from the asset depreciation range. Thus, for 
example, section 57(a)(3) requires a taxpayer to compute an amount using 
the straight line method of depreciation if the taxpayer uses an 
accelerated method of depreciation. For purposes of section 57(a)(3), 
the amount for property in a vintage account shall be computed using the 
asset depreciation period for the vintage account selected from the 
asset depreciation range. In the case of property to which the taxpayer 
does not elect to apply this section, such amount computed by using the 
straight line method shall be determined under Sec.  1.167(b)-1 without 
regard to this section.
    (ii) Examples. The principles of this subparagraph may be 
illustrated by the following example:

    Example. (a) Corporation X places a new asset in service to which it 
elects to apply this section. The cost of the asset is $200,000 and the 
estimated salvage value is zero. The taxpayer selects 9 years from the 
applicable asset depreciation range of 8 to 12 years. Corporation X 
adopts the double declining balance method of depreciation and thus the 
rate of depreciation is 22.2 percent (twice the applicable straight line 
rate). The depreciation allowance in the first year would be $44,400, 
that is, 22.2 percent of $200,000.
    (b) Assume that the provisions of section 57(a)(3) apply to the 
property. The amount of the tax preference would be $22,200, that is, 
the excess of the depreciation allowed under this section ($44,400) over 
the depreciation which would have been allowable if the taxpayer had 
used the period selected from the

[[Page 434]]

asset depreciation range and the straight line rate ($22,200).

(Secs. 167(m), 85 Stat. 508 (26 U.S.C. 167(m) and 7805, 68A Stat. 917, 
(26 U.S.C. 7805))

[T.D. 7272, 38 FR 9967, Apr. 23, 1973]

    Editorial Note: For Federal Register citations affecting Sec.  
1.167(a)-11, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.



Sec.  1.167(a)-12  Depreciation based on class lives for property 
first placed in service before January 1, 1971.

    (a) In general--(1) Summary. This section provides an elective class 
life system for determining the reasonable allowance for depreciation of 
certain classes of assets for taxable years ending after December 31, 
1970. The system applies only to assets placed in service before January 
1, 1971. Depreciation for such assets during periods prior to January 1, 
1971, may have been determined in accordance with Revenue Procedure 62-
21. Accordingly, rules are provided which permit taxpayers to apply the 
system in taxable years ending after December 31, 1970, to such assets 
without the necessity of changing or regrouping their depreciation 
accounts other than as previously required by Revenue Procedure 62-21. 
The system is designed to minimize disputes between taxpayers and the 
Internal Revenue Service as to the useful life of assets, salvage value, 
and repairs. See Sec.  1.167(a)-11 for a similar system for property 
placed in service after December 31, 1970. See paragraph (d)(2) of Sec.  
1.167(a)-11 for treatment of expenditures for the repair, maintenance, 
rehabilitation or improvement of certain property. The system provided 
by this section is optional with the taxpayer. An election under this 
section applies only to qualified property in an asset guideline class 
for which an election is made and only for the taxable year of election. 
The taxpayer's election is made with the income tax return for the 
taxable year. This section also revokes the reserve ratio test for 
taxable years ending after December 31, 1970, and provides transitional 
rules for taxpayers who after January 11, 1971, adopt Revenue Procedure 
62-21 for a taxable year ending prior to January 1, 1971.
    (2) Revocation of reserve ratio test and other matters. Except as 
otherwise expressly provided in this section and in paragraph (b)(5)(vi) 
of Sec.  1.167(a)-11, the provisions of Revenue Procedure 62-21 shall 
not apply to any property for any taxable year ending after December 31, 
1970, whether or not the taxpayer elects to apply this section to any 
property. See paragraph (f) of this section for rules for the adoption 
of Revenue Procedure 62-21 for taxable years ending prior to January 1, 
1971.
    (3) Definition of qualified property. The term ``qualified 
property'' means tangible property which is subject to the allowance for 
depreciation provided by section 167(a), but only if--
    (i) An asset guideline class and asset guideline period are in 
effect for such property for the taxable year, and
    (ii) The property is first placed in service by the taxpayer before 
January 1, 1971,
    (iii) The property is placed in service before January 1, 1971, but 
first placed in service by the taxpayer after December 31, 1970, and is 
not includible in an election under Sec.  1.167(a)-11 by reason of Sec.  
1.167(a)-11(b)(7) (property acquired as a result of a mere change in 
form) or Sec.  1.167(a)-11(e)(3)(i) (certain property acquired in a 
transaction to which section 381(a) applies), or
    (iv) The property is acquired and first placed in service by the 
taxpayer after December 31, 1970, pursuant to a binding written contract 
entered into prior to January 1, 1971, and is excluded in accordance 
with paragraph (b)(5)(iv) of Sec.  1.167(a)-11 from an election to apply 
Sec.  1.167(a)-11.

The provisions of paragraph (e)(1) of Sec.  1.167(a)-11 apply in 
determining whether property is first placed in service before January 
1, 1971. See subparagraph (4)(ii) of this paragraph for special rules 
for the exclusion of property from the definition of qualified property.
    (4) Requirements of election--(i) In general. An election to apply 
this section to qualified property must be made within the time and in 
the manner specified in paragraph (e) of this section. The election must 
specify that the taxpayer consents to and agrees to apply all the 
provisions of this section. The election may be made separately

[[Page 435]]

for each asset guideline class. Thus, a taxpayer may for the taxable 
year elect to apply this section to one, more than one, or all asset 
guideline classes in which he has qualified property. An election to 
apply this section for a taxable year must include all qualified 
property in the asset guideline class for which the election is made.
    (ii) Special rules for exclusion of property from application of 
this section. (a) If for the taxable year of election, the taxpayer 
computes depreciation under section 167(k) or computes amortization 
under sections 169, 185, 187, 188, or paragraph (b) of Sec.  1.162-11 
with respect to property, such property is not qualified property for 
such taxable year. If for the taxable year of election, the taxpayer 
computes depreciation under any method of depreciation (other than a 
method described in the preceding sentence) not permitted by 
subparagraph (5)(v) of this paragraph for any property in an asset 
guideline class (other than subsidiary assets excluded from an election 
under (b) of this subdivision), no property in such asset guideline 
class is qualified property for such taxable year.
    (b) The taxpayer may exclude from an election to apply this section 
all (but not less than all) subsidiary assets. Subsidiary assets so 
excluded are not qualified property for such taxable year. For purposes 
of this subdivision the term ``subsidiary assets'' includes jigs, dies, 
molds, returnable containers, glassware, silverware, textile mill cam 
assemblies, and other equipment includable in Group One, Class 5, of 
Revenue Procedure 62-21 which is usually and properly accounted for 
separately from other property and under a method of depreciation not 
expressed in terms of years.
    (iii) Special rule for certain public utility property. (a) In the 
case of public utility property described in section 167(1)(3)(A)(iii) 
for which no guideline life was prescribed in Revenue Procedure 62-21 
(or for which reference was made in Revenue Procedure 62-21 to lives or 
rates established by governmental regulatory agencies) of a taxpayer 
which--
    (1) Is entitled to use a method of depreciation other than a 
``subsection (1) method'' of depreciation (as defined in section 
167(1)(3)(F)) only if it uses the ``normalization method of accounting'' 
(as defined in section 167(1)(3)(G)) with respect to such property, or
    (2) Is entitled for the taxable year to use only a ``subsection (1) 
method'' of depreciation, such property shall be qualified property (as 
defined in subparagraph (3) of this paragraph) only if the taxpayer 
normalizes the tax deferral resulting from the election to apply this 
section.
    (b) The taxpayer will be considered to normalize the tax deferral 
resulting from the election to apply this section only if it computes 
its tax expense for purposes of establishing its cost of service for 
ratemaking purposes and for reflecting operating results in its 
regulated books of account using a period for depreciation no less than 
the period used for computing its depreciation expense for ratemaking 
purposes and for reflecting operating results in its regulated books of 
account for the taxable year, and the taxpayer makes adjustments to a 
reserve to reflect the deferral of taxes resulting from the use of a 
period for depreciation under section 167 in accordance with an election 
to apply this section different from the period used for computing its 
depreciation expense for ratemaking purposes and for reflecting 
operating results in its regulated books of account for the taxable 
year. A determination whether the taxpayer is considered to normalize 
under this subdivision the tax deferral resulting from the election to 
apply this section shall be made in a manner consistent with the 
principles for determining whether a taxpayer is using the 
``normalization method of accounting'' (within the meaning of section 
167(1)(3)(G)). See Sec.  1.167(l)-1(h).
    (c) If a taxpayer, which has elected to apply this section to any 
qualified public utility property and is required under (a) of this 
subdivision to normalize the tax deferral resulting from the election to 
apply this section to such property, fails to normalize such tax 
deferral, the election to apply this section to such property shall 
terminate as of the beginning of the taxable year for which the taxpayer 
fails to normalize such tax deferral. Application of this section to 
such property for any period prior to the termination

[[Page 436]]

date will not be affected by this termination.
    (5) Determination of reasonable allowance for depreciation--(i) In 
general. The allowance for depreciation of qualified property to which 
the taxpayer elects to apply this section shall be determined in 
accordance with this section. The annual allowance for depreciation is 
determined by using the method of depreciation adopted by the taxpayer 
and a rate based upon a life permitted by this section. In the case of 
the straight-line method of depreciation, the rate of depreciation shall 
be based upon the class life (or individual life if the taxpayer assigns 
individual depreciable lives in accordance with subdivision (iii) of 
this subparagraph) used by the taxpayer with respect to the assets in 
the asset guideline class. Such rate will be applied to the unadjusted 
basis of the asset guideline class (individual assets or depreciation 
accounts if the taxpayer assigns individual depreciable lives). In the 
case of the sum of the years-digits method of depreciation, the rate of 
depreciation will be determined based upon the remaining life of the 
class (or individual remaining lives if the taxpayer assigns such lives 
in accordance with subdivision (iii) of this subparagraph) and is 
applied to the adjusted basis of the class (or individual accounts or 
assets) as of the beginning of the taxable year of election. The 
remaining life of a depreciation account is determined by dividing the 
unrecovered cost or other basis of the account, as computed by straight-
line depreciation, by the gross cost or unadjusted basis of the account, 
and multiplying the result by the class life used with respect to the 
account. In the case of the declining balance method of depreciation, 
the rate of depreciation for the asset guideline class shall be based 
upon the class life (or individual life if the taxpayer assigns such 
lives in accordance with subdivision (iii) of this subparagraph). Such 
rate is applied to the adjusted basis of the class (or individual 
accounts or assets) as of the beginning of the taxable year of election.
    (ii) Reasonable allowance by reference to class lives. The amount of 
depreciation for all qualified property in an asset guideline class to 
which the taxpayer elects to apply this section will constitute the 
reasonable allowance provided by section 167(a) and the depreciation for 
the asset guideline class will not be adjusted if--
    (a) The taxpayer's qualified property is accounted for in one or 
more depreciation accounts which conform to the asset guideline class, 
and the depreciation for each such account is determined by using a rate 
based upon a life not less than the class life, or
    (b) The taxpayer's qualified property is accounted for in one or 
more depreciation accounts (whether or not conforming to the asset 
guideline class) for which depreciation is determined at a rate based 
upon the taxpayer's estimate of the lives of the assets (instead of the 
class life) and the total amount of depreciation so determined for the 
asset guideline class for the taxable year of election is not more than 
would be permitted under (a) of this subdivision for such year using the 
method of depreciation adopted by the taxpayer for the property.

See subdivision (vii) of this subparagraph for determination of 
reasonable allowance if depreciation exceeds the amount permitted by 
this subdivision. See paragraph (b) of this section for rules regarding 
the determination of ``class life''. For rules for regrouping 
depreciation accounts to conform to the asset guideline class, see 
subdivision (iv) of this subparagraph.
    (iii) Consistency when individual lives are used. If the taxpayer 
assigns individual depreciable lives to assets in accordance with 
subdivision (ii)(b) of this subparagraph, even though the total amount 
of depreciation for the asset guideline class will not be adjusted, the 
lives assigned to the various assets in the asset guideline class must 
be reasonably in proportion to their relative expected periods of use in 
the taxpayer's business. Thus, although the taxpayer who uses individual 
asset lives normally has latitude in thereby allocating the depreciation 
for the asset guideline class among the assets, if the lives are grossly 
disproportionate (as where a short life is assigned to one asset and a 
long life to another even though the expected periods of use are the 
same), the taxpayer's allocation of

[[Page 437]]

depreciation to particular assets or depreciation accounts may be 
adjusted. For example, the taxpayer's allocation may be adjusted for 
purposes of determining adjusted basis under section 1016(a) or in 
allocating depreciation to the 50-percent limitation on percentage 
depletion provided by section 613(a). See paragraph (d) of this section 
for rules regarding the use of individual asset lives for purposes of 
classifying retirements as normal or abnormal.
    (iv) Regrouping depreciation accounts. Without the consent of the 
Commissioner, the taxpayer may for any taxable year for which he elects 
to apply this section to an asset guideline class, regroup his accounts 
for that and all succeeding taxable years to conform to the asset 
guideline class. Other changes in accounting, including a change from 
item accounts to multiple-asset accounting, may be made with the consent 
of the Commissioner. No depreciation accounts for which the straight 
line or sum of the years-digits method of depreciation is adopted may be 
combined under this section which would not be permitted to be combined 
under part III of Revenue Procedure 65-13, as in effect on January 1, 
1971. Accordingly, whether or not the taxpayer adopted the guideline 
system of Revenue Procedure 62-21 for a taxable year to which part III 
of Revenue Procedure 65-13 is applicable, the depreciation allowance for 
any taxable year of election under this section may not exceed that 
amount which would have been allowed for such year if the taxpayer had 
used item accounts or year of acquisition accounts. Thus, for example, 
if a calendar year taxpayer acquired a $90 asset on the first day of 
each year from 1966 through 1970, placed such assets in a single 
multiple asset account, adopted the sum of the years-digits method of 
depreciation and used a 5-year depreciable life for such assets, and in 
1971 uses the 5-year class life determined under paragraph (b) of this 
section, the depreciation allowance for such assets in 1971 under this 
section may not exceed $60, that is, the amount which would be allowed 
if the taxpayer had used year of acquisition accounts for the assets for 
the years 1966 through 1970.

For purposes of this subparagraph, a taxpayer's depreciation accounts 
conform to the asset guideline class if each depreciation account 
includes only assets of the same asset guideline class.
    (v) Method of depreciation. The same method of depreciation must be 
applied to all property in a single depreciation account. The method of 
depreciation is subject to the limitations of section 167 (c), (j), and 
(l). Except as otherwise provided in this subdivision, the taxpayer must 
apply a method of depreciation described in section 167(b) (1), (2), or 
(3) for qualified property to which the taxpayer elects to apply this 
section. A method of depreciation permitted under section 167(b)(4) may 
be used under this section if the method was used by the taxpayer with 
respect to the property for his last taxable year ending before January 
1, 1971, the method is expressed in terms of years, the taxpayer 
establishes to the satisfaction of the Commissioner that the method is 
both a reasonable and consistent method, and if the taxpayer applies 
paragraph (b)(2) of this section (relating to class lives in special 
situations) to determine a class life, that the method of determining 
such class life is consistent with the principles of Revenue Procedure 
62-21 as applied to such a method. If the taxpayer has applied a method 
of depreciation with respect to the property which is not described in 
section 167(b) (1), (2), (3), or (4) (as permitted under the preceding 
sentence), he must change under this section to a method of depreciation 
described in section 167(b) (1), (2), or (3) for the first taxable year 
for which an election is made under this section. Other changes in 
depreciation method may be made with the consent of the Commissioner 
(see sec. 446 and the regulations thereunder). (See also sec. 167(e).)
    (vi) Salvage value. In applying the method of depreciation adopted 
by the taxpayer, the annual allowance for depreciation is determined 
without adjustment for the salvage value of the property, except that no 
depreciation account may be depreciated below a reasonable salvage value 
for the account. See paragraph (c) of this section for definition and 
treatment of salvage value.

[[Page 438]]

    (vii) Reasonable allowance when depreciation exceeds amount based on 
class life. In the event that the total amount of depreciation claimed 
by the taxpayer on his income tax return, in a claim for refund, or 
otherwise, for an asset guideline class with respect to which an 
election is made under this section for the taxable year, exceeds the 
maximum amount permitted under subdivision (ii)(a) of this 
subparagraph--
    (a) If the excess is established to the satisfaction of the 
Commissioner to be the result of a good faith mistake by the taxpayer in 
determining the maximum amount permitted under subdivision (ii) (a) of 
this subparagraph, the taxpayer's election to apply this section will be 
treated as valid and only such excess will be disallowed, and
    (b) In all other cases, the taxpayer's election to apply this 
section to the asset guideline class for the taxable year is invalid and 
the reasonable allowance for depreciation will be determined without 
regard to this section. (See Sec.  1.167(a)-1 (b) for rules regarding 
the estimated useful life of property.)
    (b) Determination of class lives--(1) Class lives in general. The 
class life determined under this paragraph (without regard to any range 
or variance permitted with respect to class lives under Sec.  1.167(a)-
11) will be applied for purposes of determining whether the allowance 
for depreciation for qualified property included in an election under 
this section is subject to adjustment. The taxpayer is not required to 
use the class life determined under this paragraph for purposes of 
determining the allowance for depreciation. Except as provided in 
subparagraph (2) of this paragraph, the class life of qualified property 
to which the taxpayer elects to apply this section is the shorter of--
    (i) The asset guideline period for the asset guideline class as set 
forth in Revenue Procedure 72-10 as in effect on March 1, 1972 (applied 
without regard to any special provision therein with respect to property 
predominantly used outside the United States), or
    (ii) The asset guideline period for the asset guideline class as set 
forth in any supplement or revision of Revenue Procedure 72-10, but only 
if and to the extent by express reference in such supplement or revision 
made applicable for the purpose of changing the asset guideline period 
or classification of qualified property to which this section applies.

See paragraph (e)(3)(iii) of this section for requirement that the 
election for the taxable year specify the class life for each asset 
guideline class. Generally, the applicable asset guideline class and 
asset guideline period for qualified property to which the taxpayer has 
elected to apply this section will not be changed for the taxable year 
of election to reflect any supplement or revision thereof after the 
taxable year. However, if expressly provided in such a supplement or 
revision, the taxpayer may, at his option in the manner specified 
therein, apply the revised or supplemented asset guideline classes or 
periods to such property for such taxable year and succeeding taxable 
years. The principles of this subparagraph may be illustrated by the 
following example:

    Example. (i) Corporation X, a calendar year taxpayer, has assets in 
asset guideline class 20.4 of Revenue Procedure 72-10 which were placed 
in service by corporation X in 1967, 1968, and 1970. Corporation X also 
has assets in asset guideline class 22.1 of Revenue Procedure 72-10 
which were placed in service at various times prior to 1971. Corporation 
X has no other qualified property. Corporation X elects to apply this 
section for 1971 to both classes. Assume that the class lives are 
determined under this subparagraph and not under subparagraph (2) of 
this paragraph.
    (ii) The class lives for asset guideline classes 20.4 and 22.1 are 
their respective asset guideline periods of 12 years and 9 years in 
Revenue Procedure 72-10.
    (iii) Accordingly, in the election for the taxable year, in 
accordance with paragraph (e)(3)(iii) of this section, corporation X 
specifies a class life of 12 years for asset guideline class 20.4 and a 
class life of 9 years for asset guideline class 22.1.

    (2) Class lives in special situations. Notwithstanding subparagraph 
(1) of this paragraph, for the purposes of this section the class life 
for the asset guideline class determined under this subparagraph shall 
be used if such class life is shorter than the class life determined 
under subparagraph (1) of this paragraph. If property described in 
paragraph (a)(2)(iii) of this section in an asset guideline class is 
acquired by the taxpayer in a transaction to which section 381(a) 
applies, for purposes of

[[Page 439]]

this subparagraph such property shall be segregated from other property 
in the class and treated as in a separate asset guideline class, and the 
class life for that asset guideline class under this subparagraph shall 
be the shortest class life the transferor was entitled to use under this 
section for such property on the date of such transfer. In all other 
cases, the class life for the asset guideline class for purposes of this 
subparagraph shall be the shortest class life (within the meaning of 
sec. 4, part II, of Revenue Procedure 62-21) which can be justified by 
application of secs. 3.02(a), 3.03(a), or 3.05, part II, of Revenue 
Procedure 62-21 (other than the portion of such sec. 3.05 dealing with 
justification of a class life by reference to facts and circumstances) 
for the taxpayer's last taxable year ending prior to January 1, 1971.

A class life justified by application of section 3.03(a), Part II, of 
Revenue Procedure 62-21 shall not be shorter than can be justified under 
the Adjustment Table for Class Lives in Part III of such Revenue 
Procedure. For purposes of this subparagraph and paragraph (f)(1)(iii) 
of this section, the reserve ratio test is met only if the taxpayer's 
reserve ratio does not exceed the upper limit of the appropriate reserve 
ratio range or in the alternative during the transitional period there 
provided does not exceed the appropriate ``transitional upper limit'' in 
section 3, Part II, of Revenue Procedure 65-13. References to Revenue 
Procedure 62-21 include all morifications, amendments, and supplements 
thereto as of January 1, 1971. The guideline form of the reserve ratio 
test, as described in Revenue Procedure 65-13, may be applied for 
purposes of this subparagraph in a manner consistent with the rules 
contained in section 7, Part II, of Revenue Procedure 65-13 and sections 
3.02, 3.03, and 3.05, Part II, of Revenue Procedure 62-21. The 
principles of this subparagraph may be illustrated by the following 
examples:

    Example 1. Corporation X, a calendar year taxpayer, has all its 
assets in asset guideline class 20.4 of Revenue Procedure 72-10 which 
were placed in service by corporation X prior to 1971. Corporation X 
elects to apply this section for 1971. For taxable years 1967 through 
1969, corporation X had used a class life (within the meaning of section 
4, Part II, of Revenue Procedure 62-21) for asset guideline class 20.4 
of 12 years. The asset guideline period in Revenue Procedure 72-10 in 
effect for 1971 is also 12 years. Assume that for 1969 corporation X's 
reserve ratio was below the appropriate reserve ratio lower limit. 
However, corporation X could not justify a class life shorter than the 
asset guideline period of 12 years for 1970 since corporation X had not 
used the 12-year class life for a period at least equal to one-half of 
12 years. (See section 3.03(a), Part II, of Revenue Procedure 62-21.) 
Accordingly, the class life for asset guideline class 20.4 in 1971 is 
the asset guideline period of 12 years in accordance with subparagraph 
(1) of this paragraph.
    Example 2. The facts are the same as in example (1) except that 
corporation X had used a class life of 10 years for guideline class 20.4 
since 1967. Corporation X had not used the class life of 10 years for a 
period at least equal to one-half of 10 years. However, in 1968 
corporation X's 10-year class life was accepted on audit by the Internal 
Revenue Service and corporation X met the reserve ratio test in 1970 for 
guideline class 20.4 using a test life of 10 years. (See section 3.05, 
Part II, of Revenue Procedure 62-21.) Accordingly, the class life of 10 
years is justified for 1970 and the class life for 1971 is 10 years in 
accordance with this subparagraph. If the taxpayer's class life had not 
been audited and accepted for 1968, and in the absence of other 
circumstances, the taxpayer could not justify a class life shorter than 
the asset guideline period of 12 years since it had not used the 10-year 
class life for a period at least equal to one-half of 10 years. (See 
section 3.02, Part II, of Revenue Procedure 62-21.)
    Example 3. Corporation Y, a calendar year taxpayer, has all its 
assets in asset guideline class 13.3 of Revenue Procedure 72-10 which 
were placed in service from 1960 through 1970. Corporation Y elects to 
apply this section for 1971. The asset guideline period in Revenue 
Procedure 72-10 in effect for 1971 is 16 years. Since 1963 corporation Y 
had used a class life of 16 years for asset guideline 13.3. At the end 
of 1969 corporation Y's reserve ratio for guideline class 13.3 was 36 
percent. With a growth rate of 8 percent and a test life of 16 years the 
appropriate reserve ratio lower limit was 37 percent. Corporation Y's 
reserve ratio of 36 percent was below the lower limit of the appropriate 
reserve ratio range. Corporation Y had used the 16-year class life for 
at least eight years. A class life of 13.5 years for 1970 was justified 
by application of section 3.03(a), Part II, of Revenue Procedure 62-21 
and the Adjustment Table for Class Lives in Part III, of Revenue 
Procedure 62-21. The class life for 1971 is 13.5 years in accordance 
with this subparagraph.


[[Page 440]]


    (3) Classification of property--(i) In general. Property to which 
this section applies shall be included in the asset guideline class for 
the activity in which the property is primarily used in the taxable year 
of election. See paragraph (d)(5) of this section for rule regarding the 
classification of leased property.
    (ii) Insubstantial activity. The provisions of Revenue Produce 62-21 
with respect to classification of assets used in an activity which is 
insubstantial may be applied under this section.
    (iii) Special rule for certain public utilities. An electric or gas 
utility which in accordance with Revenue Procedure 64-21 used a 
composite guideline class basis for applying Revenue Procedure 62-21 for 
its last taxable year prior to January 1, 1971, may apply Revenue 
Procedure 72-10 and this section on the basis of such composite asset 
guideline class determined as provided in Revenue Procedure 64-21. For 
the purposes of this section all property in the composite guideline 
class shall be treated as included in a single asset guideline class.
    (c) Salvage value--(1) In general--(i) Definition of gross salvage 
value. ``Gross salvage'' value is the amount (determined at or as of the 
time of acquisition but without regard to the application of Revenue 
Procedure 62-21) which is estimated will be realized upon a sale or 
other disposition of qualified property when it is no longer useful in 
the taxpayer's trade or business or in the production of his income and 
is to be retired from service, without reduction for the cost of 
removal, dismantling, demolition, or similar operations. ``Net salvage'' 
is gross salvage reduced by the cost of removal, dismantling, 
demolition, or similar operations. If a taxpayer customarily sells or 
otherwise disposes of property at a time when such property is still in 
good operating condition, the gross salvage value of such property is 
the amount expected to be realized upon such sale or disposition, and 
under certain circumstances, as where such property is customarily sold 
at a time when it is still relatively new, the gross salvage value may 
constitute a relatively large proportion of the unadjusted basis of such 
property.
    (ii) Definition of salvage value. ``Salvage value'' for purposes of 
this section means gross or net salvage value less the amount, if any, 
by which reduced by application of section 167(f). Generally, as 
provided in section 167(f), a taxpayer may reduce the gross or net 
salvage value for an account by an amount which does not exceed 10 
percent of the unadjusted basis of the personal property (as defined in 
section 167(f)(2)) in the account.
    (2) Estimation of salvage value--(i) In general. For the first 
taxable year for which he elects to apply this section, the taxpayer 
must (in accordance with paragraph (e)(3)(iv)(c) of this section) 
establish salvage value for all qualified property to which the election 
applies. The taxpayer may (in accordance with subparagraph (1) of this 
paragraph) determine either gross or net salvage, but an election under 
this section does not constitute permission to change the manner of 
estimating salvage. Permission to change the manner of estimating 
salvage must be obtained by filing form 3115 with the Commissioner of 
Internal Revenue, Washington, D.C. 20224, within the time otherwise 
permitted for the taxable year or before September 6, 1973. Salvage 
value in succeeding taxable years of election will be determined by 
adjustments of such initial salvage value for the account, as 
retirements occur. This salvage value established by the taxpayer for 
the first taxable year of election will not be redetermined merely as a 
result of fluctuations in price levels or as a result of other 
circumstances occurring after the close of such taxable year. See 
paragraph (e)(3)(iv) of this section for requirements that the taxpayer 
specify in his election the aggregate amount of salvage value for an 
asset guideline class and that the taxpayer maintain records reasonably 
sufficient to identify the salvage value established for each 
depreciation account in the class.
    (ii) Salvage as limitation on depreciation. In no case may an 
account be depreciated under this section below a reasonable salvage 
value, after taking into account any reduction in gross or net salvage 
value permitted by section 167(f). For example, if the salvage value of 
an account for 1971 is $75, the

[[Page 441]]

unadjusted basis of the account is $500, and the depreciation reserve is 
$425, no depreciation is allowable for 1971.
    (iii) Special rule for first taxable year. If for a taxable year 
ending prior to January 1, 1971, the taxpayer had adopted Revenue 
Procedure 62-21 prior to January 12, 1971 (see paragraph (f)(2) of this 
section), no adjustment in the amount of depreciation allowable for any 
taxable year ending prior to January 1, 1971, shall be made solely by 
reason of establishing salvage value under this paragraph for any 
taxable year ending after December 31, 1970. The principles of this 
subdivision may be illustrated by the following example:

    Example. Taxpayer A had adopted Revenue Procedure 62-21 prior to 
January 12, 1971, for taxable years prior to 1971. Taxpayer A had not 
taken into account any salvage value for account No. 1 which is one of 
four depreciation accounts A has in the class. The reserve ratio test 
has been met for all years prior to 1971 and in accordance with Revenue 
Procedure 62-21 no adjustments in depreciable lives or salvage values 
were made. At the end of A's taxable year 1970, the unadjusted basis of 
account No. 1 was $10,000 and the reserve for depreciation was $9,800. 
Pursuant to this paragraph, A establishes a salvage value of $400 for 
account No. 1 (determined at or as of the time of acquisition). This 
salvage value is determined to be correct. No depreciation is allowable 
for account No. 1 in 1971. No depreciation is disallowed for any taxable 
year prior to 1971, solely by reason of establishing salvage value under 
this paragraph.

    (3) Limitation on adjustment of reasonable salvage value. The 
salvage value established by the taxpayer for a depreciation account 
will not be redetermined if it is reasonable. Since the determination of 
salvage value is a matter of estimation, minimal adjustments will not be 
made. The salvage value established by the taxpayer will be deemed to be 
reasonable unless there is sufficient basis for a determination of an 
amount of salvage value for the account which exceeds the salvage value 
established by the taxpayer for the account by an amount greater than 10 
percent of the unadjusted basis of the account at the close of such 
taxable year. If the salvage value established by the taxpayer for the 
account is not within the 10-percent range or if the taxpayer follows 
the practice of understating his estimates of salvage to take advantage 
of this subdivision, and if there is a determination of an amount of 
salvage value for the account for the taxable year which exceeds the 
salvage value established by the taxpayer for the account for such 
taxable year, an adjustment will be made by increasing the salvage value 
established by the taxpayer for the account by an amount equal to the 
difference between the salvage value as determined and the salvage value 
established by the taxpayer for the account. For the purposes of this 
subdivision, a determination of salvage value shall include all 
determinations at all levels of audit and appellate proceedings, and as 
well as all final determinations within the meaning of section 
1313(a)(1). This subparagraph shall apply to each such determination.
    (4) Examples. The principles of this paragraph may be illustrated by 
the following examples in which it is assumed that the taxpayer has 
established salvage value in accordance with this paragraph and has not 
followed a practice of understating his estimates of salvage value:

    Example 1. Taxpayer B elects to apply this section for 1971. Assets 
Y and Z are the only assets in a multiple asset account of 1967, the 
year in which the assets were acquired. The unadjusted basis of asset Y 
is $50,000 and the unadjusted basis of asset Z is $30,000. B estimated a 
gross salvage value of $55,000 at the time of acquisition. The property 
qualified under section 167(f)(2) and B reduced the amount of salvage 
taken into account by $8,000 (that is, 10 percent of $80,000, under sec. 
167(f)). Thus, in accordance with this paragraph and paragraph 
(e)(3)(iv)(c) of this section, B establishes a salvage value of $47,000 
for the account for 1971. Assume that there is not sufficient basis for 
determining a salvage value for the account greater $52,000 (that is 
$60,000 minus the $8,000 reduction under sec. 167(f)). Since the salvage 
value of $47,000 established by B for the account is within the 10 
percent range, it is reasonable. Salvage for the account will not be 
redetermined.
    Example 2. The facts are the same as in example (1) except that B 
estimated a gross salvage value of $50,000 and establishes a salvage 
value of $42,000 for the account (that is, $50,000 minus the $8,000 
reduction under section 167(f)). There is sufficient basis for 
determining an amount of salvage value greater than $50,000 (that is, 
$58,000 minus the $8,000 reduction under section 167(f)). The salvage 
value of $42,000 established by B for the account can be redetermined 
without regard to the limitation in subparagraph (3) of this paragraph, 
since it is not within the 10

[[Page 442]]

percent range. Upon audit of B's tax return for 1971 (a year in which 
the redetermination would affect the amount of depreciation allowable 
for the account), salvage value is determined to be $52,000 after taking 
into account the reduction under section 167(f). Salvage value for the 
account will be adjusted to $52,000.
    Example 3. The facts are the same as in example (1) except that upon 
audit of B's tax return for 1971 the examining officer determines the 
salvage value to be $58,000 (that is, $66,000 minus the $8,000 reduction 
under section 167(f)), and proposes to adjust salvage value for the 
account to $58,000 which will result in disallowing an amount of 
depreciation for the taxable year. B does not agree with the finding of 
the examining officer. After receipt of a ``30-day letter,'' B waives a 
district conference and initiates proceedings before the Appellate 
Division. In consideration of the case by the Appellate Division it is 
concluded that there is not sufficient basis for determining an amount 
of salvage value for the account in excess of $55,000 (that is, $63,000 
minus the $8,000 reduction under section 167(f)). Since the salvage 
value of $47,000 established by B for the account is within the 10 
percent range, it is reasonable. Salvage value for the account will not 
be redetermined.
    Example 4. For 1971, taxpayer C elects to apply this section to 
factory building X which is in an item account of 1965, the year in 
which the building was acquired. The unadjusted basis of factory 
building X is $90,000. C estimated a gross salvage value for the account 
of $10,000. The property did not qualify under section 167(f)(2). Thus, 
C establishes a salvage value of $10,000 for the account for 1971. 
Assume that there is not sufficient basis for determining a salvage 
value for the account greater than $14,000. Since the salvage value of 
$10,000 established by C for the account is within the 10-percent range, 
it is reasonable. Salvage value for the account will not be 
redetermined.

    (d) Accounting for qualified property--(1) In general. Qualified 
property for which the taxpayer elects to apply this section may be 
accounted for in any number of item or multiple asset accounts.
    (2) Retirements of qualified property--(i) In general. The 
provisions of this subparagraph and Sec.  1.167(a)-8 apply to 
retirements of qualified property to which the taxpayer elects to apply 
this section for the taxable year. See subdivision (iii) of this 
subparagraph for special rule for normal retirements.
    (ii) Adjusted basis of assets retired. In the case of a taxpayer who 
depreciates qualified property in a multiple-asset account conforming to 
the asset guideline class at a rate based on the class life in 
accordance with paragraph (a)(5)(ii)(a) of this section, Sec.  1.167(a)-
8(c) (relating to basis of assets retired) shall be applied by assuming 
that the class life is the average expected useful life of the assets in 
the account. See Sec.  1.167(a)-8, generally, for the basis of assets 
retired.
    (iii) Definition of normal retirements. Notwithstanding Sec.  
1.167(a)-8(b), the determination whether a retirement of qualified 
property is normal or abnormal shall be made in light of all the facts 
and circumstances, primarily with reference to the expected period of 
use of the asset in the taxpayer's business without regard to paragraph 
(a)(5)(ii) of this section. A retirement is not abnormal unless the 
taxpayer can show that the withdrawal of the asset was not due to a 
cause which would customarily be contemplated (in light of the 
taxpayer's practice and experience) in setting a depreciation rate for 
the assets without regard to paragraph (a)(5)(ii) of this section. Thus, 
for example, a retirement is normal if made within the range of years 
which would customarily be taken into account in setting such 
depreciation rate and if the asset has reached a condition at which, in 
the normal course of events, the taxpayer customarily retires similar 
assets from use in his business. A retirement may be abnormal if the 
asset is withdrawn at an earlier time or under other circumstances, as, 
for example, when the asset has been damaged by casualty or has lost its 
usefulness suddenly as the result of extraordinary obsolescence.
    (3) Special rules--(i) In general. The provisions of this 
subparagraph shall apply to qualified property in a taxable year for 
which an election to apply this section is made.
    (ii) Repairs. For the purpose of sections 162 and 263 and the 
regulations thereunder, whether an expenditure prolongs the life of an 
asset shall be determined by reference to the expected period of use of 
the asset in the taxpayer's business without regard to paragraph 
(a)(5)(ii) of this section.
    (iii) Sale and lease. For the purpose of comparison with the term of 
a lease of such property, the remaining life of

[[Page 443]]

qualified property shall be determined by reference to the expected 
period of use of the asset in the taxpayer's business without regard to 
paragraph (a)(5)(ii) of this section.
    (4) Expected period of use. For the purposes of subparagraphs (2) 
and (3) of this paragraph, the determination of the expected period of 
use of an asset shall be made in light of all the facts and 
circumstances. The expected period of use of a particular asset will not 
necessarily coincide with the class life used for depreciation (or with 
the individual asset life for depreciation under the alternative method 
in paragraph (a)(5)(ii) (b) of this section for applying the class 
life). Thus, for example, if the question is whether an asset has been 
leased for a period less than, equal to or greater than its remaining 
life, the determination shall be based on the remaining expected period 
of use of the individual asset without regard to the fact that the asset 
is depreciated at a rate based on the class life in accordance with 
paragraph (a)(5)(ii)(a) of this section.
    (5) Leased property. In the case of a lessor of qualified property, 
unless there is an asset guideline class in effect for such lessors, the 
asset guideline class for such property shall be determined by reference 
to the activity in which such property is primarily used by the lessee. 
See paragraph (b)(3) of this section for general rule for classification 
of qualified property according to primary use. However, in the case of 
an asset guideline class based upon the type of property (such as trucks 
or railroad cars), as distinguished from the activity in which used, the 
property shall be classified without regard to the activity of the 
lessee.
    (e) Election under this section--(1) Consent to change in method of 
accounting. An election to apply this section for a taxable year ending 
after December 31, 1970, is a method of accounting but the consent of 
the Commissioner will be deemed granted to make an annual election.
    (2) Election for taxable years ending after December 31, 1976. For 
taxable years ending after December 31, 1976, the election to apply this 
section for a taxable year shall be made by attaching to the income tax 
return a statement that an election under this section is being made. If 
the taxpayer does not file a timely return (taking into account 
extensions of time for filing) for the taxable year, the election shall 
be made at the time the taxpayer files his first return for the taxable 
year. The election may be made with an amended return only if such 
amended return is filed no later than the time prescribed by law 
(including extensions thereof) for filing the return for the taxable 
year. A taxpayer who makes an election under this subparagraph must 
maintain books and records reflecting the information described in 
paragraph (e)(3) (ii) and (iii) of this section.
    (3) Election for taxable years ending on or before December 31, 
1976. (i) For taxable years ending on or before December 31, 1976, the 
election to apply this section for a taxable year may be made by filing 
Form 5006 with the income tax return for the taxable year. If the 
taxpayer does not file a timely return (taking into account extensions 
of time for filing) for the taxable year, the election shall be filed at 
the time the taxpayer files his first return for the taxable year. The 
election may be made with an amended return only if such amended return 
is filed no later than the later of (a) the time prescribed by law 
(including extensions thereof) for filing the return for the taxable 
year, or (b) November 5, 1973.
    (ii) The election to apply this section for a taxable year ending on 
or before December 31, 1976, will be deemed to be made if the tax return 
(filed within the periods referred to in paragraph (e)(3)(i) of this 
section) contains information sufficient to establish the following:
    (a) Each asset guideline class for which the election is intended to 
apply;
    (b) The class life for each such asset guideline class and whether 
the class life is determined under paragraph (b)(1) or (2) of this 
section;
    (c) For each asset guideline class, as of the end of the taxable 
year of election, (1) the total unadjusted basis of all qualified 
property, (2) the aggregate of the reserves for depreciation of all 
accounts in the asset guideline class, and (3) the aggregate of the 
salvage

[[Page 444]]

value established for all accounts in the asset guideline class; and
    (d) Whether the taxpayer is an electric or gas utility using a 
composite asset guideline class basis in accordance with paragraph 
(b)(3)(iii) of this section.

If an election is deemed to be made under this subdivision (ii), the 
taxpayer will be deemed to have consented to apply all the provisions of 
this section.
    (iii) A taxpayer to whom the election applies shall maintain books 
and records for each asset guideline class reasonably sufficient to 
identify the unadjusted basis, reserve for depreciation and salvage 
value established for each depreciation account in such asset guidelines 
class.
    (f) Depreciation for taxable years ending before January 1, 1971--
(1) Adoption of Revenue Procedure 62-21--(i) In general. Except as 
provided in subdivision (ii) of this subparagraph, a taxpayer may elect 
to be examined under the provisions of Revenue Procedure 62-21 for a 
taxable year ending before January 1, 1971, only in accordance with the 
rules of this paragraph. The election must specify:
    (a) That the taxpayer makes such election and consents to, and 
agrees to apply, all the provisions of this paragraph;
    (b) Each guideline class and taxable year for which the taxpayer 
elects to be examined under Revenue Procedure 62-21;
    (c) The class life claimed for each such guideline class;
    (d) The class life and the total amount of the depreciation for the 
guideline class claimed on the last income tax return for such taxable 
year filed prior to January 12, 1971 (or in case no income tax return 
was filed prior to January 12, 1971, on the first income tax return 
filed for such taxable year);
    (e) The class life claimed and the total amount of depreciation for 
the guideline class under the election to apply Revenue Procedure 62-21, 
in accordance with this paragraph, for the taxable year; and
    (f) If the class life or total amount of depreciation for the 
guideline class is different in (d) and (e) of this subdivision, a 
reasonable description of the computation of the class life in (e) of 
this subdivision, the amount of difference in tax liability resulting 
therefrom, and the amount of any refund or reduction in any deficiency 
in tax. The election shall be made in an amended tax return or claim for 
refund (or by a supplement to the tax return or claim) for the taxable 
year, and if the class life or total amount of depreciation for the 
guideline class is different in accordance with (f) of this subdivision, 
such difference shall be reflected in the amended tax return or claim 
for refund. Forms may be provided for making the election and submission 
of the information. In the case of an election made after issuance of 
such forms and more than 30 days after publication of notice thereof in 
the Internal Revenue Bulletin, the election may be made and the 
information submitted only in accordance with such forms. An election 
will not otherwise be invalid under this paragraph so long as there is 
substantial compliance, in good faith, with the requirements of this 
paragraph.
    (ii) Special rule. The provisions of this subparagraph shall not 
apply to a guideline class in any taxable year for which the taxpayer 
has prior to January 12, 1971, adopted Revenue Procedure 62-21 for such 
class. See subparagraph (2) of this paragraph for determination of 
adoption of Revenue Procedure 62-21 prior to January 12, 1971.
    (iii) Justification of class life claimed and limitations on 
refunds. If the taxpayer elects for a taxable year to be examined under 
the provisions of Revenue Procedure 62-21 in accordance with subdivision 
(i) of this subparagraph, any of the provisions of Revenue Procedure 62-
21 may be applied to justify a class life claimed on the income tax 
return filed for such year or to offset an increase in tax liability for 
such year. Unless it meets the reserve ratio test, no class life will be 
accepted on audit which (after all other adjustments in tax liability 
for such year) results in a reduction (or further reduction) in the 
amount of tax liability shown on the income tax return (specified in 
subdivision (i)(d) of this subparagraph) for such taxable year, or 
results in an amount of loss carryback or carryover to any taxable year, 
but if it

[[Page 445]]

is justified under Revenue Procedure 62-21 and meets the reserve ratio 
test, a class life will be accepted on audit without regard to the 
foregoing limitations and, for example, may produce a refund or credit 
against tax. For example, if a class life of 9 years is otherwise 
justified under Revenue Procedure 62-21 for 1969, but the taxpayer does 
not meet the reserve ratio test for 1969 using a test life of 9 years, a 
class life of 9 years (or any class life justified under Revenue 
Procedure 62-21) will be accepted on audit under Revenue Procedure 62-21 
pursuant to an election in accordance with this paragraph provided it 
does not result in the reduction or further reduction in tax liability 
or in an amount of loss carryback or carryover as described in the 
preceding sentence. On the other hand, for example, if a class life of 
10 years is justified under Revenue Procedure 62-21 for 1969 and the 
taxpayer meets the reserve ratio test for 1969 using a test life of 10 
years, a class life of 10 years will be accepted on audit under Revenue 
Procedure 62-21 pursuant to an election in accordance with this 
paragraph even though it results in a reduction or further reduction in 
tax liability or in an amount of loss carryback or carryover as 
described above and produces a refund of tax. For purposes of this 
section, the term ``audit'' includes examination of claims for refund or 
credit against tax.
    (iv) Definitions. For purposes of this paragraph, the determination 
whether the reserve ratio test is met shall be made in accordance with 
that portion of paragraph (b)(2) of this section which is by express 
reference therein made applicable to this paragraph. In addition, the 
guideline form of the reserve ratio test, as described in Revenue 
Procedure 65-13, may be applied. For purposes of this paragraph, 
references to Revenue Procedure 62-21 include all modifications, 
amendments, and supplements thereto as of January 11, 1971. The terms 
``class life'' and ``guideline class'' have the same meaning as in 
Revenue Procedure 62-21.
    (2) Determination whether Revenue Procedure 62-21 adopted prior to 
January 12, 1971--(i) In general. For the purposes of this paragraph, a 
taxpayer will be treated as having adopted prior to January 12, 1971, 
Revenue Procedure 62-21 for a guideline class for a taxable year ending 
before January 1, 1971, only if--
    (a) For the guideline class and taxable year, the taxpayer adopted 
Revenue Procedure 62-21 by expressly so indicating on the income tax 
return filed for such taxable year prior to January 12, 1971;
    (b) For the guideline class and taxable year, the taxpayer adopted 
Revenue Procedure 62-21 prior to January 12, 1971, by expressly so 
indicating in a proceeding before the Internal Revenue Service (such as 
upon examination of the income tax return for such taxable year) and 
there is reasonable evidence to that effect; or
    (c) There is other reasonable evidence that prior to January 12, 
1971, the taxpayer adopted Revenue Procedure 62-21 for the guideline 
class and taxable year.

If not treated under (b) or (c) of this subdivision as having done so 
for the last taxable year ending before January 1, 1971, and if the 
taxpayer files his first income tax return for such taxable year after 
January 11, 1971, the taxpayer will be treated as having adopted Revenue 
Procedure 62-21 prior to January 12, 1971, for a guideline class for 
such taxable year if he expressly so indicated on that return, or is 
treated under this subparagraph as having adopted Revenue Procedure 62-
21 prior to January 12, 1971, for that guideline class for the 
immediately preceding taxable year.
    (ii) Examples. The principles of this subparagraph may be 
illustrated by the following examples:

    Example 1. Taxpayer A, an individual who uses the calendar year as 
his taxable year, has property in Group Three, Class 16(a), of Revenue 
Procedure 62-21. On A's income tax return for 1968, filed prior to 
January 12, 1971, he adopted Revenue Procedure 62-21 for the guideline 
class by so indicating under ``Summary of Depreciation'' in the 
appropriate schedule of Form 1040 for 1968. Under subdivision (i) (a) of 
this subparagraph, A is treated as having adopted Revenue Procedure 62-
21 for the guideline class for 1968 prior to January 12, 1971.
    Example 2. Taxpayer B, an individual who uses the calendar year as 
his taxable year, has property in Group Two, Class 5, of Revenue 
Procedure 62-21. B filed timely income tax returns for 1966 through 1968 
but did not adopt Revenue Procedures 62-21 on any of

[[Page 446]]

such returns. In 1969 upon audit of B's taxable years 1966 through 1968, 
B exercised his option to be examined under the provisions of Revenue 
Procedure 62-21. The Revenue Agent's report shows that B was examined 
under Revenue Procedure 62-21 for taxable years 1966 through 1968. B 
will be treated under subdivision (ii)(b) of this subparagraph as having 
adopted Revenue Procedure 62-21 for such years prior to January 12, 
1971.
    Example 3. The facts are the same as in example (2) except that B 
did not upon examination by the Revenue Agent in 1969 exercise his 
option to be examined under Revenue Procedure 62-21. B has six accounts 
in the guideline class, Nos. 1 through 6. The Revenue Agent proposed to 
lengthen the depreciable lives on accounts Nos. 2 and 3 from 8 years to 
12 years. In proceedings before the Appellate Division in 1970, B 
exercised his option to be examined under the provisions of Revenue 
Procedure 62-21. This is shown by correspondence between B and the 
Appellate Conferee as well as by other documents in the case before the 
Appellate Division. The case was settled on that basis before the 
Appellate Division without adjustment of the depreciable lives for B's 
accounts Nos. 2 and 3. B will be treated under subdivision (ii) (b) of 
this subparagraph as having adopted Revenue Procedure 62-21 for taxable 
years 1966 through 1968 prior to January 12, 1971.
    Example 4. Corporation X uses the calendar year as its taxable year 
and has assets in Group Two, Class 5, of Revenue Procedure 62-21. 
Beginning in 1964, corporation X used the guideline life of 10 years as 
the depreciable life for all assets in the guideline class. In 1967, 
corporation X's taxable years 1964 through 1966 were examined and 
corporation X exercised its option to be examined under the provisions 
of Revenue Procedure 62-21. Corporation X did not adopt Revenue 
Procedure 62-21 on any of its income tax returns, for the years 1964 
through 1970. Corporation X has not been examined since 1967, but has 
continued to use the guideline life of 10 years for all property in the 
guideline class including additions since 1966. Corporation X will be 
treated under subdivision (ii) (c) and (d) of this subparagraph as 
having adopted Revenue Procedure 62-21 prior to January 12, 1971, for 
taxable years 1964 through 1970.
    Example 5. Corporation Y uses the calendar year as its taxable year 
and has asset in Group Two, Class 5, of Revenue Procedure 62-21. Since 
1964, corporation Y has used various depreciable lives, based on the 
facts and circumstances, for different accounts in the guideline class. 
Corporation Y was examined in 1968 for taxable years 1965 through 1967. 
Corporation Y was also examined in 1970 for taxable years 1968 and 1969. 
Corporation Y did not exercise its option to be examined under the 
provisions of Revenue Procedure 62-21. Corporation Y has not adopted 
Revenue Procedure 62-21 on any income tax return. For taxable years 1964 
through 1970, corporation Y's class life (within the meaning of section 
4, Part II, of Revenue Procedure 62-21) was between 12 and 14 years. In 
August of 1971, corporation Y filed amended income tax returns for 1968 
and 1969, and an income tax return for 1970, using a depreciable life of 
10 years (equal to the guideline life) for all assets in the guideline 
class. Corporation Y will not be treated as having adopted Revenue 
Procedure 62-21 prior to January 12, 1971.
    Example 6. Corporation Z uses the calendar year as its taxable year 
and has assets in group 2, class 5, of Revenue Procedure 62-21. 
Corporation Z adopted Revenue Procedure 62-21 for this guideline class 
by expressly so indicating on its tax return for 1966, which was filed 
before January 12, 1971. Corporation Z computed its allowable 
depreciation for 1966 as if it adopted Revenue Procedure 62-21 for this 
guideline class for its taxable years 1962 through 1965, although it had 
earlier filed its tax returns for those years without regard to Revenue 
Procedure 62-21. The depreciation thus claimed in 1966 was less than 
what would have been allowable if corporation Z first adopted Revenue 
Procedure 62-21 in 1966. This was the result of certain accounts 
becoming fully depreciated through use of Revenue Procedure 62-21 in 
computing depreciation for 1962 through 1965. In addition, in deferred 
tax accounting procedures employed before January 12, 1971, for 
financial reporting purposes, corporation Z calculated its tax deferrals 
on the basis that it had adopted Revenue Procedure 62-21 for the years 
1962 through 1965. Corporation Z will be treated under subdivision (i) 
(c) of this subparagraph as having adopted Revenue Procedure 62-21 for 
taxable years 1962 through 1965 prior to January 12, 1971.

(Sec. 167(m), 85 Stat. 508 (26 U.S.C. 167))

[T.D. 7278, 38 FR 14923, June 7, 1973, as amended by T.D. 7315, 39 FR 
20195, June 7, 1974; T.D. 7517, 42 FR 58934, Nov. 14, 1977]



Sec.  1.167(a)-13T  Certain elections for intangible property (temporary).

    For rules applying the elections under section 13261(g) (2) and (3) 
of the Omnibus Budget Reconciliation Act of 1993 to intangible property 
described in section 167(f), see Sec.  1.197-1T.

[59 FR 11922, Mar. 15, 1994]



Sec.  1.167(a)-14  Treatment of certain intangible property 
excluded from section 197.

    (a) Overview. This section provides rules for the amortization of 
certain intangibles that are excluded from section 197 (relating to the 
amortization

[[Page 447]]

of goodwill and certain other intangibles). These excluded intangibles 
are specifically described in Sec.  1.197-2(c) (4), (6), (7), (11), and 
(13) and include certain computer software and certain other separately 
acquired rights, such as rights to receive tangible property or 
services, patents and copyrights, certain mortgage servicing rights, and 
rights of fixed duration or amount. Intangibles for which an 
amortization amount is determined under section 167(f) and intangibles 
otherwise excluded from section 197 are amortizable only if they qualify 
as property subject to the allowance for depreciation under section 
167(a).
    (b) Computer software--(1) In general. The amount of the deduction 
for computer software described in section 167(f)(1) and Sec.  1.197-
2(c)(4) is determined by amortizing the cost or other basis of the 
computer software using the straight line method described in Sec.  
1.167(b)-1 (except that its salvage value is treated as zero) and an 
amortization period of 36 months beginning on the first day of the month 
that the computer software is placed in service. Before determining the 
amortization deduction allowable under this paragraph (b), the cost or 
other basis of computer software that is section 179 property, as 
defined in section 179(d)(1)(A)(ii), must be reduced for any portion of 
the basis the taxpayer properly elects to treat as an expense under 
section 179. In addition, the cost or other basis of computer software 
that is qualified property under section 168(k)(2) or Sec.  1.168(k)-1, 
50-percent bonus depreciation property under section 168(k)(4) or Sec.  
1.168(k)-1, or qualified New York Liberty Zone property under section 
1400L(b) or Sec.  1.1400L(b)-1, must be reduced by the amount of the 
additional first year depreciation deduction allowed or allowable, 
whichever is greater, under section 168(k) or section 1400L(b) for the 
computer software. If costs for developing computer software that the 
taxpayer properly elects to defer under section 174(b) result in the 
development of property subject to the allowance for depreciation under 
section 167, the rules of this paragraph (b) will apply to the 
unrecovered costs. In addition, this paragraph (b) applies to the cost 
of separately acquired computer software if the cost to acquire the 
software is separately stated and the cost is required to be capitalized 
under section 263(a).
    (2) Exceptions. Paragraph (b)(1) of this section does not apply to 
the cost of computer software properly and consistently taken into 
account under Sec.  1.162-11. The cost of acquiring an interest in 
computer software that is included, without being separately stated, in 
the cost of the hardware or other tangible property is treated as part 
of the cost of the hardware or other tangible property that is 
capitalized and depreciated under other applicable sections of the 
Internal Revenue Code.
    (3) Additional rules. Rules similar to those in Sec.  1.197-2 
(f)(1)(iii), (f)(1)(iv), and (f)(2) (relating to the computation of 
amortization deductions and the treatment of contingent amounts) apply 
for purposes of this paragraph (b).
    (c) Certain interests or rights not acquired as part of a purchase 
of a trade or business--(1) Certain rights to receive tangible property 
or services. The amount of the deduction for a right (other than a right 
acquired as part of a purchase of a trade or business) to receive 
tangible property or services under a contract or from a governmental 
unit (as specified in section 167(f)(2) and Sec.  1.197-2(c)(6)) is 
determined as follows:
    (i) Amortization of fixed amounts. The basis of a right to receive a 
fixed amount of tangible property or services is amortized for each 
taxable year by multiplying the basis of the right by a fraction, the 
numerator of which is the amount of tangible property or services 
received during the taxable year and the denominator of which is the 
total amount of tangible property or services received or to be received 
under the terms of the contract or governmental grant. For example, if a 
taxpayer acquires a favorable contract right to receive a fixed amount 
of raw materials during an unspecified period, the taxpayer must 
amortize the cost of acquiring the contract right by multiplying the 
total cost by a fraction, the numerator of which is the amount of raw 
materials received under the contract during the taxable year and the 
denominator of which is the total amount of raw materials received or to 
be received under the contract.

[[Page 448]]

    (ii) Amortization of unspecified amount over fixed period. The cost 
or other basis of a right to receive an unspecified amount of tangible 
property or services over a fixed period is amortized ratably over the 
period of the right. (See paragraph (c)(3) of this section regarding 
renewals).
    (iii) Amortization in other cases. [Reserved]
    (2) Rights of fixed duration or amount. The amount of the deduction 
for a right (other than a right acquired as part of a purchase of a 
trade or business) of fixed duration or amount received under a contract 
or granted by a governmental unit (specified in section 167(f)(2) and 
Sec.  1.197-2(c)(13)) and not covered by paragraph (c)(1) of this 
section is determined as follows:
    (i) Rights to a fixed amount. The basis of a right to a fixed amount 
is amortized for each taxable year by multiplying the basis by a 
fraction, the numerator of which is the amount received during the 
taxable year and the denominator of which is the total amount received 
or to be received under the terms of the contract or governmental grant.
    (ii) Rights to an unspecified amount over fixed duration of less 
than 15 years. The basis of a right to an unspecified amount over a 
fixed duration of less than 15 years is amortized ratably over the 
period of the right.
    (3) Application of renewals. (i) For purposes of paragraphs (c) (1) 
and (2) of this section, the duration of a right under a contract (or 
granted by a governmental unit) includes any renewal period if, based on 
all of the facts and circumstances in existence at any time during the 
taxable year in which the right is acquired, the facts clearly indicate 
a reasonable expectancy of renewal.
    (ii) The mere fact that a taxpayer will have the opportunity to 
renew a contract right or other right on the same terms as are available 
to others, in a competitive auction or similar process that is designed 
to reflect fair market value and in which the taxpayer is not 
contractually advantaged, will generally not be taken into account in 
determining the duration of such right provided that the bidding 
produces a fair market value price comparable to the price that would be 
obtained if the rights were purchased immediately after renewal from a 
person (other than the person granting the renewal) in an arm's-length 
transaction.
    (iii) The cost of a renewal not included in the terms of the 
contract or governmental grant is treated as the acquisition of a 
separate intangible asset.
    (4) Patents and copyrights. If the purchase price of an interest 
(other than an interest acquired as part of a purchase of a trade or 
business) in a patent or copyright described in section 167(f)(2) and 
Sec.  1.197-2(c)(7) is payable on at least an annual basis as either a 
fixed amount per use or a fixed percentage of the revenue derived from 
the use of the patent or copyright, the depreciation deduction for a 
taxable year is equal to the amount of the purchase price paid or 
incurred during the year. Otherwise, the basis of such patent or 
copyright (or an interest therein) is depreciated either ratably over 
its remaining useful life or under section 167(g) (income forecast 
method). If a patent or copyright becomes valueless in any year before 
its legal expiration, the adjusted basis may be deducted in that year.
    (5) Additional rules. The period of amortization under paragraphs 
(c) (1) through (4) of this section begins when the intangible is placed 
in service, and rules similar to those in Sec.  1.197-2(f)(2) apply for 
purposes of this paragraph (c).
    (d) Mortgage servicing rights--(1) In general. The amount of the 
deduction for mortgage servicing rights described in section 167(f)(3) 
and Sec.  1.197-2(c)(11) is determined by using the straight line method 
described in Sec.  1.167(b)-1 (except that the salvage value is treated 
as zero) and an amortization period of 108 months beginning on the first 
day of the month that the rights are placed in service. Mortgage 
servicing rights are not depreciable to the extent the rights are 
stripped coupons under section 1286.
    (2) Treatment of rights acquired as a pool--(i) In general. Except 
as provided in paragraph (d)(2)(ii) of this section, all mortgage 
servicing rights acquired in the same transaction or in a series

[[Page 449]]

of related transactions are treated as a single asset (the pool) for 
purposes of determining the depreciation deduction under this paragraph 
(d) and any gain or loss from the sale, exchange, or other disposition 
of the rights. Thus, if some (but not all) of the rights in a pool 
become worthless as a result of prepayments, no loss is recognized by 
reason of the prepayment and the adjusted basis of the pool is not 
affected by the unrecognized loss. Similarly, any amount realized from 
the sale or exchange of some (but not all) of the mortgage servicing 
rights is included in income and the adjusted basis of the pool is not 
affected by the realization.
    (ii) Multiple accounts. If the taxpayer establishes multiple 
accounts within a pool at the time of its acquisition, gain or loss is 
recognized on the sale or exchange of all mortgage servicing rights 
within any such account.
    (3) Additional rules. Rules similar to those in Sec.  1.197-
2(f)(1)(iii), (f)(1)(iv), and (f)(2) (relating to the computation of 
amortization deductions and the treatment of contingent amounts) apply 
for purposes of this paragraph (d).
    (e) Effective dates--(1) In general. This section applies to 
property acquired after January 25, 2000, except that Sec.  1.167(a)-
14(c)(2) (depreciation of the cost of certain separately acquired 
rights) and so much of Sec.  1.167(a)-14(c)(3) as relates to Sec.  
1.167(a)-14(c)(2) apply to property acquired after August 10, 1993 (or 
July 25, 1991, if a valid retroactive election has been made under Sec.  
1.197-1T).
    (2) Change in method of accounting. See Sec.  1.197-2(l)(4) for 
rules relating to changes in method of accounting for property to which 
Sec.  1.167(a)-14 applies. However, see Sec.  1.168(k)-1(g)(4) or 
1.1400L(b)-1(g)(4) for rules relating to changes in method of accounting 
for computer software to which the third sentence in Sec.  1.167(a)-
14(b)(1) applies.
    (3) Qualified property, 50-percent bonus depreciation property, 
qualified New York Liberty Zone property, or section 179 property. This 
section also applies to computer software that is qualified property 
under section 168(k)(2) or qualified New York Liberty Zone property 
under section 1400L(b) acquired by a taxpayer after September 10, 2001, 
and to computer software that is 50-percent bonus depreciation property 
under section 168(k)(4) acquired by a taxpayer after May 5, 2003. This 
section also applies to computer software that is section 179 property 
placed in service by a taxpayer in a taxable year beginning after 2002 
and before 2010.

[T.D. 8867, 65 FR 3825, Jan. 25, 2000, as amended by T.D. 9091, 68 FR 
52990, Sept. 8, 2003; T.D. 9283, 71 FR 51737, Aug. 31, 2006]



Sec.  1.167(b)-0  Methods of computing depreciation.

    (a) In general. Any reasonable and consistently applied method of 
computing depreciation may be used or continued in use under section 
167. Regardless of the method used in computing depreciation, deductions 
for depreciation shall not exceed such amounts as may be necessary to 
recover the unrecovered cost or other basis less salvage during the 
remaining useful life of the property. The reasonableness of any claim 
for depreciation shall be determined upon the basis of conditions known 
to exist at the end of the period for which the return is made. It is 
the responsibility of the taxpayer to establish the reasonableness of 
the deduction for depreciation claimed. Generally, depreciation 
deductions so claimed will be changed only where there is a clear and 
convincing basis for a change.
    (b) Certain methods. Methods previously found adequate to produce a 
reasonable allowance under the Internal Revenue Code of 1939 or prior 
revenue laws will, if used consistently by the taxpayer, continue to be 
acceptable under section 167(a). Examples of such methods which continue 
to be acceptable are the straight line method, the declining balance 
method with the rate limited to 150 percent of the applicable straight 
line rate, and under appropriate circumstances, the unit of production 
method. The methods described in section 167(b) and Sec. Sec.  1.167(b)-
1, 1.167(b)-2, 1.167(b)-3, and 1.167(b)-4 shall be deemed to produce a 
reasonable allowance for depreciation except as limited under section 
167(c) and Sec.  1.167(c)-1. See also Sec.  1.167(e)-1 for rules 
relating to change in method of computing depreciation.

[[Page 450]]

    (c) Application of methods. In the case of item accounts, any method 
which results in a reasonable allowance for depreciation may be selected 
for each item of property, but such method must thereafter be applied 
consistently to that particular item. In the case of group, classified, 
or composite accounts, any method may be selected for each account. Such 
method must be applied to that particular account consistently 
thereafter but need not necessarily be applied to acquisitions of 
similar property in the same or subsequent years, provided such 
acquisitions are set up in separate accounts. See, however, Sec.  
1.167(e)-1 and section 446 and the regulations thereunder, for rules 
relating to changes in the method of computing depreciation, and Sec.  
1.167(c)-1 for restriction on the use of certain methods. See also Sec.  
1.167(a)-7 for definition of account.



Sec.  1.167(b)-1  Straight line method.

    (a) In general. Under the straight line method the cost or other 
basis of the property less its estimated salvage value is deductible in 
equal annual amounts over the period of the estimated useful life of the 
property. The allowance for depreciation for the taxable year is 
determined by dividing the adjusted basis of the property at the 
beginning of the taxable year, less salvage value, by the remaining 
useful life of the property at such time. For convenience, the allowance 
so determined may be reduced to a percentage or fraction. The straight 
line method may be used in determining a reasonable allowance for 
depreciation for any property which is subject to depreciation under 
section 167 and it shall be used in all cases where the taxpayer has not 
adopted a different acceptable method with respect to such property.
    (b) Illustrations. The straight line method is illustrated by the 
following examples:

    Example 1. Under the straight line method items may be depreciated 
separately:

------------------------------------------------------------------------
                                  Cost or               Depreciation
                                   other    Useful        allowable
         Year and item             basis     life  ---------------------
                                   less    (years)
                                 salaries            1954    1955   1956
------------------------------------------------------------------------
1954:
  Asset A......................    $1,600       4      \1\   $400   $400
                                                      $200
  Asset B......................    12,000      40      \1\    300    300
                                                       150
------------------------------------------------------------------------
\1\ In this example it is assumed that the assets were placed in service
  on July 1, 1954.

    Example 2. In group, classified, or composite accounting, a number 
of assets with the same or different useful lives may be combined into 
one account, and a single rate of depreciation, i.e., the group, 
classified, or composite rate used for the entire account. In the case 
of group accounts, i.e., accounts containing assets which are similar in 
kind and which have approximately the same estimated useful lives, the 
group rate is determined from the average of the useful lives of the 
assets. In the case of classified or composite accounts, the classified 
or composite rate is generally computed by determining the amount of one 
year's depreciation for each item or each group of similar items, and by 
dividing the total depreciation thus obtained by the total cost or other 
basis of the assets. The average rate so obtained is to be used as long 
as subsequent additions, retirements, or replacements do not 
substantially alter the relative proportions of different types of 
assets in the account. An example of the computation of a classified or 
composite rate follows:

------------------------------------------------------------------------
                         Estimated useful life
  Cost or other basis           (years)            Annual depreciation
------------------------------------------------------------------------
         $10,000                       5                   $2,000
          10,000                      15                      667
                                               -------------------------
          20,000        ......................              2,667
------------------------------------------------------------------------


Average rate is 13.33 percent ($2,667 / $20,000) unadjusted for salvage. 
Assuming the estimated salvage value is 10 percent of the cost or other 
basis, the rate adjusted for salvage will be 13.33 percent minus 10 
percent of 13.33 percent (13.33%-1.33%), or 12 percent.
    Example 3. The use of the straight line method for group, 
classified, or composite accounts is illustrated by the following 
example: A taxpayer filing his returns on a calendar year basis 
maintains an asset account for which a group rate of 20 percent has been 
determined, before adjustment for salvage. Estimated salvage is 
determined to be 6\2/3\ percent, resulting in an adjusted rate of 18.67 
percent. During the years illustrated, the initial investment, 
additions, retirements, and salvage recoveries, which were determined 
not to change the composition of the group sufficiently to require a 
change in rate, were assumed to have been made as follows:
    1954--Initial investment of $12,000.

[[Page 451]]

    1957--Retirement $2,000, salvage realized $200.
    1958--Retirement $2,000, salvage realized $200.
    1959--Retirement $4,000, salvage realized $400.
    1959--Additions $10,000.
    1960--Retirement $2,000, no salvage realized.
    1961--Retirement $2,000, no salvage realized.

                   Depreciable Asset Account and Depreciation Computation on Average Balances
----------------------------------------------------------------------------------------------------------------
                                     Asset                             Asset
               Year                 balance   Current     Current     balance   Average     Rate      Allowable
                                    Jan. 1   additions  retirements   Dec. 31   balance  (percent)  depreciation
----------------------------------------------------------------------------------------------------------------
1954.............................  ........    $12,000  ...........   $12,000    $6,000      18.67      $1,120
1955.............................   $12,000  .........  ...........    12,000    12,000      18.67       2,240
1956.............................    12,000  .........  ...........    12,000    12,000      18.67       2,240
1957.............................    12,000  .........      $2,000     10,000    11,000      18.67       2,054
1958.............................    10,000  .........       2,000      8,000     9,000      18.67       1,680
1959.............................     8,000     10,000       4,000     14,000    11,000      18.67       2,054
1960.............................    14,000  .........       2,000     12,000    13,000      18.67       2,427
1961.............................    12,000  .........       2,000     10,000    11,000      18.67       2,054
----------------------------------------------------------------------------------------------------------------


                                   Corresponding Depreciation Reserve Account
----------------------------------------------------------------------------------------------------------------
                                                                                                   Depreciation
              Year                 Depreciation    Depreciation       Current         Salvage      reserve Dec.
                                  reserve Jan. 1     allowable      retirements      realized           31
----------------------------------------------------------------------------------------------------------------
1954............................  ..............          $1,120  ..............  ..............          $1,120
1955............................          $1,120           2,240  ..............  ..............           3,360
1956............................           3,360           2,240  ..............  ..............           5,600
1957............................           5,600           2,054          $2,000            $200           5,854
1958............................           5,854           1,680           2,000             200           5,734
1959............................           5,734           2,054           4,000             400           4,188
1960............................           4,188           2,427           2,000  ..............           4,615
1961............................           4,615           2,054           2,000  ..............           4,669
----------------------------------------------------------------------------------------------------------------



Sec.  1.167(b)-2  Declining balance method.

    (a) Application of method. Under the declining balance method a 
uniform rate is applied each year to the unrecovered cost or other basis 
of the property. The unrecovered cost or other basis is the basis 
provided by section 167(g), adjusted for depreciation previously allowed 
or allowable, and for all other adjustments provided by section 1016 and 
other applicable provisions of law. The declining balance rate may be 
determined without resort to formula. Such rate determined under section 
167(b)(2) shall not exceed twice the appropriate straight line rate 
computed without adjustment for salvage. While salvage is not taken into 
account in determining the annual allowances under this method, in no 
event shall an asset (or an account) be depreciated below a reasonable 
salvage value. However, see section 167(f) and Sec.  1.167(f)-1 for 
rules which permit a reduction in the amount of salvage value to be 
taken into account for certain personal property acquired after October 
16, 1962. Also, see section 167(c) and Sec.  1.167(c)-1 for restrictions 
on the use of the declining balance method.
    (b) Illustrations. The declining balance method is illustrated by 
the following examples:

    Example 1. A new asset having an estimated useful life of 20 years 
was purchased on January 1, 1954, for $1,000. The normal straight line 
rate (without adjustment for salvage) is 5 percent, and the declining 
balance rate at twice the normal straight line rate is 10 percent. The 
annual depreciation allowances for 1954, 1955, and 1956 are as follows:

------------------------------------------------------------------------
                                                 Declining
                                                  balance   Depreciation
               Year                    Basis       rate       allowance
                                                 (percent)
------------------------------------------------------------------------
1954..............................      $1,000          10         $100
1955..............................         900          10           90
1956..............................         810          10           81
------------------------------------------------------------------------

    Example 2. A taxpayer filing his returns on a calendar year basis 
maintains a group account to which a 5 year life and a 40 percent 
declining balance rate are applicable. Original investment, additions, 
retirements, and salvage recoveries are the same as those set

[[Page 452]]

forth in example (3) of paragraph (b) of Sec.  1.167(b)-1. Although 
salvage value is not taken into consideration in computing a declining 
balance rate, it must be recognized and accounted for when assets are 
retired.

                             Depreciable Asset Account and Depreciation Computation Using Average Asset and Reserve Balances
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                          Average
                                                   Asset    Current     Current      Asset                reserve        Net        Rate      Allowable
                      Year                        balance  additions  retirements   balance   Average     before     depreciable   (pct.)   depreciation
                                                  Jan. 1                            Dec. 31            depreciation    balance
--------------------------------------------------------------------------------------------------------------------------------------------------------
1954...........................................  ........    $12,000  ...........   $12,000    $6,000  ............      $6,000         40      $2,400
1955...........................................   $12,000  .........  ...........    12,000    12,000      $2,400         9,600         40       3,840
1956...........................................    12,000  .........  ...........    12,000    12,000       6,240         5,760         40       2,304
1957...........................................    12,000  .........      $2,000     10,000    11,000       7,644         3,356         40       1,342
1958...........................................    10,000  .........       2,000      8,000     9,000       7,186         1,814         40         726
1959...........................................     8,000     10,000       4,000     14,000    11,000       5,212         5,788         40       2,315
1960...........................................    14,000  .........       2,000     12,000    13,000       4,727         8,273         40       3,309
1961...........................................    12,000  .........       2,000     10,000    11,000       6,036         4,964         40       1,986
--------------------------------------------------------------------------------------------------------------------------------------------------------


                                                                  Depreciation Reserve
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                   Average
                                                                  Reserve    Current     Salvage  Reserve Dec.     reserve      Allowable   Reserve Dec.
                              Year                                Jan. 1   retirements  realized   31, before      before     depreciation    31, after
                                                                                                  depreciation  depreciation                depreciation
--------------------------------------------------------------------------------------------------------------------------------------------------------
1954...........................................................  ........  ...........  ........  ............  ............      $2,400        $2,400
1955...........................................................    $2,400  ...........  ........      $2,400        $2,400         3,840         6,240
1956...........................................................     6,240  ...........  ........       6,240         6,240         2,304         8,544
1957...........................................................     8,544      $2,000       $200       6,744         7,644         1,342         8,086
1958...........................................................     8,086       2,000        200       6,286         7,186           726         7,012
1959...........................................................     7,012       4,000        400       3,412         5,212         2,315         5,727
1960...........................................................     5,727       2,000   ........       3,727         4,727         3,309         7,036
1961...........................................................     7,036       2,000   ........       5,036         6,036         1,986         7,022
--------------------------------------------------------------------------------------------------------------------------------------------------------

    Where separate depreciation accounts are maintained by year of 
acquisition and there is an unrecovered balance at the time of the last 
retirement, such unrecovered balance may be deducted as part of the 
depreciation allowance for the year of such retirement. Thus, if the 
taxpayer had kept separate depreciation accounts by year of acquisition 
and all the retirements shown in the example above were from 1954 
acquisitions, depreciation would be computed on the 1954 and 1959 
acquisitions as follows:

                                                                    1954 Acquisitions
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                               Asset                                Asset             Avg. reserve      Net
                    Year                      balance  Acquisitions    Current     balance   Average     before     depreciable     Rate      Allowable
                                              Jan. 1                 retirements   Dec. 31   balance  depreciation    balance    (percent)  depreciation
--------------------------------------------------------------------------------------------------------------------------------------------------------
1954.......................................  ........     $12,000    ...........   $12,000    $6,000  ............      $6,000          40      $2,400
1955.......................................   $12,000  ............  ...........    12,000    12,000      $2,400         9,600          40       3,840
1956.......................................    12,000  ............  ...........    12,000    12,000       6,240         5,760          40       2,304
1957.......................................    12,000  ............      $2,000     10,000    11,000       7,644         3,356          40       1,342
1958.......................................    10,000  ............       2,000      8,000     9,000       7,186         1,814          40         726
1959.......................................     8,000  ............       4,000      4,000     6,000       5,212           788          40         315
1960.......................................     4,000  ............       2,000      2,000     3,000       2,727           273          40         109
1961.......................................     2,000  ............       2,000   ........     1,000         836           164   .........     \1\ 164
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Balance allowable as depreciation in the year of retirement of the last survivor of the 1954 acquisitions.


                                                       Depreciation Reserve for 1954 Acquisitions
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                   Average
                                                                  Reserve    Current     Salvage  Reserve Dec.     reserve      Allowable   Reserve Dec.
                              Year                                Jan. 1   retirements  realized   31, before      before     depreciation    31, after
                                                                                                  depreciation  depreciation                depreciation
--------------------------------------------------------------------------------------------------------------------------------------------------------
1954...........................................................  ........  ...........  ........  ............  ............      $2,400        $2,400

[[Page 453]]

 
1955...........................................................    $2,400  ...........  ........      $2,400        $2,400         3,840         6,240
1956...........................................................     6,240  ...........  ........       6,240         6,240         2,304         8,544
1957...........................................................     8,544      $2,000       $200       6,744         7,644         1,342         8,086
1958...........................................................     8,086       2,000        200       6,286         7,186           726         7,012
1959...........................................................     7,012       4,000        400       3,412         5,212           315         3,727
1960...........................................................     3,727       2,000   ........       1,727         2,727           109         1,836
1961...........................................................     1,836       2,000   ........        (164)          836           164    ............
--------------------------------------------------------------------------------------------------------------------------------------------------------


                                                                    1959 Acquisitions
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                Asset                  Asset             Reserve Dec.      Net                              Reserve Dec.
                    Year                       balance  Acquisition   balance    Avg.     31, before   depreciable    Rate      Allowable     31, after
                                               Jan. 1                 Dec. 31   balance  depreciation    balance     percent  depreciation  depreciation
--------------------------------------------------------------------------------------------------------------------------------------------------------
1959........................................  ........     $10,000    $10,000    $5,000        None        $5,000         40      $2,000        $2,000
1960........................................   $10,000  ...........    10,000    10,000      $2,000         8,000         40       3,200         5,200
1961........................................    10,000  ...........    10,000    10,000       5,200         4,800         40       1,920         7,120
--------------------------------------------------------------------------------------------------------------------------------------------------------


In the above example, the allowable depreciation on the 1954 
acquisitions totals $11,200. This amount when increased by salvage 
realized in the amount of $800, equals the entire cost or other basis of 
the 1954 acquisitions ($12,000).

    (c) Change in estimated useful life. In the declining balance method 
when a change is justified in the useful life estimated for an account, 
subsequent computations shall be made as though the revised useful life 
had been originally estimated. For example, assume that an account has 
an estimated useful life of ten years and that a declining balance rate 
of 20 percent is applicable. If, at the end of the sixth year, it is 
determined that the remaining useful life of the account is six years, 
computations shall be made as though the estimated useful life was 
originally determined as twelve years. Accordingly, the applicable 
depreciation rate will be 16\2/3\ percent. This rate is thereafter 
applied to the unrecovered cost or other basis.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6712, 29 FR 
3653, Mar. 24, 1964]



Sec.  1.167(b)-3  Sum of the years-digits method.

    (a) Applied to a single asset--(1) General rule. Under the sum of 
the years-digits method annual allowances for depreciation are computed 
by applying changing fractions to the cost or other basis of the 
property reduced by estimated salvage. The numerator of the fraction 
changes each year to a number which corresponds to the remaining useful 
life of the asset (including the year for which the allowance is being 
computed), and the denominator which remains constant is the sum of all 
the years digits corresponding to the estimated useful life of the 
asset. See section 167(c) and Sec.  1.167(c)-1 for restrictions on the 
use of the sum of the years-digits method.
    (i) Illustrations. Computation of depreciation allowances on a 
single asset under the sum of the years-digits method is illustrated by 
the following examples:

    Example 1. A new asset having an estimated useful life of five years 
was acquired on January 1, 1954, for $1,750. The estimated salvage is 
$250. For a taxpayer filing his returns on a calendar year basis, the 
annual depreciation allowances are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                Cost or
                                                                 other
                             Year                                basis   Fraction\1\    Allowable   Depreciation
                                                                 less                 depreciation     reserve
                                                                salvage
----------------------------------------------------------------------------------------------------------------
1954.........................................................    $1,500      \5/15\         $500          $500
1955.........................................................     1,500      \4/15\          400           900
1956.........................................................     1,500      \3/15\          300         1,200
1957.........................................................     1,500      \2/15\          200         1,400
1958.........................................................     1,500      \1/15\          100         1,500
                                                              --------------------------------------------------
 

[[Page 454]]

 
Unrecovered value (salvage)..................................  ........  ...........  ............        $250
----------------------------------------------------------------------------------------------------------------
\1\ The denominator of the fraction is the sum of the digits representing the years of useful life, i.e., 5, 4,
  3, 2, and 1, or 15.

    Example 2. Assume in connection with an asset acquired in 1954 that 
three-fourths of a year's depreciation is allowable in that year. The 
following illustrates a reasonable method of allocating depreciation:

----------------------------------------------------------------------------------------------------------------
                                                                   Depreciation       Allowable depreciation
                                                                      for 12    --------------------------------
                                                                      months        1954       1955       1956
----------------------------------------------------------------------------------------------------------------
1st year.........................................................        $500      (\3/4\)    (\1/4\)
                                                                                      $375       $125
2d year..........................................................         400    .........    (\3/4\)    (\1/4\)
                                                                                                  300       $100
3d year..........................................................         300    .........  .........    (\3/4\)
                                                                                                             225
                                                                  ----------------------------------------------
  Total..........................................................  ............        375        425        325
----------------------------------------------------------------------------------------------------------------

    (ii) Change in useful life. Where in the case of a single asset, a 
change is justified in the useful life, subsequent computations shall be 
made as though the remaining useful life at the beginning of the taxable 
year of change were the useful life of a new asset acquired at such time 
and with a basis equal to the unrecovered cost or other basis of the 
asset at that time. For example, assume that a new asset with an 
estimated useful life of ten years is purchased in 1954. At the time of 
making out his return for 1959, the taxpayer finds that the asset has a 
remaining useful life of seven years from January 1, 1959. Depreciation 
for 1959 should then be computed as though 1959 were the first year of 
the life of an asset estimated to have a useful life of seven years, and 
the allowance for 1959 would be \7/28\ of the unrecovered cost or other 
basis of the asset after adjustment for salvage.
    (2) Remaining life--(i) Application. Under the sum of the years-
digits method, annual allowances for depreciation may also be computed 
by applying changing fractions to the unrecovered cost or other basis of 
the asset reduced by estimated salvage. The numerator of the fraction 
changes each year to a number which corresponds to the remaining useful 
life of the asset (including the year for which the allowance is being 
computed), and the denominator changes each year to a number which 
represents the sum of the digits corresponding to the years of estimated 
remaining useful life of the asset. For decimal equivalents of such 
fractions, see Table I of subdivision (ii) of this subparagraph. For 
example, a new asset with an estimated useful life of 10 years is 
purchased January 1, 1954, for $6,000. Assuming a salvage value of $500, 
the depreciation allowance for 1954 is $1,000 ($5,500 x 0.1818, the 
applicable rate from Table I). For 1955, the unrecovered balance is 
$4,500, and the remaining life is 9 years. The depreciation allowance 
for 1955 would then be $900 ($4,500 x 0.2000, the applicable rate from 
Table I).
    (ii) Table I. This table shows decimal equivalents of sum of the 
years-digits fractions corresponding to remaining lives from 1 to 100 
years.

 Table I--Decimal Equivalents for Use of Sum of the Years-Digits Method,
                         Based on Remaining Life
------------------------------------------------------------------------
                                                                Decimal
                   Remaining life (years)                     equivalent
------------------------------------------------------------------------
100.0.......................................................     0.0198
99.9........................................................      .0198
99.8........................................................      .0198
99.7........................................................      .0199
99.6........................................................      .0199
99.5........................................................      .0199
99.4........................................................      .0199
99.3........................................................      .0199
99.2........................................................      .0200
99.1........................................................      .0200
99.0........................................................      .0200
98.9........................................................      .0200
98.8........................................................      .0200
98.7........................................................      .0201
98.6........................................................      .0201
98.5........................................................      .0201
98.4........................................................      .0201
98.3........................................................      .0201
98.2........................................................      .0202
98.1........................................................      .0202
98.0........................................................      .0202
97.9........................................................      .0202
97.8........................................................      .0202
97.7........................................................      .0203
97.6........................................................      .0203
97.5........................................................      .0203
97.4........................................................      .0203
97.3........................................................      .0203
97.2........................................................      .0204
97.1........................................................      .0204
97.0........................................................      .0204
96.9........................................................      .0204
96.8........................................................      .0204
96.7........................................................      .0205
96.6........................................................      .0205
96.5........................................................      .0205
96.4........................................................      .0205
96.3........................................................      .0206
96.2........................................................      .0206
96.1........................................................      .0206

[[Page 455]]

 
96.0........................................................      .0206
95.9........................................................      .0206
95.8........................................................      .0207
95.7........................................................      .0207
95.6........................................................      .0207
95.5........................................................      .0207
95.4........................................................      .0207
95.3........................................................      .0208
95.2........................................................      .0208
95.1........................................................      .0208
95.0........................................................      .0208
94.9........................................................      .0209
94.8........................................................      .0209
94.7........................................................      .0209
94.6........................................................      .0209
94.5........................................................      .0209
94.4........................................................      .0210
94.3........................................................      .0210
94.2........................................................      .0210
94.1........................................................      .0210
94.0........................................................      .0211
93.9........................................................      .0211
93.8........................................................      .0211
93.7........................................................      .0211
93.6........................................................      .0211
93.5........................................................      .0212
93.4........................................................      .0212
93.3........................................................      .0212
93.2........................................................      .0212
93.1........................................................      .0213
93.0........................................................      .0213
92.9........................................................      .0213
92.8........................................................      .0213
92.7........................................................      .0213
92.6........................................................      .0214
92.5........................................................      .0214
92.4........................................................      .0214
92.3........................................................      .0214
92.2........................................................      .0215
92.1........................................................      .0215
92.0........................................................      .0215
91.9........................................................      .0215
91.8........................................................      .0216
91.7........................................................      .0216
91.6........................................................      .0216
91.5........................................................      .0216
91.4........................................................      .0216
91.3........................................................      .0217
91.2........................................................      .0217
91.1........................................................      .0217
91.0........................................................      .0217
90.9........................................................      .0218
90.8........................................................      .0218
90.7........................................................      .0218
90.6........................................................      .0218
90.5........................................................      .0219
90.4........................................................      .0219
90.3........................................................      .0219
90.2........................................................      .0219
90.1........................................................      .0220
90.0........................................................      .0220
89.9........................................................      .0220
89.8........................................................      .0220
89.7........................................................      .0221
89.6........................................................      .0221
89.5........................................................      .0221
89.4........................................................      .0221
89.3........................................................      .0221
89.2........................................................      .0222
89.1........................................................      .0222
89.0........................................................      .0222
88.9........................................................      .0222
88.8........................................................      .0223
88.7........................................................      .0223
88.6........................................................      .0223
88.5........................................................      .0223
88.4........................................................      .0224
88.3........................................................      .0224
88.2........................................................      .0224
88.1........................................................      .0224
88.0........................................................      .0225
87.9........................................................      .0225
87.8........................................................      .0225
87.7........................................................      .0225
87.6........................................................      .0226
87.5........................................................      .0226
87.4........................................................      .0226
87.3........................................................      .0226
87.2........................................................      .0227
87.1........................................................      .0227
87.0........................................................      .0227
86.9........................................................      .0228
86.8........................................................      .0228
86.7........................................................      .0228
86.6........................................................      .0228
86.5........................................................      .0229
86.4........................................................      .0229
86.3........................................................      .0229
86.2........................................................      .0229
86.1........................................................      .0230
86.0........................................................      .0230
85.9........................................................      .0230
85.8........................................................      .0230
85.7........................................................      .0231
85.6........................................................      .0231
85.5........................................................      .0231
85.4........................................................      .0231
85.3........................................................      .0232
85.2........................................................      .0232
85.1........................................................      .0232
85.0........................................................      .0233
84.9........................................................      .0233
84.8........................................................      .0233
84.7........................................................      .0233
84.6........................................................      .0234
84.5........................................................      .0234
84.4........................................................      .0234
84.3........................................................      .0234
84.2........................................................      .0235
84.1........................................................      .0235
84.0........................................................      .0235
83.9........................................................      .0236
83.8........................................................      .0236
83.7........................................................      .0236
83.6........................................................      .0236
83.5........................................................      .0237
83.4........................................................      .0237
83.3........................................................      .0237
83.2........................................................      .0238
83.1........................................................      .0238
83.0........................................................      .0238
82.9........................................................      .0238
82.8........................................................      .0239
82.7........................................................      .0239
82.6........................................................      .0239
82.5........................................................      .0240

[[Page 456]]

 
82.4........................................................      .0240
82.3........................................................      .0240
82.2........................................................      .0240
82.1........................................................      .0241
82.0........................................................      .0241
81.9........................................................      .0241
81.8........................................................      .0242
81.7........................................................      .0242
81.6........................................................      .0242
81.5........................................................      .0242
81.4........................................................      .0243
81.3........................................................      .0243
81.2........................................................      .0243
81.1........................................................      .0244
81.0........................................................      .0244
80.9........................................................      .0244
80.8........................................................      .0244
80.7........................................................      .0245
80.6........................................................      .0245
80.5........................................................      .0245
80.4........................................................      .0246
80.3........................................................      .0246
80.2........................................................      .0246
80.1........................................................      .0247
80.0........................................................      .0247
79.9........................................................      .0247
79.8........................................................      .0248
79.7........................................................      .0248
79.6........................................................      .0248
79.5........................................................      .0248
79.4........................................................      .0249
79.3........................................................      .0249
79.2........................................................      .0249
79.1........................................................      .0250
79.0........................................................      .0250
78.9........................................................      .0250
78.8........................................................      .0251
78.7........................................................      .0251
78.6........................................................      .0251
78.5........................................................      .0252
78.4........................................................      .0252
78.3........................................................      .0252
78.2........................................................      .0253
78.1........................................................      .0253
78.0........................................................      .0253
77.9........................................................      .0253
77.8........................................................      .0254
77.7........................................................      .0254
77.6........................................................      .0254
77.5........................................................      .0255
77.4........................................................      .0255
77.3........................................................      .0255
77.2........................................................      .0256
77.1........................................................      .0256
77.0........................................................      .0256
76.9........................................................      .0257
76.8........................................................      .0257
76.7........................................................      .0257
76.6........................................................      .0258
76.5........................................................      .0258
76.4........................................................      .0258
76.3........................................................      .0259
76.2........................................................      .0259
76.1........................................................      .0259
76.0........................................................      .0260
75.9........................................................      .0260
75.8........................................................      .0260
75.7........................................................      .0261
75.6........................................................      .0261
75.5........................................................      .0261
75.4........................................................      .0262
75.3........................................................      .0262
75.2........................................................      .0262
75.1........................................................      .0263
75.0........................................................      .0263
74.9........................................................      .0264
74.8........................................................      .0264
74.7........................................................      .0264
74.6........................................................      .0265
74.5........................................................      .0265
74.4........................................................      .0265
74.3........................................................      .0266
74.2........................................................      .0266
74.1........................................................      .0266
74.0........................................................      .0267
73.9........................................................      .0267
73.8........................................................      .0267
73.7........................................................      .0268
73.6........................................................      .0268
73.5........................................................      .0268
73.4........................................................      .0269
73.3........................................................      .0269
73.2........................................................      .0270
73.1........................................................      .0270
73.0........................................................      .0270
72.9........................................................      .0271
72.8........................................................      .0271
72.7........................................................      .0271
72.6........................................................      .0272
72.5........................................................      .0272
72.4........................................................      .0272
72.3........................................................      .0273
72.2........................................................      .0273
72.1........................................................      .0274
72.0........................................................      .0274
71.9........................................................      .0274
71.8........................................................      .0275
71.7........................................................      .0275
71.6........................................................      .0275
71.5........................................................      .0276
71.4........................................................      .0276
71.3........................................................      .0277
71.2........................................................      .0277
71.1........................................................      .0277
71.0........................................................      .0278
70.9........................................................      .0278
70.8........................................................      .0279
70.7........................................................      .0279
70.6........................................................      .0279
70.5........................................................      .0280
70.4........................................................      .0280
70.3........................................................      .0280
70.2........................................................      .0281
70.1........................................................      .0281
70.0........................................................      .0282
69.9........................................................      .0282
69.8........................................................      .0282
69.7........................................................      .0283
69.6........................................................      .0283
69.5........................................................      .0284
69.4........................................................      .0284
69.3........................................................      .0284
69.2........................................................      .0285
69.1........................................................      .0285
69.0........................................................      .0286
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68.8........................................................      .0287
68.7........................................................      .0287
68.6........................................................      .0287
68.5........................................................      .0288
68.4........................................................      .0288
68.3........................................................      .0289
68.2........................................................      .0289
68.1........................................................      .0289
68.0........................................................      .0290
67.9........................................................      .0290
67.8........................................................      .0291
67.7........................................................      .0291
67.6........................................................      .0292
67.5........................................................      .0292
67.4........................................................      .0292
67.3........................................................      .0293
67.2........................................................      .0293
67.1........................................................      .0294
67.0........................................................      .0294
66.9........................................................      .0295
66.8........................................................      .0295
66.7........................................................      .0295
66.6........................................................      .0296
66.5........................................................      .0296
66.4........................................................      .0297
66.3........................................................      .0297
66.2........................................................      .0298
66.1........................................................      .0298
66.0........................................................      .0299
65.9........................................................      .0299
65.8........................................................      .0299
65.7........................................................      .0300
65.6........................................................      .0300
65.5........................................................      .0301
65.4........................................................      .0301
65.3........................................................      .0302
65.2........................................................      .0302
65.1........................................................      .0303
65.0........................................................      .0303
64.9........................................................      .0303
64.8........................................................      .0304
64.7........................................................      .0304
64.6........................................................      .0305
64.5........................................................      .0305
64.4........................................................      .0306
64.3........................................................      .0306
64.2........................................................      .0307
64.1........................................................      .0307
64.0........................................................      .0308
63.9........................................................      .0308
63.8........................................................      .0309
63.7........................................................      .0309
63.6........................................................      .0310
63.5........................................................      .0310
63.4........................................................      .0311
63.3........................................................      .0311
63.2........................................................      .0312
63.1........................................................      .0312
63.0........................................................      .0313
62.9........................................................      .0313
62.8........................................................      .0313
62.7........................................................      .0314
62.6........................................................      .0314
62.5........................................................      .0315
62.4........................................................      .0315
62.3........................................................      .0316
62.2........................................................      .0316
62.1........................................................      .0317
62.0........................................................      .0317
61.9........................................................      .0318
61.8........................................................      .0318
61.7........................................................      .0319
61.6........................................................      .0319
61.5........................................................      .0320
61.4........................................................      .0320
61.3........................................................      .0321
61.2........................................................      .0322
61.1........................................................      .0322
61.0........................................................      .0323
60.9........................................................      .0323
60.8........................................................      .0324
60.7........................................................      .0324
60.6........................................................      .0325
60.5........................................................      .0325
60.4........................................................      .0326
60.3........................................................      .0326
60.2........................................................      .0327
60.1........................................................      .0327
60.0........................................................      .0328
59.9........................................................      .0328
59.8........................................................      .0329
59.7........................................................      .0329
59.6........................................................      .0330
59.5........................................................      .0331
59.4........................................................      .0331
59.3........................................................      .0332
59.2........................................................      .0332
59.1........................................................      .0333
59.0........................................................      .0333
58.9........................................................      .0334
58.8........................................................      .0334
58.7........................................................      .0335
58.6........................................................      .0336
58.5........................................................      .0336
58.4........................................................      .0337
58.3........................................................      .0337
58.2........................................................      .0338
58.1........................................................      .0338
58.0........................................................      .0339
57.9........................................................      .0340
57.8........................................................      .0340
57.7........................................................      .0341
57.6........................................................      .0341
57.5........................................................      .0342
57.4........................................................      .0342
57.3........................................................      .0343
57.2........................................................      .0344
57.1........................................................      .0344
57.0........................................................      .0345
56.9........................................................      .0345
56.8........................................................      .0346
56.7........................................................      .0347
56.6........................................................      .0347
56.5........................................................      .0348
56.4........................................................      .0348
56.3........................................................      .0349
56.2........................................................      .0350
56.1........................................................      .0350
56.0........................................................      .0351
55.9........................................................      .0351
55.8........................................................      .0352
55.7........................................................      .0353
55.6........................................................      .0353
55.5........................................................      .0354
55.4........................................................      .0355
55.3........................................................      .0355

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55.2........................................................      .0356
55.1........................................................      .0356
55.0........................................................      .0357
54.9........................................................      .0358
54.8........................................................      .0358
54.7........................................................      .0359
54.6........................................................      .0360
54.5........................................................      .0360
54.4........................................................      .0361
54.3........................................................      .0362
54.2........................................................      .0362
54.1........................................................      .0363
54.0........................................................      .0364
53.9........................................................      .0364
53.8........................................................      .0365
53.7........................................................      .0366
53.6........................................................      .0366
53.5........................................................      .0367
53.4........................................................      .0368
53.3........................................................      .0368
53.2........................................................      .0369
53.1........................................................      .0370
53.0........................................................      .0370
52.9........................................................      .0371
52.8........................................................      .0372
52.7........................................................      .0372
52.6........................................................      .0373
52.5........................................................      .0374
52.4........................................................      .0374
52.3........................................................      .0375
52.2........................................................      .0376
52.1........................................................      .0377
52.0........................................................      .0377
51.9........................................................      .0378
51.8........................................................      .0379
51.7........................................................      .0379
51.6........................................................      .0380
51.5........................................................      .0381
51.4........................................................      .0382
51.3........................................................      .0382
51.2........................................................      .0383
51.1........................................................      .0384
51.0........................................................      .0385
50.9........................................................      .0385
50.8........................................................      .0386
50.7........................................................      .0387
50.6........................................................      .0388
50.5........................................................      .0388
50.4........................................................      .0389
50.3........................................................      .0390
50.2........................................................      .0391
50.1........................................................      .0391
50.0........................................................      .0392
49.9........................................................      .0393
49.8........................................................      .0394
49.7........................................................      .0394
49.6........................................................      .0395
49.5........................................................      .0396
49.4........................................................      .0397
49.3........................................................      .0398
49.2........................................................      .0398
49.1........................................................      .0399
49.0........................................................      .0400
48.9........................................................      .0401
48.8........................................................      .0402
48.7........................................................      .0402
48.6........................................................      .0403
48.5........................................................      .0404
48.4........................................................      .0405
48.3........................................................      .0406
48.2........................................................      .0406
48.1........................................................      .0407
48.0........................................................      .0408
47.9........................................................      .0409
47.8........................................................      .0410
47.7........................................................      .0411
47.6........................................................      .0411
47.5........................................................      .0412
47.4........................................................      .0413
47.3........................................................      .0414
47.2........................................................      .0415
47.1........................................................      .0416
47.0........................................................      .0417
46.9........................................................      .0418
46.8........................................................      .0418
46.7........................................................      .0419
46.6........................................................      .0420
46.5........................................................      .0421
46.4........................................................      .0422
46.3........................................................      .0423
46.2........................................................      .0424
46.1........................................................      .0425
46.0........................................................      .0426
45.9........................................................      .0426
45.8........................................................      .0427
45.7........................................................      .0428
45.6........................................................      .0429
45.5........................................................      .0430
45.4........................................................      .0431
45.3........................................................      .0432
45.2........................................................      .0433
45.1........................................................      .0434
45.0........................................................      .0435
44.9........................................................      .0436
44.8........................................................      .0437
44.7........................................................      .0438
44.6........................................................      .0439
44.5........................................................      .0440
44.4........................................................      .0440
44.3........................................................      .0441
44.2........................................................      .0442
44.1........................................................      .0443
44.0........................................................      .0444
43.9........................................................      .0445
43.8........................................................      .0446
43.7........................................................      .0447
43.6........................................................      .0448
43.5........................................................      .0449
43.4........................................................      .0450
43.3........................................................      .0451
43.2........................................................      .0452
43.1........................................................      .0453
43.0........................................................      .0455
42.9........................................................      .0456
42.8........................................................      .0457
42.7........................................................      .0458
42.6........................................................      .0459
42.5........................................................      .0460
42.4........................................................      .0461
42.3........................................................      .0462
42.2........................................................      .0463
42.1........................................................      .0464
42.0........................................................      .0465
41.9........................................................      .0466
41.8........................................................      .0467
41.7........................................................      .0468

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41.6........................................................      .0469
41.5........................................................      .0471
41.4........................................................      .0472
41.3........................................................      .0473
41.2........................................................      .0474
41.1........................................................      .0475
41.0........................................................      .0476
40.9........................................................      .0477
40.8........................................................      .0478
40.7........................................................      .0480
40.6........................................................      .0481
40.5........................................................      .0482
40.4........................................................      .0483
40.3........................................................      .0484
40.2........................................................      .0485
40.1........................................................      .0487
40.0........................................................      .0488
39.9........................................................      .0489
39.8........................................................      .0490
39.7........................................................      .0491
39.6........................................................      .0493
39.5........................................................      .0494
39.4........................................................      .0495
39.3........................................................      .0496
39.2........................................................      .0497
39.1........................................................      .0499
39.0........................................................      .0500
38.9........................................................      .0501
38.8........................................................      .0502
38.7........................................................      .0504
38.6........................................................      .0505
38.5........................................................      .0506
38.4........................................................      .0508
38.3........................................................      .0509
38.2........................................................      .0510
38.1........................................................      .0511
38.0........................................................      .0513
37.9........................................................      .0514
37.8........................................................      .0515
37.7........................................................      .0517
37.6........................................................      .0518
37.5........................................................      .0519
37.4........................................................      .0521
37.3........................................................      .0522
37.2........................................................      .0524
37.1........................................................      .0525
37.0........................................................      .0526
36.9........................................................      .0528
36.8........................................................      .0529
36.7........................................................      .0530
36.6........................................................      .0532
36.5........................................................      .0533
36.4........................................................      .0525
36.3........................................................      .0536
36.2........................................................      .0538
36.1........................................................      .0539
36.0........................................................      .0541
35.9........................................................      .0542
35.8........................................................      .0543
35.7........................................................      .0545
35.6........................................................      .0546
35.5........................................................      .0548
35.4........................................................      .0549
35.3........................................................      .0551
35.2........................................................      .0552
35.1........................................................      .0554
35.0........................................................      .0556
34.9........................................................      .0557
34.8........................................................      .0559
34.7........................................................      .0560
34.6........................................................      .0562
34.5........................................................      .0563
34.4........................................................      .0565
34.3........................................................      .0566
34.2........................................................      .0566
34.1........................................................      .0570
34.0........................................................      .0571
33.9........................................................      .0573
33.8........................................................      .0575
33.7........................................................      .0576
33.6........................................................      .0578
33.5........................................................      .0580
33.4........................................................      .0581
33.3........................................................      .0583
33.2........................................................      .0585
33.1........................................................      .0586
33.0........................................................      .0588
32.9........................................................      .0590
32.8........................................................      .0592
32.7........................................................      .0593
32.6........................................................      .0595
32.5........................................................      .0597
32.4........................................................      .0599
32.3........................................................      .0600
32.2........................................................      .0602
32.1........................................................      .0604
32.0........................................................      .0606
31.9........................................................      .0608
31.8........................................................      .0610
31.7........................................................      .0611
31.6........................................................      .0613
31.5........................................................      .0615
31.4........................................................      .0617
31.3........................................................      .0619
31.2........................................................      .0621
31.1........................................................      .0623
31.0........................................................      .0625
30.9........................................................      .0627
30.8........................................................      .0629
30.7........................................................      .0631
30.6........................................................      .0633
30.5........................................................      .0635
30.4........................................................      .0637
30.3........................................................      .0639
30.2........................................................      .0641
30.1........................................................      .0643
30.0........................................................      .0645
29.9........................................................      .0647
29.8........................................................      .0649
29.7........................................................      .0651
29.6........................................................      .0653
29.5........................................................      .0656
29.4........................................................      .0658
29.3........................................................      .0660
29.2........................................................      .0662
29.1........................................................      .0664
29.0........................................................      .0667
28.9........................................................      .0669
28.8........................................................      .0671
28.7........................................................      .0673
28.6........................................................      .0675
28.5........................................................      .0678
28.4........................................................      .0680
28.3........................................................      .0682
28.2........................................................      .0685
28.1........................................................      .0687

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28.0........................................................      .0690
27.9........................................................      .0692
27.8........................................................      .0694
27.7........................................................      .0697
27.6........................................................      .0699
27.5........................................................      .0702
27.4........................................................      .0704
27.3........................................................      .0707
27.2........................................................      .0709
27.1........................................................      .0712
27.0........................................................      .0714
26.9........................................................      .0717
26.8........................................................      .0719
26.7........................................................      .0722
26.6........................................................      .0724
26.5........................................................      .0727
26.4........................................................      .0730
26.3........................................................      .0732
26.2........................................................      .0735
26.1........................................................      .0738
26.0........................................................      .0741
25.9........................................................      .0743
25.8........................................................      .0746
25.7........................................................      .0749
25.6........................................................      .0752
25.5........................................................      .0754
25.4........................................................      .0757
25.3........................................................      .0760
25.2........................................................      .0763
25.1........................................................      .0766
25.0........................................................      .0769
24.9........................................................      .0772
24.8........................................................      .0775
24.7........................................................      .0778
24.6........................................................      .0781
24.5........................................................      .0784
24.4........................................................      .0787
24.3........................................................      .0790
24.2........................................................      .0793
24.1........................................................      .0797
24.0........................................................      .0800
23.9........................................................      .0803
23.8........................................................      .0806
23.7........................................................      .0809
23.6........................................................      .0813
23.5........................................................      .0816
23.4........................................................      .0819
23.3........................................................      .0823
23.2........................................................      .0826
23.1........................................................      .0830
23.0........................................................      .0833
22.9........................................................      .0837
22.8........................................................      .0840
22.7........................................................      .0844
22.6........................................................      .0847
22.5........................................................      .0851
22.4........................................................      .0854
22.3........................................................      .0858
22.2........................................................      .0862
22.1........................................................      .0866
22.0........................................................      .0870
21.9........................................................      .0873
21.8........................................................      .0877
21.7........................................................      .0881
21.6........................................................      .0885
21.5........................................................      .0888
21.4........................................................      .0892
21.3........................................................      .0896
21.2........................................................      .0901
21.1........................................................      .0905
21.0........................................................      .0909
20.9........................................................      .0913
20.8........................................................      .0917
20.7........................................................      .0921
20.6........................................................      .0925
20.5........................................................      .0930
20.4........................................................      .0934
20.3........................................................      .0939
20.2........................................................      .0943
20.1........................................................      .0948
20.0........................................................      .0952
19.9........................................................      .0957
19.8........................................................      .0961
19.7........................................................      .0966
19.6........................................................      .0970
19.5........................................................      .0975
19.4........................................................      .0980
19.3........................................................      .0985
19.2........................................................      .0990
19.1........................................................      .0995
19.0........................................................      .1000
18.9........................................................      .1005
18.8........................................................      .1010
18.7........................................................      .1015
18.6........................................................      .1020
18.5........................................................      .1025
18.4........................................................      .1030
18.3........................................................      .1036
18.2........................................................      .1041
18.1........................................................      .1047
18.0........................................................      .1053
17.9........................................................      .1058
17.8........................................................      .1063
17.7........................................................      .1069
17.6........................................................      .1074
17.5........................................................      .1080
17.4........................................................      .1086
17.3........................................................      .1092
17.2........................................................      .1098
17.1........................................................      .1105
17.0........................................................      .1111
16.9........................................................      .1117
16.8........................................................      .1123
16.7........................................................      .1129
16.6........................................................      .1135
16.5........................................................      .1142
16.4........................................................      .1148
16.3........................................................      .1155
16.2........................................................      .1162
16.1........................................................      .1169
16.0........................................................      .1176
15.9........................................................      .1183
15.8........................................................      .1190
15.7........................................................      .1197
15.6........................................................      .1204
15.5........................................................      .1211
15.4........................................................      .1218
15.3........................................................      .1226
15.2........................................................      .1234
15.1........................................................      .1242
15.0........................................................      .1250
14.9........................................................      .1257
14.8........................................................      .1265
14.7........................................................      .1273
14.6........................................................      .1281
14.5........................................................      .1289

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14.4........................................................      .1297
14.3........................................................      .1306
14.2........................................................      .1315
14.1........................................................      .1324
14.0........................................................      .1333
13.9........................................................      .1342
13.8........................................................      .1350
13.7........................................................      .1359
13.6........................................................      .1368
13.5........................................................      .1378
13.4........................................................      .1387
13.3........................................................      .1397
13.2........................................................      .1407
13.1........................................................      .1418
13.0........................................................      .1429
12.9........................................................      .1438
12.8........................................................      .1448
12.7........................................................      .1458
12.6........................................................      .1469
12.5........................................................      .1479
12.4........................................................      .1490
12.3........................................................      .1502
12.2........................................................      .1514
12.1........................................................      .1526
12.0........................................................      .1538
11.9........................................................      .1549
11.8........................................................      .1561
11.7........................................................      .1573
11.6........................................................      .1585
11.5........................................................      .1597
11.4........................................................      .1610
11.3........................................................      .1624
11.2........................................................      .1637
11.1........................................................      .1652
11.0........................................................      .1667
10.9........................................................      .1680
10.8........................................................      .1693
10.7........................................................      .1707
10.6........................................................      .1721
10.5........................................................      .1736
10.4........................................................      .1751
10.3........................................................      .1767
10.2........................................................      .1783
10.1........................................................      .1800
10.0........................................................      .1818
9.9.........................................................      .1833
9.8.........................................................      .1849
9.7.........................................................      .1865
9.6.........................................................      .1882
9.5.........................................................      .1900
9.4.........................................................      .1918
9.3.........................................................      .1938
9.2.........................................................      .1957
9.1.........................................................      .1978
9.0.........................................................      .2000
8.9.........................................................      .2018
8.8.........................................................      .2037
8.7.........................................................      .2057
8.6.........................................................      .2077
8.5.........................................................      .2099
8.4.........................................................      .2121
8.3.........................................................      .2145
8.2.........................................................      .2169
8.1.........................................................      .2195
8.0.........................................................      .2222
7.9.........................................................      .2244
7.8.........................................................      .2267
7.7.........................................................      .2292
7.6.........................................................      .2317
7.5.........................................................      .2344
7.4.........................................................      .2372
7.3.........................................................      .2401
7.2.........................................................      .2432
7.1.........................................................      .2465
7.0.........................................................      .2500
6.9.........................................................      .2527
6.8.........................................................      .2556
6.7.........................................................      .2587
6.6.........................................................      .2619
6.5.........................................................      .2653
6.4.........................................................      .2689
6.3.........................................................      .2727
6.2.........................................................      .2768
6.1.........................................................      .2811
6.0.........................................................      .2857
5.9.........................................................      .2892
5.8.........................................................      .2929
5.7.........................................................      .2969
5.6.........................................................      .3011
5.5.........................................................      .3056
5.4.........................................................      .3103
5.3.........................................................      .3155
5.2.........................................................      .3210
5.1.........................................................      .3269
5.0.........................................................      .3333
4.9.........................................................      .3379
4.8.........................................................      .3429
4.7.........................................................      .3481
4.6.........................................................      .3538
4.5.........................................................      .3600
4.4.........................................................      .3667
4.3.........................................................      .3739
4.2.........................................................      .3818
4.1.........................................................      .3905
4.0.........................................................      .4000
3.9.........................................................      .4063
3.8.........................................................      .4130
3.7.........................................................      .4205
3.6.........................................................      .4286
3.5.........................................................      .4375
3.4.........................................................      .4474
3.3.........................................................      .4583
3.2.........................................................      .4706
3.1.........................................................      .4844
3.0.........................................................      .5000
2.9.........................................................      .5088
2.8.........................................................      .5185
2.7.........................................................      .5294
2.6.........................................................      .5417
2.5.........................................................      .5556
2.4.........................................................      .5714
2.3.........................................................      .5897
2.2.........................................................      .6111
2.1.........................................................      .6364
2.0.........................................................      .6667
1.9.........................................................      .6786
1.8.........................................................      .6923
1.7.........................................................      .7083
1.6.........................................................      .7273
1.5.........................................................      .7500
1.4.........................................................      .7778
1.3.........................................................      .8125
1.2.........................................................      .8571
1.1.........................................................      .9167
1.0.........................................................     1.0000
------------------------------------------------------------------------


[[Page 462]]

    Note: For determination of decimal equivalents of remaining lives 
falling between those shown in the above table, the taxpayer may use the 
next longest life shown in the table, interpolate from the table, or use 
the following formula from which the table was derived.

D = 2R / (W + 2F)(W + 1)

where:

D = Decimal equivalent.
R = Remaining life.
W = Whole number of years in remaining life.
F = Fractional part of a year in remaining life.

If the taxpayer desires to carry his calculations of decimal equivalents 
to a greater number of decimal places than is provided in the table, he 
may use the formula. The procedure adopted must be consistently followed 
thereafter.

    (b) Applied to group, classified, or composite accounts--(1) General 
rule. The sum of the years-digits method may be applied to group, 
classified, or composite accounts in accordance with the plan described 
in subparagraph (2) of this paragraph or in accordance with other plans 
as explained in subparagraph (3) of this paragraph.
    (2) Remaining life plan. The remaining life plan as applied to a 
single asset is described in paragraph (a)(2) of this section. This plan 
may also be applied to group, classified, or composite accounts. Under 
this plan the allowance for depreciation is computed by applying 
changing fractions to the unrecovered cost or other basis of the account 
reduced by estimated salvage. The numerator of the fraction changes each 
year to a number which corresponds to the remaining useful life of the 
account (including the year for which the allowance is being computed), 
and the denominator changes each year to a number which represents the 
sum of the years digits corresponding to the years of estimated 
remaining useful life of the account. Decimal equivalents of such 
fractions can be obtained by use of Table I under paragraph (a)(2)(ii) 
of this section. The proper application of this method requires that the 
estimated remaining useful life of the account be determined each year. 
This determination, of course, may be made each year by analysis, i.e., 
by determining the remaining lives for each of the components in the 
account, and averaging them. The estimated remaining life of any 
account, however, may also be determined arithmetically. For example, it 
may be computed by dividing the unrecovered cost or other basis of the 
account, as computed by straight line depreciation, by the gross cost or 
other basis of the account, and multiplying the result by the average 
life of the assets in the account. Salvage value is not a factor for the 
purpose of determining remaining life. Thus, if a group account with an 
average life of ten years had at January 1, 1958, a gross asset balance 
of $12,600 and a depreciation reserve computed on the straight line 
method of $9,450, the remaining life of the account at January 1, 1958, 
would be computed as follows:

$12,600-$9,450 / $12,600 x 10 years equals 2.50 years.

    Example. The use of the sum of the years-digits method with group, 
classified, or composite accounts under the remaining life plan is 
illustrated by the following example:

A calendar year taxpayer maintains a group account to which a five-year 
life is applicable. Original investment, additions, retirements, and 
salvage recoveries are the same as those set forth in example (3) of 
paragraph (b) of Sec.  1.167(b)-1.

[[Page 463]]


                                                             Depreciation Computations on a Group Account Under Remaining Life Plan
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                          1         2         3         4         5         6         7         8         9        10        11        12        13        14
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
 


------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                               Straight    Straight   Remaining    Asset    Current    Salvage        Sum of the years digits depreciation
                                                                                 line        line        life     balance  additions  realized -------------------------------------------------
                                                                                amount     reserve   -----------  reduced   reduced  ---------- Accumulated  Unrecovered    Rate      Allowable
                                                                              -----------------------               by         by                 reserve       Jan. 1    based on  depreciation
                                     Asset                            Average                         [Col. (1)-  salvage   salvage                Jan. 1   ------------- Col. (7) -------------
               Year                 balance   Current     Current      asset                           Col. (6) ---------------------          -------------                from
                                    Jan. 1   additions  retirements   balance             Col. (5)-     / Col.                                     Prior                   Table 1   Col. (12) x
                                                                               Col. (4)    Col. (3)     (1)] x   Col. (1)  Col (2) x             reserve +    Col. (8)-  ----------  Col. (13) +
                                                                                / life   accumulated   average   x (100%-    (100%-             Col. (14) +   Col. (11)              \1/2\ Col.
                                                                                            Jan. 1     service    6.67%)     6.67%)              Col. (10)-                          (9) x F\2\
                                                                                                         life                                     Col. (3)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
1954.............................  ........    $12,000  ...........    $6,000       \1\  ...........       5.00  ........    $11,200  ........  ...........  ...........    0.3333      $1,866
                                                                                 $1,200
1955.............................   $12,000  .........  ...........    12,000     2,400      $1,200        4.50   $11,200  .........  ........      $1,866       $9,334      .3600       3,360
1956.............................    12,000  .........  ...........    12,000     2,400       3,600        3.50    11,200  .........  ........       5,226        5,974      .4375       2,614
1957.............................    12,000  .........      $2,000     11,000     2,200       6,000        2.50    11,200  .........      $200       7,840        3,360      .5556       1,867
1958.............................    10,000  .........       2,000      9,000     1,800       6,200        1.90     9,333  .........       200       7,907        1,426      .6786         968
1959.............................     8,000     10,000       4,000     11,000     2,200       6,000        1.25     7,466      9,333       400       7,075          391      .8125       1,874
1960.............................    14,000  .........       2,000     13,000     2,600       4,200        3.50    13,066  .........  ........       5,349        7,717      .4375       3,376
1961.............................    12,000  .........       2,000     11,000     2,200       4,800        3.00    11,200  .........  ........       6,725        4,475      .5000       2,238
1962.............................  ........  .........  ...........  ........  ........       5,000   .........  ........  .........  ........       6,963
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ \1/2\ year's amount.
\2\ F = Rate based on average service life (0.3333 in this example).


[[Page 464]]

    (3) Other plans for application of the sum of the years-digits 
method. Taxpayers who wish to use the sum of the years-digits method in 
computing depreciation for group, classified, or composite accounts in 
accordance with a sum of the years digits plan other than the remaining 
life plan described herein may do so only with the consent of the 
Commissioner. Request for permission to use plans other than that 
described shall be addressed to the Commissioner of Internal Revenue, 
Washington, D.C. 20224.



Sec.  1.167(b)-4  Other methods.

    (a) Under section 167(b)(4) a taxpayer may use any consistent method 
of computing depreciation, such as the sinking fund method, provided 
depreciation allowances computed in accordance with such method do not 
result in accumulated allowances at the end of any taxable year greater 
than the total of the accumulated allowances which could have resulted 
from the use of the declining balance method described in section 
167(b)(2). This limitation applies only during the first two-thirds of 
the useful life of the property. For example, an asset costing $1,000 
having a useful life of six years may be depreciated under the declining 
balance method in accordance with Sec.  1.167(b)-2, at a rate of 33\1/3\ 
percent. During the first four years or \2/3\ of its useful life, 
maximum depreciation allowances under the declining balance method would 
be as follows:

------------------------------------------------------------------------
                                     Current     Accumulated
                                  depreciation  depreciation    Balance
------------------------------------------------------------------------
Cost of asset...................  ............  ............      $1,000
First year......................         $333          $333          667
Second year.....................          222           555          445
Third year......................          148           703          297
Fourth year.....................           99           802          198
------------------------------------------------------------------------


An annual allowance computed by any other method under section 167(b)(4) 
could not exceed $333 for the first year, and at the end of the second 
year the total allowances for the two years could not exceed $555. 
Likewise, the total allowances for the three years could not exceed $703 
and for the four years could not exceed $802. This limitation would not 
apply in the fifth and sixth years. See section 167(c) and Sec.  
1.167(c)-1 for restriction on the use of certain methods.
    (b) It shall be the responsibility of the taxpayer to establish to 
the satisfaction of the Commissioner that a method of depreciation under 
section 167(b)(4) is both a reasonable and consistent method and that it 
does not produce depreciation allowances in excess of the amount 
permitted under the limitations provided in such section.



Sec.  1.167(c)-1  Limitations on methods of computing depreciation 
under section 167(b) (2), (3), and (4).

    (a) In general. (1) Section 167(c) provides limitations on the use 
of the declining balance method described in section 167(b)(2), the sum 
of the years-digits method described in section 167(b)(3), and certain 
other methods authorized by section 167(b)(4). These methods are 
applicable only to tangible property having a useful life of three years 
or more. If construction, reconstruction, or erection by the taxpayer 
began before January 1, 1954, and was completed after December 31, 1953, 
these methods apply only to that portion of the basis of the property 
which is properly attributable to such construction, reconstruction, or 
erection after December 31, 1953. Property is considered as constructed, 
reconstructed, or erected by the taxpayer if the work is done for him in 
accordance with his specifications. The portion of the basis of such 
property attributable to construction, reconstruction, or erection after 
December 31, 1953, consists of all costs of the property allocable to 
the period after December 31, 1953, including the cost or other basis of 
materials entering into such work. It is not necessary that such 
materials be acquired after December 31, 1953, or that they be new in 
use. If construction or erection by the taxpayer began after December 
31, 1953, the entire cost or other basis of such construction or 
erection qualifies for these methods of depreciation. In the case of 
reconstruction of property, these methods do not apply to any part of 
the adjusted basis of such property on December 31, 1953. For purposes 
of this section, construction, reconstruction, or erection by the 
taxpayer begins when physical work is

[[Page 465]]

started on such construction, reconstruction, or erection.
    (2) If the property was not constructed, reconstructed, or erected 
by the taxpayer, these methods apply only if it was acquired after 
December 31, 1953, and if the original use of the property commences 
with the taxpayer and commences after December 31, 1953. For the purpose 
of the preceding sentence, property shall be deemed to be acquired when 
reduced to physical possession, or control. The term ``original use'' 
means the first use to which the property is put, whether or not such 
use corresponds to the use of such property by the taxpayer. For 
example, a reconditioned or rebuilt machine acquired after December 31, 
1953, will not be treated as being put to original use by the taxpayer 
even though it is put to a different use, nor will a horse acquired for 
breeding purposes be treated as being put to original use by the 
taxpayer if prior to the purchase the horse was used for racing 
purposes. See Sec. Sec.  1.167(b)-2, 1.167 (b)-3, and 1.167(b)-4 for 
application of the various methods.
    (3) Assets having an estimated average useful life of less than 
three years shall not be included in a group, classified, or composite 
account to which the methods described in Sec. Sec.  1.167 (b)-2, 
1.167(b)-3, and 1.167(b)-4 are applicable. However, an incidental 
retirement of an asset from such an account prior to the expiration of a 
useful life of three years will not prevent the application of these 
methods to such an account.
    (4) See section 381(c)(6) and the regulations thereunder for rules 
covering the use of depreciation methods by acquiring corporations in 
the case of certain corporate acquisitions.
    (5) See Sec. Sec.  1.1502-12(g) and 1.1502-13 for provisions dealing 
with depreciation of property received by a member of an affiliated 
group from another member of the group during a consolidated return 
period.
    (6) Except in the cases described in subparagraphs (4) and (5) of 
this paragraph, the methods of depreciation described in Sec. Sec.  
1.167(b)-2, 1.167(b-(3), and 1.167(b)-4 are not applicable to property 
in the hands of a distributee, vendee, transferee, donee, or grantee 
unless the original use of the property begins with such person and the 
conditions required by section 167(c) and this section are otherwise 
met. For example, these methods of depreciation may not be used by a 
corporation with respect to property which it acquires from an 
individual or partnership in exchange for its stock. Similarly, if an 
individual or partnership receives property in a distribution upon 
dissolution of a corporation, these methods of depreciation may not be 
used with respect to property so acquired by such individual or 
partnership. As a further example, these methods of depreciation may not 
be used by a partnership with respect to contributed property, nor by a 
partner with respect to partnership property distributed to him. 
Moreover, where a partnership is entitled to use these depreciation 
methods, and the optional adjustment to basis of partnership property 
provided by section 743 is applicable, (i) in the case of an increase in 
the adjusted basis of the partnership property under such section, the 
transferee partner with respect to whom such adjustment is applicable 
shall not be entitled to use such methods with respect to such increase, 
and (ii) in the case of a decrease in the adjusted basis of the 
partnership property under such section, the transferee partner with 
respect to whom such adjustment is applicable shall include in his 
income an amount equal to the portion of the depreciation deducted by 
the partnership which is attributable to such decrease.
    (b) Illustrations. (1) The application of these methods to property 
constructed, reconstructed, or erected by the taxpayer after December 
31, 1953, may be illustrated by the following examples:

    Example 1. If a building with a total cost of $100,000 is completed 
after December 31, 1953, and the portion attributable to construction 
after December 31, 1953, is determined by engineering estimates or by 
cost accounting records to be $30,000, the methods referred to in 
paragraph (a)(1) of this section are applicable only to the $30,000 
portion of the total.
    Example 2. In 1954, a taxpayer has an old machine with an 
unrecovered cost of $1,000. If he contracts to have it reconditioned, or 
reconditions it himself, at a cost of an additional $5,000, only the 
$5,000 may be depreciated under the methods referred to in paragraph 
(a)(1) of this section, whether or not the materials used for 
reconditioning are new in use.

[[Page 466]]

    Example 3. A taxpayer who acquired a building in 1940 makes major 
maintenance or repair expenditures in 1954 of a type which must be 
capitalized. For these expenditures the taxpayer may use a method of 
depreciation different from that used on the building (for example, the 
methods referred to in paragraph (a)(1) of this section) only if he 
accounts for such expenditures separately from the account which 
contained the original building. In such case, the unadjusted basis on 
any parts replaced shall be removed from the asset account and shall be 
charged to the appropriate depreciation reserve account. In the 
alternative he may capitalize such expenditures by charging them to the 
depreciation reserve account for the building.

    (2) The application of these methods to property which was not 
constructed, reconstructed, or erected by the taxpayer but which was 
acquired after December 31, 1953, may be illustrated by the following 
examples:

    Example 1. A taxpayer contracted in 1953 to purchase a new machine 
which he acquired in 1954 and put into first use in that year. He may 
use the methods referred to in paragraph (a)(1) of this section, in 
recovering the cost of the new machine.
    Example 2. A taxpayer instead of reconditioning his old machine buys 
a ``factory reconditioned'' machine in 1954 to replace it. He cannot 
apply the methods referred to in paragraph (a)(1) of this section, to 
any part of the cost of the reconditioned machine since he is not the 
first user of the machine.
    Example 3. In 1954, a taxpayer buys a house for $20,000 which had 
been used as a personal residence and thus had not been subject to 
depreciation allowances. He makes a capital addition of $5,000 and rents 
the property to another. The taxpayer may use the methods referred to in 
paragraph (a)(1) of this section, only with respect to the $5,000 cost 
of the addition.

    (c) Election to use methods. Subject to the limitations set forth in 
paragraph (a) of this section, the methods of computing the allowance 
for depreciation specified in section 167(b) (2), (3), and (4) may be 
adopted without permission and no formal election is required. In order 
for a taxpayer to elect to use these methods for any property described 
in paragraph (a) of this section, he need only compute depreciation 
thereon under any of these methods for any taxable year ending after 
December 31, 1953, in which the property may first be depreciated by 
him. The election with respect to any property shall not be binding with 
respect to acquisitions of similar property in the same year or 
subsequent year which are set up in separate accounts. If a taxpayer has 
filed his return for a taxable year ending after December 31, 1953, for 
which the return is required to be filed on or before September 15, 
1956, an election to compute the depreciation allowance under any of the 
methods specified in section 167 (b) or a change in such an election may 
be made in an amended return or claim for refund filed on or before 
September 15, 1956.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 7244, 37 FR 28897, Dec. 30, 1972; T.D. 8560, 59 FR 
41674, Aug. 15, 1994; T.D. 8597, 60 FR 36679, July 18, 1995]



Sec.  1.167(d)-1  Agreement as to useful life and rates of depreciation.

    After August 16, 1954, a taxpayer may, for taxable years ending 
after December 31, 1953, enter into an agreement with respect to the 
estimated useful life, method and rate of depreciation and treatment of 
salvage of any property which is subject to the allowance for 
depreciation. An application for such agreement may be made to the 
district director for the internal revenue district in which the 
taxpayer's return is required to be filed. Such application shall be 
filed in quadruplicate and shall contain in such detail as may be 
practical the following information:
    (a) The character and location of the property.
    (b) The original cost or other basis and date of acquisition.
    (c) Proper adjustments to the basis including depreciation 
accumulated to the first taxable year to be covered by the agreement.
    (d) Estimated useful life and estimated salvage value.
    (e) Method and rate of depreciation.
    (f) Any other facts and circumstances pertinent to making a 
reasonable estimate of the useful life of the property and its salvage 
value.

The agreement must be in writing and must be signed by the taxpayer and 
by the district director. The agreement must be signed in quadruplicate, 
and two of the signed copies will be returned to the taxpayer. The 
agreement

[[Page 467]]

shall set forth its effective date, the estimated remaining useful life, 
the estimated salvage value, and rate and method of depreciation of the 
property and the facts and circumstances taken into consideration in 
adoption of the agreement, and shall relate only to depreciation 
allowances for such property on and after the effective date of the 
agreement. Such an agreement shall be binding on both parties until such 
time as facts and circumstances which were not taken into account in 
making the agreement are shown to exist. The party wishing to modify or 
change the agreement shall have the responsibility of establishing the 
existence of such facts and circumstances. Any change in the useful life 
or rate specified in such agreement shall be effective only 
prospectively, that is, it shall be effective beginning with the taxable 
year in which notice of the intention to change, including facts and 
circumstances warranting the adjustment of useful life and rate, is sent 
by the party proposing the change to the other party and is sent by 
registered mail, if such notice is mailed before September 3, 1958, or 
is sent by certified mail or registered mail, if such notice is mailed 
after September 2, 1958. A copy of the agreement (and any modification 
thereof) shall be filed with the taxpayer's return for the first taxable 
year which is affected by the agreement (or any modification thereof). A 
signed copy should be retained with the permanent records of the 
taxpayer. For rules relating to changes in method of depreciation, see 
Sec.  1.167(e)-1 and section 446 and the regulations thereunder.



Sec.  1.167(e)-1  Change in method.

    (a) In general. (1) Any change in the method of computing the 
depreciation allowances with respect to a particular account (other than 
a change in method permitted or required by reason of the operation of 
former section 167(j)(2) and Sec.  1.167(j)-3(c)) is a change in method 
of accounting, and such a change will be permitted only with the consent 
of the Commissioner, except that certain changes to the straight line 
method of depreciation will be permitted without consent as provided in 
former section 167(e)(1), (2), and (3). Except as provided in paragraphs 
(c) and (d) of this section, a change in method of computing 
depreciation will be permitted only with respect to all the assets 
contained in a particular account as defined in Sec.  1.167(a)-7. Any 
change in the percentage of the current straight line rate under the 
declining balance method, for example, from 200 percent of the straight 
line rate to any other percent of the straight line rate, or any change 
in the interest factor used in connection with a compound interest or 
sinking fund method, will constitute a change in method of depreciation. 
Any request for a change in method of depreciation shall be made in 
accordance with section 446(e) and the regulations under section 446(e). 
For rules covering the use of depreciation methods by acquiring 
corporations in the case of certain corporate acquisitions, see section 
381(c)(6) and the regulations under section 381(c)(6).
    (2) Paragraphs (b), (c), and (d) of this section apply to property 
for which depreciation is determined under section 167 (other than under 
section 168, section 1400I, section 1400L(c), under section 168 prior to 
its amendment by the Tax Reform Act of 1986 (100 Stat. 2121), or under 
an additional first year depreciation deduction provision (for example, 
section 168(k), 1400L(b), or 1400N(d))) of the Internal Revenue Code.
    (b) Declining balance to straight line. In the case of an account to 
which the method described in section 167(b)(2) is applicable, a 
taxpayer may change without the consent of the Commissioner from the 
declining balance method of depreciation to the straight line method at 
any time during the useful life of the property under the following 
conditions. Such a change may not be made if a provision prohibiting 
such a change is contained in an agreement under section 167(d). When 
the change is made, the unrecovered cost or other basis (less a 
reasonable estimate for salvage) shall be recovered through annual 
allowances over the estimated remaining useful life determined in 
accordance with the circumstances existing at the time. With respect to 
any account, this change will be permitted only if applied to all the 
assets in the account as defined in

[[Page 468]]

Sec.  1.167(a)-7. If the method of depreciation described in section 
167(b)(2) (the declining balance method of depreciation using a rate not 
exceeding 200 percent of the straight line rate) is an acceptable method 
of depreciation with respect to a particular account, the taxpayer may 
elect under this paragraph to change to the straight line method of 
depreciation even if with respect to that particular account the 
declining balance method is permitted under a provision other than 
section 167(b)(2). Thus, for example, in the case of section 1250 
property to which section 167(j)(1) is applicable, section 167(b) does 
not apply, but the declining balance method of depreciation using 150 
percent of the straight line rate is an acceptable method of 
depreciation under section 167(j)(1)(B). Accordingly, the taxpayer may 
elect under this paragraph to change to the straight line method of 
depreciation with respect to such property. Similarly, if the taxpayer 
acquired used property before July 25, 1969, and adopted the 150 percent 
declining balance method of depreciation permitted with respect to such 
property under Sec.  1.167(b)-0(b), the taxpayer may elect under this 
paragraph to change to the straight line method of depreciation with 
respect to such property. The taxpayer shall furnish a statement with 
respect to the property which is the subject of the change showing the 
date of acquisition, cost or other basis, amounts recovered through 
depreciation and other allowances, the estimated salvage value, the 
character of the property, the remaining useful life of the property, 
and such other information as may be required. The statement shall be 
attached to the taxpayer's return for the taxable year in which the 
change is made. A change to the straight line method must be adhered to 
for the entire taxable year of the change and for all subsequent taxable 
years unless, with the consent of the Commissioner, a change to another 
method is permitted.
    (c) Change with respect to section 1245 property. (1) In respect of 
his first taxable year beginning after December 31, 1962, a taxpayer may 
elect, without the consent of the Commissioner, to change the method of 
depreciation of section 1245 property (as defined in section 1245(a)(3)) 
from any declining balance method or sum of the years-digits method to 
the straight line method. With respect to any account (as defined in 
Sec.  1.167(a)-7), this change may be made notwithstanding any provision 
to the contrary in an agreement under section 167(d), but such change 
shall constitute (as of the first day of such taxable year) a 
termination of such agreement as to all property in such account. With 
respect to any account, this change will be permitted only if applied to 
all the section 1245 property in the account. The election shall be made 
by a statement on, or attached to, the return for such taxable year 
filed on or before the last day prescribed by law, including any 
extensions thereof, for filing such return.
    (2) When an election under this paragraph is made in respect of 
section 1245 property in an account, the unrecovered cost or other basis 
(less a reasonable estimate for salvage) of all the section 1245 
property in the account shall be recovered through annual allowances 
over the estimated remaining useful life determined in accordance with 
the circumstances existing at that time. If there is other property in 
such account, the other property shall be placed in a separate account 
and depreciated by using the same method as was used before the change 
permitted by this paragraph, but the estimated useful life of such 
property shall be redetermined in accordance with Sec.  1.167(b)-2, or 
1.167(b)-3, whichever is applicable. The taxpayer shall maintain records 
which permit specific identification of the section 1245 property in the 
account with respect to which the election is made, and any other 
property in such account. The records shall also show for all the 
property in the account the date of acquisition, cost or other basis, 
amounts recovered through depreciation and other allowances, the 
estimated salvage value, the character of the property, and the 
remaining useful life of the property. A change to the straight line 
method under this paragraph must be adhered to for the entire taxable 
year of the change and for all subsequent taxable years unless, with the 
consent of the Commissioner, a change to another method is permitted.

[[Page 469]]

    (d) Change with respect to section 1250 property. (1) In respect of 
his first taxable year beginning after July 24, 1969, a taxpayer may 
elect, without the consent of the Commissioner, to change the method of 
depreciation of section 1250 property (as defined in section 1250(c)) 
from any declining balance method or sum of the years-digits method to 
the straight line method. With respect to any account (as defined in 
Sec.  1.167(a)-7) this change may be made notwithstanding any provision 
to the contrary in an agreement under section 167(d), but such change 
will constitute (as of the first day of such taxable year) a termination 
of such agreement as to all property in such account. With respect to 
any account, this change will be permitted only if applied to all the 
section 1250 property in the account. The election shall be made by a 
statement on, or attached to, the return for such taxable year filed on 
or before the last day prescribed by law, including extensions thereof, 
for filing such return.
    (2) When an election under this paragraph is made in respect of 
section 1250 property in an account, the unrecovered cost or other basis 
(less a reasonable estimate for salvage) of all the section 1250 
property in the account shall be recovered through annual allowances 
over the estimated remaining useful life determined in accordance with 
the circumstances existing at that time. If there is other property in 
such account, the other property shall be placed in a separate account 
and depreciated by using the same method as was used before the change 
permitted by this paragraph, but the estimated useful life of such 
property shall be redetermined in accordance with Sec.  1.167(b)-2 or 
Sec.  1.167(b)-3, whichever is applicable. The taxpayer shall maintain 
records which permit specific identification of the section 1250 
property in the account with respect to which the election is made and 
any other property in such account. The records shall also show for all 
the property in the account the date of the acquisition, cost or other 
basis, amounts recovered through depreciation and other allowances, the 
estimated salvage value, the character of the property, and the 
estimated remaining useful life of the property. A change to the 
straight line method under this paragraph must be adhered to for the 
entire taxable year of the change and for all subsequent taxable years 
unless, with the consent of the Commissioner, a change to another method 
is permitted.
    (e) Effective date. This section applies on or after December 30, 
2003. For the applicability of regulations before December 30, 2003, see 
Sec.  1.167(e)-1 in effect prior to December 30, 2003 (Sec.  1.167(e)-1 
as contained in 26 CFR part 1 edition revised as of April 1, 2003).

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6832, 30 FR 
8573, July 7, 1965; T.D. 7166, 37 FR 5245, Mar. 11, 1972; T.D. 9105, 69 
FR 7, Jan. 2, 2004; T.D. 9307, 71 FR 78068, Dec. 28, 2006]



Sec.  1.167(f)-1  Reduction of salvage value taken into account 
for certain personal property.

    (a) In general. For taxable years beginning after December 31, 1961, 
and ending after October 16, 1962, a taxpayer may reduce the amount 
taken into account as salvage value in computing the allowance for 
depreciation under section 167(a) with respect to ``personal property'' 
as defined in section 167(f)(2) and paragraph (b) of this section. The 
reduction may be made in an amount which does not exceed 10 percent of 
the basis of the property for determining depreciation, as of the time 
as of which salvage value is required to be determined (or when salvage 
value is redetermined), taking into account all adjustments under 
section 1016 other than (1) the adjustment under section 1016(a)(2) for 
depreciation allowed or allowable to the taxpayer, and (2) the 
adjustment under section 1016(a)(19) for a credit earned by the taxpayer 
under section 38, to the extent such adjustment is reflected in the 
basis for depreciation. See paragraph (c) of Sec.  1.167(a)-1 for the 
definition of salvage value, the time for making the determination, the 
redetermination of salvage value, and the general rules with respect to 
the treatment of salvage value. See also section 167(g) and Sec.  
1.167(g)-1 for basis for depreciation. A reduction of the amount taken 
into account as salvage value with respect to any property shall not be 
binding with

[[Page 470]]

respect to other property. In no event shall an asset (or an account) be 
depreciated below a reasonable salvage value after taking into account 
the reduction in salvage value permitted by section 167(f) and this 
section.
    (b) Definitions and special rules. The following definitions and 
special rules apply for purposes of section 167(f) and this section.
    (1) Personal property. The term ``personal property'' shall include 
only depreciable--
    (i) Tangible personal property (as defined in section 48 and the 
regulations thereunder) and
    (ii) Intangible personal property

which has an estimated useful life (determined at the time of 
acquisition) of 3 years or more and which is acquired after October 16, 
1962. Such term shall not include livestock. The term ``livestock'' 
includes horses, cattle, hogs, sheep, goats, and mink and other 
furbearing animals, irrespective of the use to which they are put or the 
purpose for which they are held. The original use of the property need 
not commence with the taxpayer so long as he acquired it after October 
16, 1962; thus, the property may be new or used. For purposes of 
determining the estimated useful life, the provisions of paragraph (b) 
of Sec.  1.167(a)-1 shall be applied. For rules determining when 
property is acquired, see subparagraph (2) of this paragraph. For 
purposes of determining the types of intangible personal property which 
are subject to the allowance for depreciation, see Sec.  1.167(a)-3.
    (2) Acquired. In determining whether property is acquired after 
October 16, 1962, property shall be deemed to be acquired when reduced 
to physical possession, or control. Property which has not been used in 
the taxpayer's trade or business or held for the production of income 
and which is thereafter converted by the taxpayer to such use shall be 
deemed to be acquired on the date of such conversion. In addition, 
property shall be deemed to be acquired if constructed, reconstructed, 
or erected by the taxpayer. If construction, reconstruction, or erection 
by the taxpayer began before October 17, 1962, and was completed after 
October 16, 1962, section 167(f) and this section apply only to that 
portion of the basis of the property which is properly attributable to 
such construction, reconstruction, or erection after October 16, 1962. 
Property is considered as constructed, reconstructed, or erected by the 
taxpayer if the work is done for him in accordance with his 
specifications. The portion of the basis of such property attributable 
to construction, reconstruction, or erection after October 16, 1962, 
consists of all costs of the property allocable to the period after 
October 16, 1962, including the cost or other basis of materials 
entering into such work. It is not necessary that such materials be 
acquired after October 16, 1962, or that they be new in use. If 
construction or erection by the taxpayer began after October 16, 1962, 
the entire cost or other basis of such construction or erection 
qualifies for the reduction provided for by section 167(f) and this 
section. In the case of reconstruction of property, section 167(f) and 
this section do not apply to any part of the adjusted basis of such 
property on October 16, 1962. For purposes of this section, 
construction, reconstruction, or erection by the taxpayer begins when 
physical work is started on such construction, reconstruction, or 
erection.
    (c) Illustrations. The provisions of paragraphs (a) and (b) of this 
section may be illustrated by the following examples:

    Example 1. Taxpayer A purchases a new asset for use in his business 
on January 1, 1963, for $10,000. The asset qualifies for the investment 
credit under section 38 and for the additional first-year depreciation 
allowance under section 179. A is entitled to an investment credit of 
$700 (7% x $10,000) and elects to take an additional first-year 
depreciation allowance of $2,000 (20% x $10,000). The basis for 
depreciation (determined in accordance with the provisions of section 
167(g) and Sec.  1.167(g)-1) is computed as follows:

Purchase price................................................   $10,000
Less: Adjustment required for taxable years               $700
 beginning before Jan. 1, 1964, under section
 1016(a)(19), for the investment credit.............
Adjustment required under section 1016(a)(2) for the     2,000
 additional first-year depreciation allowance.......
-----------------------------------------------------
                                                         2,700
                                                               ---------
Basis for depreciation for the taxable year 1963..............     7,300
                                                     ===========
 


[[Page 471]]


However, the basis of the property for determining depreciation as of 
the time as of which salvage value is required to be determined is 
$10,000, the purchase price of the property. A files his income tax 
returns on a calendar year basis and uses the straight line method of 
depreciation. A estimates that he will use the asset in his business for 
10 years after which it will have a salvage value of $500, which is less 
than $1,000 (10% x $10,000, the basis of the property for determining 
depreciation as of the time as of which salvage value is required to be 
determined). For the taxable year 1963 A may deduct $730 as the 
depreciation allowance. As of January 1, 1964, the basis of the asset is 
increased by $700 in accordance with paragraph (d) of Sec.  1.48-7. In 
computing his total depreciation allowance on the asset, A may reduce 
the amount taken into account as salvage value to zero and may claim 
depreciation deductions (including the additional first-year 
depreciation allowance) totaling $10,000. See paragraph (d) of Sec.  
1.48-7 for the computation of depreciation for taxable years beginning 
after December 31, 1963, where there is an increase in basis of property 
subject to the investment credit.
    Example 2. Assume the same facts as in example (1) except that A in 
a subsequent taxable year redetermines the estimate of the useful life 
of the asset and at the same time also redetermines the estimate of 
salvage value. Assume also that at such time the only reductions 
reflected in the basis are for depreciation allowed or allowable. 
Accordingly, the reduction under section 167(f) and this section will be 
computed with regard to the purchase price and not the unrecovered basis 
for depreciation at the time of the redetermination.
    Example 3. Assume the same facts as in example (1) except that A 
estimates that the asset will have a salvage value of $1,200 at the end 
of its useful life. In computing his depreciation for the asset, A may 
reduce the amount to be taken into account as salvage value to $200 
($1,200-$1,000). Accordingly, A may claim depreciation deductions 
(including the additional first-year depreciation allowance) totaling 
$9,800, i.e., the purchase price of the property ($10,000) less the 
amount taken into account as salvage value ($200).
    Example 4. Assume the same facts as in example (1) except that the 
taxpayer had taken into account salvage value of only $200 but that the 
estimated salvage value had actually been $700. The amount of salvage 
value taken into account by the taxpayer is permissible since the 
reduction of salvage value by $500 ($700-$200) would be within the limit 
provided for in section 167 (f), i.e., $1,000 (10% x $10,000).
    Example 5. On January 1, 1963, taxpayer B, a taxicab operator, 
traded his old taxicab plus cash for a new one, which had an estimated 
useful life of three years, in a transaction qualifying as a nontaxable 
exchange. The old taxicab had an adjusted basis of $2,500. B was allowed 
$3,000 for his old taxicab and paid $1,000 in cash. The basis of the new 
taxicab for determining depreciation (as determined under section 167(g) 
and Sec.  1.167(g)-1) is the adjusted basis of the old taxicab at the 
time of trade-in ($2,500) plus the additional cash paid out ($1,000), or 
$3,500. In computing his depreciation allowance on the new taxicab, B 
may reduce the amount taken into account as salvage value by $350 (10% 
of $3,500).
    Example 6. Taxpayer C purchases a new asset for use in his business 
on January 1, 1963, for $10,000. At the time of purchase, the asset has 
an estimated useful life of 10 years and an estimated salvage value of 
$1,500. C elects to compute his depreciation allowance for the asset by 
the declining balance method of depreciation, using a rate of 20% which 
is twice the normal straight line rate of 10% (without adjustment for 
salvage value). C files his income tax returns on a calendar year basis. 
In computing his depreciation allowance for the year 1966, C changes his 
method of determining the depreciation allowance for the asset from the 
declining balance method to the straight line method (in which salvage 
value is accounted for in determining the annual depreciation 
allowances) in accordance with the provisions of section 167(e) and 
paragraph (b) of Sec.  1.167(e)-1. He also wishes to reduce the amount 
of salvage value taken into account in accordance with the provisions of 
section 167(f) and this section. At the close of the year 1966, the only 
reductions reflected in the basis of the asset are for depreciation 
allowances. Thus, C may reduce the amount of salvage value taken into 
account by $1,000 (10% x $10,000, the basis of the asset when it was 
acquired), and, therefore, will account for salvage value of only $500 
in computing his depreciation allowance for the asset in 1966 and 
subsequent years.
    Example 7. Taxpayer D purchases a station wagon for his personal use 
on January 1, 1962, for $4,500. On January 1, 1963, D converts the use 
of the station wagon to his business, and at that time it has an 
estimated useful life of 4 years, an estimated salvage value of $500, 
and a basis of $3,000 (as determined under section 167 (g) and Sec.  
1.167 (g)-1). Thus, for purposes of section 167 (f) and this section, D 
is deemed to have acquired the station wagon on January 1, 1963. D 
elects the straight line method of depreciation in computing the 
depreciation allowance for the station wagon and also wishes to reduce 
the amount of salvage value taken into account in accordance with the 
provisions of section 167(f) and this section. Accordingly, D may reduce 
the amount of salvage value taken into account by $300 (10% of $3,000). 
D files his income tax returns on a calendar year

[[Page 472]]

basis. His depreciation allowance for the year 1963 would be computed as 
follows:

Basis for depreciation..............................  ........    $3,000
Less:
  Salvage value.....................................      $500
  Reduction permitted by section 167(f).............       300
                                                     -----------
                                                                     200
                                                               ---------
Amount to be depreciated over the useful life.................     2,800
 


D's depreciation allowance on the station wagon for the year 1963 would 
be $700 ($2,800 divided by 4, the remaining useful life).

[T.D. 6712, 29 FR 3654, Mar. 24, 1964, as amended by T.D. 6838, 30 FR 
9064, July 20, 1965]



Sec.  1.167(g)-1  Basis for depreciation.

    The basis upon which the allowance for depreciation is to be 
computed with respect to any property shall be the adjusted basis 
provided in section 1011 for the purpose of determining gain on the sale 
or other disposition of such property. In the case of property which has 
not been used in the trade or business or held for the production of 
income and which is thereafter converted to such use, the fair market 
value on the date of such conversion, if less than the adjusted basis of 
the property at that time, is the basis for computing depreciation.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960. Redesignated, T.D. 6712, 29 FR 
3653, Mar. 24, 1964]



Sec.  1.167(h)-1  Life tenants and beneficiaries of trusts and estates.

    (a) Life tenants. In the case of property held by one person for 
life with remainder to another person, the deduction for depreciation 
shall be computed as if the life tenant were the absolute owner of the 
property so that he will be entitled to the deduction during his life, 
and thereafter the deduction, if any, shall be allowed to the 
remainderman.
    (b) Trusts. If property is held in trust, the allowable deduction is 
to be apportioned between the income beneficiaries and the trustee on 
the basis of the trust income allocable to each, unless the governing 
instrument (or local law) requires or permits the trustee to maintain a 
reserve for depreciation in any amount. In the latter case, the 
deduction is first allocated to the trustee to the extent that income is 
set aside for a depreciation reserve, and any part of the deduction in 
excess of the income set aside for the reserve shall be apportioned 
between the income beneficiaries and the trustee on the basis of the 
trust income (in excess of the income set aside for the reserve) 
allocable to each. For example:
    (1) If under the trust instrument or local law the income of a trust 
computed without regard to depreciation is to be distributed to a named 
beneficiary, the beneficiary is entitled to the deduction to the 
exclusion of the trustee.
    (2) If under the trust instrument or local law the income of a trust 
is to be distributed to a named beneficiary, but the trustee is directed 
to maintain a reserve for depreciation in any amount, the deduction is 
allowed to the trustee (except to the extent that income set aside for 
the reserve is less than the allowable deduction). The same result would 
follow if the trustee sets aside income for a depreciation reserve 
pursuant to discretionary authority to do so in the governing 
instrument.

No effect shall be given to any allocation of the depreciation deduction 
which gives any beneficiary or the trustee a share of such deduction 
greater than his pro rata share of the trust income, irrespective of any 
provisions in the trust instrument except as otherwise provided in this 
paragraph when the trust instrument or local law requires or permits the 
trustee to maintain a reserve for depreciation.
    (c) Estates. In the case of an estate the allowable deduction shall 
be apportioned between the estate and the heirs legatees, and devisees 
on the basis of income of the estate which is allocable to each.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960. Redesignated, T.D. 6712, 29 FR 
3653, Mar. 24, 1964]



Sec.  1.167(i)-1  Depreciation of improvements in the case of mines, etc.

    Property used in the trade or business or held for the production of 
income which is subject to the allowance for depreciation provided in 
section 611 shall be treated for all purposes of the Code as if it were 
property subject to the allowance for depreciation under section 167. 
The preceding sentence

[[Page 473]]

shall not limit the allowance for depreciation otherwise allowable under 
section 611.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960. Redesignated, T.D. 6712, 29 FR 
3653, Mar. 24, 1964]



Sec.  1.167(l)-1  Limitations on reasonable allowance in case of property 
of certain public utilities.

    (a) In general--(1) Scope. Section 167(l) in general provides 
limitations on the use of certain methods of computing a reasonable 
allowance for depreciation under section 167(a) with respect to ``public 
utility property'' (see paragraph (b) of this section) for all taxable 
years for which a Federal income tax return was not filed before August 
1, 1969. The limitations are set forth in paragraph (c) of this section 
for ``pre-1970 public utility property'' and in paragraph (d) of this 
section for ``post-1969 public utility property.'' Under section 167(l), 
a taxpayer may always use a straight line method (or other ``subsection 
(l) method'' as defined in paragraph (f) of this section). In general, 
the use of a method of depreciation other than a subsection (l) method 
is not prohibited by section 167(l) for any taxpayer if the taxpayer 
uses a ``normalization method of regulated accounting'' (described in 
paragraph (h) of this section). In certain cases, the use of a method of 
depreciation other than a subsection (l) method is not prohibited by 
section 167(l) if the taxpayer used a ``flow-through method of regulated 
accounting'' described in paragraph (i) of this section) for its ``July 
1969 regulated accounting period'' (described in paragraph (g) of this 
section) whether or not the taxpayer uses either a normalization or a 
flow-through method of regulated accounting after its July 1969 
regulated accounting period. However, in no event may a method of 
depreciation other than a subsection (l) method be used in the case of 
pre-1970 public utility property unless such method of depreciation is 
the ``applicable 1968 method'' (within the meaning of paragraph (e) of 
this section). The normalization requirements of section 167(l) with 
respect to public utility property defined in section 167(l)(3)(A) 
pertain only to the deferral of Federal income tax liability resulting 
from the use of an accelerated method of depreciation for computing the 
allowance for depreciation under section 167 and the use of straight 
line depreciation for computing tax expense and depreciation expense for 
purposes of establishing cost of services and for reflecting operating 
results in regulated books of account. Regulations under section 167(l) 
do not pertain to other book-tax timing differences with respect to 
State income taxes, F.I.C.A. taxes, construction costs, or any other 
taxes and items. The rules provided in paragraph (h)(6) of this section 
are to insure that the same time period is used to determine the 
deferred tax reserve amount resulting from the use of an accelerated 
method of depreciation for cost of service purposes and the reserve 
amount that may be excluded from the rate base or included in no-cost 
capital in determining such cost of services. The formula provided in 
paragraph (h)(6)(ii) of this section is to be used in conjunction with 
the method of accounting for the reserve for deferred taxes (otherwise 
proper under paragraph (h)(2) of this section) in accordance with the 
accounting requirements prescribed or approved, if applicable, by the 
regulatory body having jurisdiction over the taxpayer's regulated books 
of account. The formula provides a method to determine the period of 
time during which the taxpayer will be treated as having received 
amounts credited or charged to the reserve account so that the 
disallowance of earnings with respect to such amounts through rate base 
exclusion or treatment as no-cost capital will take into account the 
factor of time for which such amounts are held by the taxpayer. The 
formula serves to limit the amount of such disallowance.
    (2) Methods of depreciation. For purposes of section 167(l), in the 
case of a declining balance method each different uniform rate applied 
to the unrecovered cost or other basis of the property is a different 
method of depreciation. For purposes of section 167(l), a change in a 
uniform rate of depreciation due to a change in the useful life of the 
property or a change in the taxpayer's unrecovered cost or other basis 
for the property is not a change in the method of depreciation. The use 
of

[[Page 474]]

``guideline lives'' or ``class lives'' for Federal income tax purposes 
and different lives on the taxpayer's regulated books of account is not 
treated for purposes of section 167(l) as a different method of 
depreciation. Further, the use of an unrecovered cost or other basis or 
salvage value for Federal income tax purposes different from the basis 
or salvage value used on the taxpayer's regulated books of account is 
not treated as a different method of depreciation.
    (3) Application of certain other provisions to public utility 
property. For rules with respect to application of the investment credit 
to public utility property, see section 46(e). For rules with respect to 
the application of the class life asset depreciation range system, 
including the treatment of the use of ``class lives'' for Federal income 
tax purposes and different lives on the taxpayer's regulated books of 
account, see Sec.  1.167(a)-11 and Sec.  1.167(a)-12.
    (4) Effect on agreements under section 167(d). If the taxpayer has 
entered into an agreement under section 167(d) as to any public utility 
property and such agreement requires the use of a method of depreciation 
prohibited by section 167(l), such agreement shall terminate as to such 
property. The termination, in accordance with this subparagraph, shall 
not affect any other property (whether or not public utility property) 
covered by the agreement.
    (5) Effect of change in method of depreciation. If, because the 
method of depreciation used by the taxpayer with respect to public 
utility property is prohibited by section 167(l), the taxpayer changes 
to a method of depreciation not prohibited by section 167(l), then when 
the change is made the unrecovered cost or other basis shall be 
recovered through annual allowances over the estimated remaining useful 
life determined in accordance with the circumstances existing at that 
time.
    (b) Public utility property--(1) In general. Under section 
167(l)(3)(A), property is ``public utility property'' during any period 
in which it is used predominantly in a ``section 167(l) public utility 
activity''. The term ``section 167(l) public utility activity'' means 
the trade or business of the furnishing or sale of--
    (i) Electrical energy, water, or sewage disposal services,
    (ii) Gas or steam through a local distribution system,
    (iii) Telephone services,
    (iv) Other communication services (whether or not telephone 
services) if furnished or sold by the Communications Satellite 
Corporation for purposes authorized by the Communications Satellite Act 
of 1962 (47 U.S.C. 701), or
    (v) Transportation of gas or steam by pipeline,

if the rates for such furnishing or sale, as the case may be, are 
regulated, i.e., have been established or approved by a regulatory body 
described in section 167(l)(3)(A). The term ``regulatory body described 
in section 167(l)(3)(A)'' means a State (including the District of 
Columbia) or political subdivision thereof, any agency or 
instrumentality of the United States, or a public service or public 
utility commission or other body of any State or political subdivision 
thereof similar to such a commission. The term ``established or 
approved'' includes the filing of a schedule of rates with a regulatory 
body which has the power to approve such rates, even though such body 
has taken no action on the filed schedule or generally leaves 
undisturbed rates filed by the taxpayer involved.
    (2) Classification of property. If property is not used solely in a 
section 167(l) public utility activity, such property shall be public 
utility property if its predominant use is in a section 167(l) public 
utility activity. The predominant use of property for any period shall 
be determined by reference to the proper accounts to which expenditures 
for such property are chargeable under the system of regulated accounts 
required to be used for the period for which the determination is made 
and in accordance with the principles of Sec.  1.46-3(g)(4) (relating to 
credit for investment in certain depreciable property). Thus, for 
example, for purposes of determining whether property is used 
predominantly in the trade or business of the furnishing or sale of 
transportation of gas by pipeline, or furnishing or sale of gas through 
a local distribution system, or both, the rules prescribed in Sec.  
1.46-3(g)(4) apply,

[[Page 475]]

except that accounts 365 through 371, inclusive (Transmission Plant), 
shall be added to the accounts enumerated in subdivision (i) of such 
paragraph (g)(4).
    (c) Pre-1970 public utility property--(1) Definition. (i) Under 
section 167(l)(3)(B), the term ``pre-1970 public utility property'' 
means property which was public utility property at any time before 
January 1, 1970. If a taxpayer acquires pre-1970 public utility 
property, such property shall be pre-1970 public utility property in the 
hands of the taxpayer even though such property may have been acquired 
by the taxpayer in an arm's-length cash sale at fair market value or in 
a tax-free exchange. Thus, for example, if corporation X which is a 
member of the same controlled group of corporations (within the meaning 
of section 1563(a)) as corporation Y sells pre-1970 public utility 
property to Y, such property is pre-1970 public utility property in the 
hands of Y. The result would be the same if X and Y were not members of 
the same controlled group of corporations.
    (ii) If the basis of public utility property acquired by the 
taxpayer in a transaction is determined in whole or in part by reference 
to the basis of any of the taxpayer's pre-1970 public utility property 
by reason of the application of any provision of the code, and if 
immediately after the transaction the adjusted basis of the property 
acquired is less than 200 percent of the adjusted basis of such pre-1970 
public utility property immediately before the transaction, the property 
acquired is pre-1970 public utility property.
    (2) Methods of depreciation not prohibited. Under section 167(l)(1), 
in the case of pre-1970 public utility property, the term ``reasonable 
allowance'' as used in section 167(a) means, for a taxable year for 
which a Federal income tax return was not filed before August 1, 1969, 
and in which such property is public utility property, an allowance 
(allowable without regard to section 167(l)) computed under--
    (i) A subsection (l) method, or
    (ii) The applicable 1968 method (other than a subsection (l) method) 
used by the taxpayer for such property, but only if--
    (a) The taxpayer uses in respect of such taxable year a 
normalization method of regulated accounting for such property,
    (b) The taxpayer used a flow-through method of regulated accounting 
for such property for its July 1969 regulated accounting period, or
    (c) The taxpayer's first regulated accounting period with respect to 
such property is after the taxpayer's July 1969 regulated accounting 
period and the taxpayer used a flow-through method of regulated 
accounting for its July 1969 regulated accounting period for public 
utility property of the same kind (or if there is no property of the 
same kind, property of the most similar kind) most recently placed in 
service. See paragraph (e)(5) of this section for determination of same 
(or similar) kind.
    (3) Flow-through method of regulated accounting in certain cases. 
See paragraph (e)(6) of this section for treatment of certain taxpayers 
with pending applications for change in method of accounting as being 
deemed to have used a flow-through method of regulated accounting for 
the July 1969 regulated accounting period.
    (4) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. Corporation X, a calendar-year taxpayer subject to the 
jurisdiction of a regulatory body described in section 167(l)(3)(A), 
used the straight line method of depreciation (a subsection (l) method) 
for all of its public utility property for which depreciation was 
allowable on its Federal income tax return for 1967 (the latest taxable 
year for which X, prior to August 1, 1969, filed a return). Assume that 
under paragraph (e) of this section, X's applicable 1968 method is a 
subsection (l) method with respect to all of its public utility 
property. Thus, with respect to its pre-1970 public utility property, X 
may only use a straight line method (or any other subsection (l) method) 
of depreciation for all taxable years after 1967.
    Example 2. Corporation Y, a calendar-year taxpayer subject to the 
jurisdiction of the Federal Power Commission, is engaged exclusively in 
the transportation of gas by pipeline. On its Federal income tax return 
for 1967 (the latest taxable year for which Y, prior to August 1, 1969, 
filed a return), Y used the declining balance method of depreciation 
using a rate of 150 percent of the straightline

[[Page 476]]

rate for all of its nonsection 1250 public utility property with respect 
to which depreciation was allowable. Assume that with respect to all of 
such property, Y's applicable 1968 method under paragraph (e) of this 
section is such 150 percent declining balance method. Assume that Y used 
a normalization method of regulated accounting for all relevant 
regulated accounting periods. If Y continues to use a normalization 
method of regulated accounting, Y may compute its reasonable allowance 
for purposes of section 167(a) using such 150 percent declining balance 
method for its nonsection 1250 pre-1970 public utility property for all 
taxable years beginning with 1968, provided the use of such method is 
allowable without regard to section 167(l). Y may also use a subsection 
(l) method for any of such pre-1970 public utility property for all 
taxable years beginning after 1967. However, because each different 
uniform rate applied to the basis of the property is a different method 
of depreciation, Y may not use a declining balance method of 
depreciation using a rate of twice the straight line rate for any of 
such pre-1970 public utility property for any taxable year beginning 
after 1967.
    Example 3. Assume the same facts as in example (2) except that with 
respect to all of its nonsection 1250 pre-1970 public utility property 
accounted for in its July 1969 regulated accounting period Y used a 
flow-through method of regulated accounting for such period. Assume 
further that such property is the property on the basis of which the 
applicable 1968 method is established for pre-1970 public utility 
property of the same kind, but having a first regulated accounting 
period after the taxpayer's July 1969 regulated accounting period. 
Beginning with 1968, with respect to such property Y may compute its 
reasonable allowance for purposes of section 167(a) using the declining 
balance method of depreciation and a rate of 150 percent of the straight 
line rate, whether it uses a normalization or flow-through method of 
regulated accounting after its July 1969 regulated accounting period, 
provided the use of such method is allowable without regard to section 
167(l).

    (d) Post-1969 public utility property--(1) In general. Under section 
167(l)(3)(C), the term ``post-1969 public utility property'' means any 
public utility property which is not pre-1970 public utility property.
    (2) Methods of depreciation not prohibited. Under section 167(l)(2), 
in the case of post-1969 public utility property, the term ``reasonable 
allowance'' as used in section 167(a) means, for a taxable year, an 
allowance (allowable without regard to section 167(l)) computed under--
    (i) A subsection (l) method,
    (ii) A method of depreciation otherwise allowable under section 167 
if, with respect to the property, the taxpayer uses in respect of such 
taxable year a normalization method of regulated accounting, or
    (iii) The taxpayer's applicable 1968 method (other than a subsection 
(l) method) with respect to the property in question, if the taxpayer 
used a flow-through method of regulated accounting for its July 1969 
regulated accounting period for the property of the same (or similar) 
kind most recently placed in service, provided that the property in 
question is not property to which an election under section 167(l)(4)(A) 
applies. See Sec.  1.167(l)(2) for rules with respect to an election 
under section 167(l)(4)(A). See paragraph (e)(5) of this section for 
definition of same (or similar) kind.
    (3) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. Corporation X is engaged exclusively in the trade or 
business of the transportation of gas by pipeline and is subject to the 
jurisdiction of the Federal Power Commission. With respect to all its 
public utility property, X's applicable 1968 method (as determined under 
paragraph (e) of this section) is the straight line method of 
depreciation. X may determine its reasonable allowance for depreciation 
under section 167(a) with respect to its post-1969 public utility 
property under a straight line method (or other subsection (l) method) 
or, if X uses a normalization method of regulated accounting, any other 
method of depreciation, provided that the use of such other method is 
allowable under section 167 without regard to section 167(l).
    Example 2. Assume the same facts as in example (1) except that with 
respect to all of X's post-1969 public utility property the applicable 
1968 method (as determined under paragraph (e) of this section) is the 
declining balance method using a rate of 150 percent of the straight 
line rate. Assume further that all of X's pre-1970 public utility 
property was accounted for in its July 1969 regulated accounting period, 
and that X used a flow-through method of regulated accounting for such 
period. X may determine its reasonable allowance for depreciation under 
section 167 with respect to its post-1969 public utility property by 
using the straight line method of depreciation (or any other subsection 
(l)

[[Page 477]]

method), by using any method otherwise allowable under section 167 (such 
as a declining balance method) if X uses a normalization method of 
regulated accounting, or, by using the declining balance method using a 
rate of 150 percent of the straight line rate, whether or not X uses a 
normalization or a flow-through method of regulated accounting.

    (e) Applicable 1968 method--(1) In general. Under section 
167(l)(3)(D), except as provided in subparagraphs (3) and (4) of this 
paragraph, the term ``applicable 1968 method'' means with respect to any 
public utility property--
    (i) The method of depreciation properly used by the taxpayer in its 
Federal income tax return with respect to such property for the latest 
taxable year for which a return was filed before August 1, 1969,
    (ii) If subdivision (i) of this subparagraph does not apply, the 
method of depreciation properly used by the taxpayer in its Federal 
income tax return for the latest taxable year for which a return was 
filed before August 1, 1969, with respect to public utility property of 
the same kind (or if there is no property of the same kind, property of 
the most similar kind) most recently placed in service before the end of 
such latest taxable year, or
    (iii) If neither subdivision (i) nor (ii) of this subparagraph 
applies, a subsection (l) method.

If, on or after August 1, 1969, the taxpayer files an amended return for 
the taxable year referred to in subdivisions (i) and (ii) of this 
subparagraph, such amended return shall not be taken into consideration 
in determining the applicable 1968 method. The term ``applicable 1968 
method'' if such new method results to any public utility property, for 
the year of change and subsequent years, a method of depreciation 
otherwise allowable under section 167 to which the taxpayer changes from 
an applicable 1968 method if such new method results in a lesser 
allowance for depreciation for such property under section 167 in the 
year of change and the taxpayer secures the Commissioner's consent to 
the change in accordance with the procedures of section 446(e) and Sec.  
1.446-1.
    (2) Placed in service. For purposes of this section, property is 
placed in service on the date on which the period for depreciation 
begins under section 167. See, for example, Sec.  1.167(a)-10(b) and 
Sec.  1.167(a)-11(c)(2). If under an averaging convention property which 
is placed in service (as defined in Sec.  1.46-3(d)(ii)) by the taxpayer 
on different dates is treated as placed in service on the same date, 
then for purposes of section 167(l) the property shall be treated as 
having been placed in service on the date the period for depreciation 
with respect to such property would begin under section 167 absent such 
averaging convention. Thus, for example, if, except for the fact that 
the averaging convention used assumes that all additions and retirements 
made during the first half of the year were made on the first day of the 
year, the period of depreciation for two items of public utility 
property would begin on January 10 and March 15, respectively, then for 
purposes of determining the property of the same (or similar) kind most 
recently placed in service, such items of property shall be treated as 
placed in service on January 10 and March 15, respectively.
    (3) Certain section 1250 property. If a taxpayer is required under 
section 167(j) to use a method of depreciation other than its applicable 
1968 method with respect to any section 1250 property, the term 
``applicable 1968 method'' means the method of depreciation allowable 
under section 167(j) which is the most nearly comparable method to the 
applicable 1968 method determined under subparagraph (1) of this 
paragraph. For example, if the applicable 1968 method on new section 
1250 property is the declining balance method using 200 percent of the 
straight line rate, the most nearly comparable method allowable for new 
section 1250 property under section 167(j) would be the declining 
balance method using 150 percent of the straight line rate. If the 
applicable 1968 method determined under subparagraph (1) of this 
paragraph is the sum of the years-digits method, the term ``most nearly 
comparable method'' refers to any method of depreciation allowable under 
section 167(j).
    (4) Applicable 1968 method in certain cases. (i)(a) Under section 
167(l)(3)(E), if the taxpayer evidenced within the time

[[Page 478]]

and manner specified in (b) of this subdivision (i) the intent to use a 
method of depreciation under section 167 (other than its applicable 1968 
method as determined under subparagraph (1) or (3) of this paragraph or 
a subsection (l) method) with respect to any public utility property, 
such method of depreciation shall be deemed to be the taxpayer's 
applicable 1968 method with respect to such public utility property and 
public utility property of the same (or most similar) kind subsequently 
placed in service.
    (b) Under this subdivision (i), the intent to use a method of 
depreciation under section 167 is evidenced--
    (1) By a timely application for permission for a change in method of 
accounting filed by the taxpayer before August 1, 1969, or
    (2) By the use of such method of depreciation in the computation by 
the taxpayer of its tax expense for purposes of reflecting operating 
results in its regulated books of account for its July 1969 regulated 
accounting period, as established in the manner prescribed in paragraph 
(g)(1) (i), (ii), or (iii) of this section.
    (ii)(a) If public utility property is acquired in a transaction in 
which its basis in the hands of the transferee is determined in whole or 
in part by reference to its basis in the hands of the transferor by 
reason of the application of any provision of the Code, or in a transfer 
(including any purchase for cash or in exchange) from a related person, 
then in the hands of the transferee the applicable 1968 method with 
respect to such property shall be determined by reference to the 
treatment in respect of such property in the hands of the transferor.
    (b) For purposes of this subdivision (ii), the term ``related 
person'' means a person who is related to another person if either 
immediately before or after the transfer--
    (1) The relationship between such persons would result in a 
disallowance of losses under section 267 (relating to disallowance of 
losses, etc., between related taxpayers) or section 707(b) (relating to 
losses disallowed, etc., between partners and controlled partnerships) 
and the regulations thereunder, or
    (2) Such persons are members of the same controlled group of 
corporations, as defined in section 1563(a) (relating to definition of 
controlled group of corporations), except that ``more than 50 percent'' 
shall be substituted for ``at least 80 percent'' each place it appears 
in section 1563(a) and the regulations thereunder.
    (5) Same or similar. The classification of property as being of the 
same (or similar) kind shall be made by reference to the function of the 
public utility to which the primary use of the property relates. 
Property which performs the identical function in the identical manner 
shall be treated as property of the same kind. The determination that 
property is of a similar kind shall be made by reference to the proper 
account to which expenditures for the property are chargeable under the 
system of regulated accounts required to be used by the taxpayer for the 
period in which the property in question was acquired. Property, the 
expenditure for which is chargeable to the same account, is property of 
the most similar kind. Property, the expenditure for which is chargeable 
to an account for property which serves the same general function, is 
property of a similar kind. Thus, for example, if corporation X, a 
natural gas company, subject to the jurisdiction of the Federal Power 
Commission, had property properly chargeable to account 366 (relating to 
transmission plant structures and improvements) acquired an additional 
structure properly chargeable to account 366, under the uniform system 
of accounts prescribed for natural gas companies (class A and class B) 
by the Federal Power Commission, effective September 1, 1968, the 
addition would constitute property of the same kind if it performed the 
identical function in the identical manner. If, however, the addition 
did not perform the identical function in the identical manner, it would 
be property of the most similar kind.
    (6) Regulated method of accounting in certain cases. Under section 
167(l)(4)(B), if with respect to any pre-1970 public utility property 
the taxpayer filed a timely application for change in method of 
accounting referred to in subparagraph (4)(i)(b)(1) of this paragraph 
and

[[Page 479]]

with respect to property of the same (or similar) kind most recently 
placed in service the taxpayer used a flow-through method of regulated 
accounting for its July 1969 regulated accounting period, then for 
purposes of section 167(l)(1)(B) and paragraph (c) of this section the 
taxpayer shall be deemed to have used a flow-through method of regulated 
accounting with respect to such pre-1970 public utility property.
    (7) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. Corporation X is a calendar-year taxpayer. On its Federal 
income tax return for 1967 (the latest taxable year for which X, prior 
to August 1, 1969, filed a return) X used a straight line method of 
depreciation with respect to certain public utility property placed in 
service before 1965 and used the declining balance method of 
depreciation using 200 percent of the straight line rate (double 
declining balance) with respect to the same kind of public utility 
property placed in service after 1964. In 1968 and 1970, X placed in 
service additional public utility property of the same kind. The 
applicable 1968 method with respect to the above described public 
utility property is shown in the following chart:

----------------------------------------------------------------------------------------------------------------
        Property held in 1970             Placed in service      Method on 1967 return    Applicable 1968 method
----------------------------------------------------------------------------------------------------------------
Group 1..............................  Before 1965............  Straight line..........  Straight line.
Group 2..............................  After 1964 and before    Double declining         Double declining
                                        1968.                    balance.                 balance.
Group 3..............................  After 1967 and before    .......................   Do.
                                        1969.
Group 4..............................  After 1968.............  .......................   Do.
----------------------------------------------------------------------------------------------------------------

    Example 2. Corporation Y is a calendar-year taxpayer engaged 
exclusively in the trade or business of the furnishing of electrical 
energy. In 1954, Y placed in service hydroelectric generators and for 
all purposes Y has taken straight line depreciation with respect to such 
generators. In 1960, Y placed in service fossil fuel generators and for 
all purposes since 1960 has used the declining balance method of 
depreciation using a rate of 150 percent of the straight line rate 
(computed without reduction for salvage) with respect to such 
generators. After 1960 and before 1970 Y did not place in service any 
generators. In 1970, Y placed in service additional hydroelectric 
generators. The applicable 1968 method with respect to the hydroelectric 
generators placed in service in 1970 would be the straight line method 
because it was the method used by Y on its return for the latest taxable 
year for which Y filed a return before August 1, 1969, with respect to 
property of the same kind (i.e., hydroelectric generators) most recently 
placed in service.
    Example 3. Assume the same facts as in example (2), except that the 
generators placed in service in 1970 were nuclear generators. The 
applicable 1968 method with respect to such generators is the declining 
balance method using a rate of 150 percent of the straight line rate 
because, with respect to property of the most similar kind (fossil fuel 
generators) most recently placed in service, Y used such declining 
balance method on its return for the latest taxable year for which it 
filed a return before August 1, 1969.

    (f) Subsection (l) method. Under section 167(l)(3)(F), the term 
``subsection (l) method'' means a reasonable and consistently applied 
ratable method of computing depreciation which is allowable under 
section 167(a), such as, for example, the straight line method or a unit 
of production method or machine-hour method. The term ``subsection (l) 
method'' does not include any declining balance method (regardless of 
the uniform rate applied), sum of the years-digits method, or method of 
depreciation which is allowable solely by reason of section 167(b)(4) or 
(j)(1)(C).
    (g) July 1969 regulated accounting period--(1) In general. Under 
section 167(l)(3)(I), the term ``July 1969 regulated accounting period'' 
means the taxpayer's latest accounting period ending before August 1, 
1969, for which the taxpayer regularly computed, before January 1, 1970, 
its tax expense for purposes of reflecting operating results in its 
regulated books of account. The computation by the taxpayer of such tax 
expense may be established by reference to the following:
    (i) The most recent periodic report of a period ending before August 
1, 1969, required by a regulatory body described in section 167(l)(3)(A) 
having jurisdiction over the taxpayer's regulated books of account which 
was filed with such body before January 1, 1970 (whether or not such 
body has jurisdiction over rates).
    (ii) If subdivision (i) of this subparagraph does not apply, the 
taxpayer's most recent report to its shareholders for a period ending 
before August 1, 1969, but only if such report was distributed to the 
shareholders before January 1, 1970, and if the taxpayer's stocks or 
securities are traded in an established securities market during

[[Page 480]]

such period. For purposes of this subdivision, the term ``established 
securities market'' has the meaning assigned to such term in Sec.  
1.453-3(d)(4).
    (iii) If subdivisions (i) and (ii) of this subparagraph do not 
apply, entries made to the satisfaction of the district director before 
January 1, 1970, in its regulated books of account for its most recent 
accounting period ending before August 1, 1969.
    (2) July 1969 method of regulated accounting in certain 
acquisitions. If public utility property is acquired in a transaction in 
which its basis in the hands of the transferee is determined in whole or 
in part by reference to its basis in the hands of the transferor by 
reason of the application of any provision of the Code, or in a transfer 
(including any purchase for cash or in exchange) from a related person, 
then in the hands of the transferee the method of regulated accounting 
for such property's July 1969 regulated accounting period shall be 
determined by reference to the treatment in respect of such property in 
the hands of the transferor. See paragraph (e)(4)(ii) of this section 
for definition of ``related person''.
    (3) Determination date. For purposes of section 167(l), any 
reference to a method of depreciation under section 167(a), or a method 
of regulated accounting, taken into account by the taxpayer in computing 
its tax expense for its July 1969 regulated accounting period shall be a 
reference to such tax expense as shown on the periodic report or report 
to shareholders to which subparagraph (1) (i) or (ii) of this paragraph 
applies or the entries made on the taxpayer's regulated books of account 
to which subparagraph (1)(iii) of this paragraph applies. Thus, for 
example, assume that regulatory body A having jurisdiction over public 
utility property with respect to X's regulated books of account requires 
X to reflect its tax expense in such books using the same method of 
depreciation which regulatory body B uses for determining X's cost of 
service for ratemaking purposes. If in 1971, in the course of approving 
a rate change for X, B retroactively determines X's cost of service for 
ratemaking purposes for X's July 1969 regulated accounting period using 
a method of depreciation different from the method reflected in X's 
regulated books of account as of January 1, 1970, the method of 
depreciation used by X for its July 1969 regulated accounting period 
would be determined without reference to the method retroactively used 
by B in 1971.
    (h) Normalization method of accounting--(1) In general. (i) Under 
section 167(l), a taxpayer uses a normalization method of regulated 
accounting with respect to public utility property--
    (a) If the same method of depreciation (whether or not a subsection 
(l) method) is used to compute both its tax expense and its depreciation 
expense for purposes of establishing cost of service for ratemaking 
purposes and for reflecting operating results in its regulated books of 
account, and
    (b) If to compute its allowance for depreciation under section 167 
it uses a method of depreciation other than the method it used for 
purposes described in (a) of this subdivision, the taxpayer makes 
adjustments consistent with subparagraph (2) of this paragraph to a 
reserve to reflect the total amount of the deferral of Federal income 
tax liability resulting from the use with respect to all of its public 
utility property of such different methods of depreciation.
    (ii) In the case of a taxpayer described in section 167(l) (1) (B) 
or (2) (C), the reference in subdivision (i) of this subparagraph shall 
be a reference only to such taxpayer's ``qualified public utility 
property''. See Sec.  1.167(l)-2(b) for definition of ``qualified public 
utility property''.
    (iii) Except as provided in this subparagraph, the amount of Federal 
income tax liability deferred as a result of the use of different method 
of depreciation under subdivision (i) of this subparagraph is the excess 
(computed without regard to credits) of the amount the tax liability 
would have been had a subsection (l) method been used over the amount of 
the actual tax liability. Such amount shall be taken into account for 
the taxable year in which such different methods of depreciation are 
used. If, however, in respect of any taxable year the use of a method of 
depreciation other than a subsection (l) method for purposes of 
determining the taxpayer's reasonable allowance

[[Page 481]]

under section 167(a) results in a net operating loss carryover (as 
determined under section 172) to a year succeeding such taxable year 
which would not have arisen (or an increase in such carryover which 
would not have arisen) had the taxpayer determined his reasonable 
allowance under section 167(a) using a subsection (l) method, then the 
amount and time of the deferral of tax liability shall be taken into 
account in such appropriate time and manner as is satisfactory to the 
district director.
    (2) Adjustments to reserve. (i) The taxpayer must credit the amount 
of deferred Federal income tax determined under subparagraph (1)(i) of 
this paragraph for any taxable year to a reserve for deferred taxes, a 
depreciation reserve, or other reserve account. The taxpayer need not 
establish a separate reserve account for such amount but the amount of 
deferred tax determined under subparagraph (1) (i) of this paragraph 
must be accounted for in such a manner so as to be readily identifiable. 
With respect to any account, the aggregate amount allocable to deferred 
tax under section 167(l) shall not be reduced except to reflect the 
amount for any taxable year by which Federal income taxes are greater by 
reason of the prior use of different methods of depreciation under 
subparagraph (1)(i) of this paragraph. An additional exception is that 
the aggregate amount allocable to deferred tax under section 167(l) may 
be properly adjusted to reflect asset retirements or the expiration of 
the period for depreciation used in determining the allowance for 
depreciation under section 167(a).

    (ii) The provisions of this subparagraph may be illustrated by the 
following examples:

    Example 1. Corporation X is exclusively engaged in the 
transportation of gas by pipeline subject to the jurisdiction of the 
Federal Power Commission. With respect to its post-1969 public utility 
property, X is entitled under section 167(l)(2)(B) to use a method of 
depreciation other than a subsection (l) method if it uses a 
normalization method of regulated accounting. With respect to such 
property, X has not made any election under Sec.  1.167(a)-11 (relating 
to depreciation based on class lives and asset depreciation ranges). In 
1972, X places in service public utility property with an unadjusted 
basis of $2 million, and an estimated useful life of 20 years. X uses 
the declining balance method of depreciation with a rate twice the 
straight line rate. If X uses a normalization method of regulated 
accounting, the amount of depreciation allowable under section 167(a) 
with respect to such property for 1972 computed under the double 
declining balance method would be $200,000. X computes its tax expense 
and depreciation expense for purposes of determining its cost of service 
for rate-making purposes and for reflecting operating results in its 
regulated books of account using the straight line method of 
depreciation (a subsection (l) method). A depreciation allowance 
computed in this manner is $100,000. The excess of the depreciation 
allowance determined under the double declining balance method 
($200,000) over the depreciation expense computed using the straight 
line method ($100,000) is $100,000. Thus, assuming a tax rate of 48 
percent, X used a normalization method of regulated accounting for 1972 
with respect to property placed in service that year if for 1972 it 
added to a reserve $48,000 as taxes deferred as a result of the use by X 
of a method of depreciation for Federal income tax purposes different 
from that used for establishing its cost of service for ratemaking 
purposes and for reflecting operating results in its regulated books of 
account.
    Example 2. Assume the same facts as in example (1), except that X 
elects to apply Sec.  1.167(a)-11 with respect to all eligible property 
placed in service in 1972. Assume further that all property X placed in 
service in 1972 is eligible property. One hudnred percent of the asset 
guideline period for such property is 22 years and the asset 
depreciation range is from 17.5 years to 26.5 years. X uses the double 
declining balance method of depreciation, selects an asset depreciation 
period of 17.5 years, and applies the half-year convention (described in 
Sec.  1.167(a)-11(c)(2)(iii)). In 1972, the depreciation allowable under 
section 167(a) with respect to property placed in service in 1972 is 
$114,285 (determined without regard to the normalization requirements in 
Sec.  1.167(a)-11(b)(6) and in section 167(l)). X computes its tax 
expense for purposes of determining its cost of service for ratemaking 
purposes and for reflecting operating results in its regulated books of 
account using the straight line method of depreciation (a subsection (l) 
method), an estimated useful life of 22 years (that is, 100 percent of 
the asset guideline period), and the half-year convention. A 
depreciation allowance computed in this manner is $45,454. Assuming a 
tax rate of 48 percent, the amount that X must add to a reserve for 1972 
with respect to property placed in service that year in order to qualify 
as using a normalization method of regulated accounting under section 
167(l) (3) (G) is $27,429 and the amount in order to satisfy the 
normalization requirements of Sec.  1.167(a)-11(b)(6) is $5,610. X 
determined such amounts as follows:

[[Page 482]]



(1) Depreciation allowance on tax return (determined without    $114,285
 regard to section 167(l) and Sec.   1.167(a)-11(b) (6))....
(2) Line (1), recomputed using a straight line method.......      57,142
                                                             -----------
(3) Difference in depreciation allowance attributable to         $57,143
 different methods (line (1) minus line (2))................
(4) Amount to add to reserve under this paragraph (48             27,429
 percent of line (3)).......................................
                                                             ===========
(5) Amount in line (2)......................................     $57,142
(6) Line (5), recomputed by using an estimated useful life        45,454
 of 22 years and the half-year convention...................
                                                             -----------
(7) Difference in depreciation allowance attributable to         $11,688
 difference in depreciation periods.........................
(8) Amount to add to reserve under Sec.   1.167(a)-11(b) (6)       5,610
 (ii) (48 percent of line (7))..............................
                                                             ===========
 


If, for its depreciation expense for purposes of determining its cost of 
service for ratemaking purposes and for reflecting operating results in 
its regulated books of account, X had used a period in excess of the 
asset guideline period of 22 years, the total amount in lines (4) and 
(8) in this example would not be changed.
    Example 3. Corporation Y, a calendar-year taxpayer which is engaged 
in furnishing electrical energy, made the election provided by section 
167(l) (4) (a) with respect to its ``qualified public utility property'' 
(as defined in Sec.  1.167(l)-2(b)). In 1971, Y placed in service 
qualified public utility property which had an adjusted basis of $2 
million, estimated useful life of 20 years, and no salvage value. With 
respect to property of the same kind most recently placed in service, Y 
used a flow-through method of regulated accounting for its July 1969 
regulated accounting period and the applicable 1968 method is the 
declining balance method of depreciation using 200 percent of the 
straight line rate. The amount of depreciation allowable under the 
double declining balance method with respect to the qualified public 
utility property would be $200,000. Y computes its tax expense and 
depreciation expense for purposes of determining its cost of service for 
ratemaking purposes and for reflecting operating results in its 
regulated books of account using the straight line method of 
depreciation. A depreciation allowance with respect to the qualified 
public utility property determined in this manner is $100,000. The 
excess of the depreciation allowance determined under the double 
declining balance method ($200,000) over the depreciation expense 
computed using the straight line method ($100,000) is $100,000. Thus, 
assuming a tax rate of 48 percent, Y used a normalization method of 
regulated accounting for 1971 if for 1971 it added to a reserve $48,000 
as tax deferred as a result of the use by Y of a method of depreciation 
for Federal income tax purposes with respect to its qualified public 
utility property which method was different from that used for 
establishing its cost of service for ratemaking purposes and for 
reflecting operating results in its regulated books of account for such 
property.
    Example 4. Corporation Z, exclusively engaged in a public utility 
activity did not use a flow-through method of regulated accounting for 
its July 1969 regulated accounting period. In 1971, a regulatory body 
having jurisdiction over all of Z's property issued an order applicable 
to all years beginning with 1968 which provided, in effect, that Z use 
an accelerated method of depreciation for purposes of section 167 and 
for determining its tax expenses for purposes of reflecting operating 
results in its regulated books of account. The order further provided 
that Z normalize 50 percent of the tax deferral resulting from the use 
of the accelerated method of depreciation and that Z flow-through 50 
percent of the tax deferral resulting therefrom. Under section 167(l), 
the method of accounting provided in the order would not be a 
normalization method of regulated accounting because Z would not be 
permitted to normalize 100 percent of the tax deferral resulting from 
the use of an accelerated method of depreciation. Thus, with respect to 
its public utility property for purposes of section 167, Z may only use 
a subsection (l) method of depreciation.
    Example 5. Assume the same facts as in example (4) except that the 
order of the regulatory body provided, in effect, that Z normalize 100 
percent of the tax deferral with respect to 50 percent of its public 
utility property and flow-through the tax savings with respect to the 
other 50 percent of its property. Because the effect of such an order 
would allow Z to flow-through a portion of the tax savings resulting 
from the use of an accelerated method of depreciation, Z would not be 
using a normalization method of regulated accounting with respect to any 
of its properties. Thus, with respect to its public utility property for 
purposes of section 167, Z may only use a subsection (l) method of 
depreciation.

    (3) Establishing compliance with normalization requirements in 
respect of operating books of account. The taxpayer may establish 
compliance with the requirement in subparagraph (l)(i) of this paragraph 
in respect of reflecting operating results, and adjustments to a 
reserve, in its operating books of account by reference to the 
following:
    (i) The most recent periodic report for a period beginning before 
the end of the taxable year, required by a regulatory body described in 
section 167(l)(3)(A) having jurisdiction over the taxpayer's regulated 
operating books

[[Page 483]]

of account which was filed with such body before the due date 
(determined with regard to extensions) of the taxpayer's Federal income 
tax return for such taxable year (whether or not such body has 
jurisdiction over rates).
    (ii) If subdivision (i) of this subparagraph does not apply, the 
taxpayer's most recent report to its shareholders for the taxable year 
but only if (a) such report was distributed to the shareholders before 
the due date (determined with regard to extensions) of the taxpayer's 
Federal income tax return for the taxable year and (b) the taxpayer's 
stocks or securities are traded in an established securities market 
during such taxable year. For purposes of this subdivision, the term 
``established securities market'' has the meaning assigned to such term 
in Sec.  1.453-3(d)(4).
    (iii) If neither subdivision (i) nor (ii) of this subparagraph 
applies, entries made to the satisfaction of the district director 
before the due date (determined with regard to extensions) of the 
taxpayer's Federal income tax return for the taxable year in its 
regulated books of account for its most recent period beginning before 
the end of such taxable year.
    (4) Establishing compliance with normalization requirements in 
computing cost of service for ratemaking purposes. (i) In the case of a 
taxpayer which used a flow-through method of regulated accounting for 
its July 1969 regulated accounting period or thereafter, with respect to 
all or a portion of its pre-1970 public utility property, if a 
regulatory body having jurisdiction to establish the rates of such 
taxpayer as to such property (or a court which has jurisdiction over 
such body) issues an order of general application (or an order of 
specific application to the taxpayer) which states that such regulatory 
body (or court) will permit a class of taxpayers of which such taxpayer 
is a member (or such taxpayer) to use the normalization method of 
regulated accounting to establish cost of service for ratemaking 
purposes with respect to all or a portion of its public utility 
property, the taxpayer will be presumed to be using the same method of 
depreciation to compute both its tax expense and its depreciation 
expense for purposes of establishing its cost of service for ratemaking 
purposes with respect to the public utility property to which such order 
applies. In the event that such order is in any way conditional, the 
preceding sentence shall not apply until all of the conditions contained 
in such order which are applicable to the taxpayer have been fulfilled. 
The taxpayer shall establish to the satisfaction of the Commissioner or 
his delegate that such conditions have been fulfilled.
    (ii) In the case of a taxpayer which did not use the flow-through 
method of regulated accounting for its July 1969 regulated accounting 
period or thereafter (including a taxpayer which used a subsection (l) 
method of depreciation to compute its allowance for depreciation under 
section 167(a) and to compute its tax expense for purposes of reflecting 
operating results in its regulated books of account), with respect to 
any of its public utility property, it will be presumed that such 
taxpayer is using the same method of depreciation to compute both its 
tax expense and its depreciation expense for purposes of establishing 
its cost of service for ratemaking purposes with respect to its post-
1969 public utility property. The presumption described in the preceding 
sentence shall not apply in any case where there is (a) an expression of 
intent (regardless of the manner in which such expression of intent is 
indicated) by the regulatory body (or bodies), having jurisdiction to 
establish the rates of such taxpayer, which indicates that the policy of 
such regulatory body is in any way inconsistent with the use of the 
normalization method of regulated accounting by such taxpayer or by a 
class of taxpayers of which such taxpayer is a member, or (b) a decision 
by a court having jurisdiction over such regulatory body which decision 
is in any way inconsistent with the use of the normalization method of 
regulated accounting by such taxpayer or a class of taxpayers of which 
such taxpayer is a member. The presumption shall be applicable on 
January 1, 1970, and shall, unless rebutted, be effective until an 
inconsistent expression of intent is indicated by such regulatory body 
or by such court. An example of

[[Page 484]]

such an inconsistent expression of intent is the case of a regulatory 
body which has, after the July 1969 regulated accounting period and 
before January 1, 1970, directed public utilities subject to its 
ratemaking jurisdiction to use a flow-through method of regulated 
accounting, or has issued an order of general application which states 
that such agency will direct a class of public utilities of which the 
taxpayer is a member to use a flow-through method of regulated 
accounting. The presumption described in this subdivision may be 
rebutted by evidence that the flow-through method of regulated 
accounting is being used by the taxpayer with respect to such property.
    (iii) The provisions of this subparagraph may be illustrated by the 
following examples:

    Example 1. Corporation X is a calendar-year taxpayer and its 
``applicable 1968 method'' is a straight line method of depreciation. 
Effective January 1, 1970, X began collecting rates which were based on 
a sum of the years-digits method of depreciation and a normalization 
method of regulated accounting which rates had been approved by a 
regulatory body having jurisdiction over X. On October 1, 1971, a court 
of proper jurisdiction annulled the rate order prospectively, which 
annulment was not appealed, on the basis that the regulatory body had 
abused its discretion by determining the rates on the basis of a 
normalization method of regulated accounting. As there was no 
inconsistent expression of intent during 1970 or prior to the due date 
of X's return for 1970, X's use of the sum of the years-digits method of 
depreciation for purposes of section 167 on such return was proper. For 
1971, the presumption is in effect through September 30. During 1971, X 
may use the sum of the years-digits method of depreciation for purposes 
of section 167 from January 1 through September 30, 1971. After 
September 30, 1971, and for taxable years after 1971, X must use a 
straight line method of depreciation until the inconsistent court 
decision is no longer in effect.
    Example 2. Assume the same facts as in example (1), except that 
pursuant to the order of annulment, X was required to refund the portion 
of the rates attributable to the use of the normalization method of 
regulated accounting. As there was no inconsistent expression of intent 
during 1970 or prior to the due date of X's return for 1970, X has the 
benefit of the presumption with respect to its use of the sum of the 
years-digits method of depreciation for purposes of section 167, but 
because of the retroactive nature of the rate order X must file an 
amended return for 1970 using a straight line method of depreciation. As 
the inconsistent decision by the court was handed down prior to the due 
date of X's Federal income tax return for 1971, for 1971 and thereafter 
the presumption of subdivision (ii) of this subparagraph does not apply. 
X must file its Federal income tax returns for such years using a 
straight line method of depreciation.
    Example 3. Assume the same facts as in example (2), except that the 
annulment order was stayed pending appeal of the decision to a court of 
proper appellate jurisdiction, X has the benefit of the presumption as 
described in example (2) for the year 1970, but for 1971 and thereafter 
the presumption of subdivision (ii) of this subparagraph does not apply. 
Further, X must file an amended return for 1970 using a straight line 
method of depreciation and for 1971 and thereafter X must file its 
returns using a straight line method of depreciation unless X and the 
district director have consented in writing to extend the time for 
assessment of tax for 1970 and thereafter with respect to the issue of 
normalization method of regulated accounting for as long as may be 
necessary to allow for resolution of the appeal with respect to the 
annulment of the rate order.

    (5) Change in method of regulated accounting. The taxpayer shall 
notify the district director of a change in its method of regulated 
accounting, an order by a regulatory body or court that such method be 
changed, or an interim or final rate determination by a regulatory body 
which determination is inconsistent with the method of regulated 
accounting used by the taxpayer immediately prior to the effective date 
of such rate determination. Such notification shall be made within 90 
days of the date that the change in method, the order, or the 
determination is effective. In the case of a change in the method of 
regulated accounting, the taxpayer shall recompute its tax liability for 
any affected taxable year and such recomputation shall be made in the 
form of an amended return where necessary unless the taxpayer and the 
district director have consented in writing to extend the time for 
assessment of tax with respect to the issue of normalization method of 
regulated accounting.
    (6) Exclusion of normalization reserve from rate base. (i) 
Notwithstanding the provisions of subparagraph (1) of this paragraph, a 
taxpayer does not use a normalization method of regulated accounting if, 
for ratemaking purposes,

[[Page 485]]

the amount of the reserve for deferred taxes under section 167(l) which 
is excluded from the base to which the taxpayer's rate of return is 
applied, or which is treated as no-cost capital in those rate cases in 
which the rate of return is based upon the cost of capital, exceeds the 
amount of such reserve for deferred taxes for the period used in 
determining the taxpayer's tax expense in computing cost of service in 
such ratemaking.
    (ii) For the purpose of determining the maximum amount of the 
reserve to be excluded from the rate base (or to be included as no-cost 
capital) under subdivision (i) of this subparagraph, if solely an 
historical period is used to determine depreciation for Federal income 
tax expense for ratemaking purposes, then the amount of the reserve 
account for the period is the amount of the reserve (determined under 
subparagraph (2) of this paragraph) at the end of the historical period. 
If solely a future period is used for such determination, the amount of 
the reserve account for the period is the amount of the reserve at the 
beginning of the period and a pro rata portion of the amount of any 
projected increase to be credited or decrease to be charged to the 
account during such period. If such determination is made by reference 
both to an historical portion and to a future portion of a period, the 
amount of the reserve account for the period is the amount of the 
reserve at the end of the historical portion of the period and a pro 
rata portion of the amount of any projected increase to be credited or 
decrease to be charged to the account during the future portion of the 
period. The pro rata portion of any increase to be credited or decrease 
to be charged during a future period (or the future portion of a part-
historical and part-future period) shall be determined by multiplying 
any such increase or decrease by a fraction, the numerator of which is 
the number of days remaining in the period at the time such increase or 
decrease is to be accrued, and the denominator of which is the total 
number of days in the period (or future portion).
    (iii) The provisions of subdivision (i) of this subparagraph shall 
not apply in the case of a final determination of a rate case entered on 
or before May 31, 1973. For this purpose, a determination is final if 
all rights to request a review, a rehearing, or a redetermination by the 
regulatory body which makes such determination have been exhausted or 
have lapsed. The provisions of subdivision (ii) of this subparagraph 
shall not apply in the case of a rate case filed prior to June 7, 1974 
for which a rate order is entered by a regulatory body having 
jurisdiction to establish the rates of the taxpayer prior to September 
5, 1974, whether or not such order is final, appealable, or subject to 
further review or reconsideration.
    (iv) The provisions of this subparagraph may be illustrated by the 
following examples:

    Example 1. Corporation X is exclusively engaged in the 
transportation of gas by pipeline subject to the jurisdiction of the Z 
Power Commission. With respect to its post-1969 public utility property, 
X is entitled under section 167(l)(2)(B) to use a method of depreciation 
other than a subsection (l) method if it uses a normalization method of 
regulated accounting. With respect to X the Z Power Commission for 
purposes of establishing cost of service uses a recent consecutive 12-
month period ending not more than 4 months prior to the date of filing a 
rate case adjusted for certain known changes occurring within a 9-month 
period subsequent to the base period. X's rate case is filed on January 
1, 1975. The year 1974 is the recorded test period for X's rate case and 
is the period used in determining X's tax expense in computing cost of 
service. The rates are contemplated to be in effect for the years 1975, 
1976, and 1977. The adjustments for known changes relate only to wages 
and salaries. X's rate base at the end of 1974 is $145,000,000. The 
amount of the reserve for deferred taxes under section 167(l) at the end 
of 1974 is $1,300,000, and the reserve is projected to be $4,400,000 at 
the end of 1975, $6,500,000 at the end of 1976, and $9,800,000 at the 
end of 1977. X does not use a normalization method of regulated 
accounting if the Z Power Commission excludes more than $1,300,000 from 
the rate base to which X's rate of return is applied. Similarly, X does 
not use a normalization method of regulated accounting if, instead of 
the above, the Z Power Commission, in determining X's rate of return 
which is applied to the rate base, assigns to no-cost capital an amount 
that represents the reserve account for deferred tax that is greater 
than $1,300,000.
    Example 2. Assume the same facts as in example (1) except that the 
adjustments for known changes in cost of service made by

[[Page 486]]

the Z Power Commission include an additional depreciation expense that 
reflects the installation of new equipment put into service on January 
1, 1975. Assume further that the reserve for deferred taxes under 
section 167(1) at the end of 1974 is $1,300,000 and that the monthly net 
increases for the first 9 months of 1975 are projected to be:

January 1-31................................................    $310,000
February 1-28...............................................     300,000
March 1-31..................................................     300,000
April 1-30..................................................     280,000
May 1-31....................................................     270,000
June 1-30...................................................     260,000
July 1-31...................................................     260,000
August 1-31.................................................     250,000
September 1-30..............................................     240,000
                                                             -----------
                                                              $2,470,000
 


For its regulated books of account X accrues such increases as of the 
last day of the month but as a matter of convenience credits increases 
or charges decreases to the reserve account on the 15th day of the month 
following the whole month for which such increase or decrease is 
accrued. The maximum amount that may be excluded from the rate base is 
$2,470,879 (the amount in the reserve at the end of the historical 
portion of the period ($1,300,000) and a pro rata portion of the amount 
of any projected increase for the future portion of the period to be 
credited to the reserve ($1,170,879)). Such pro rata portion is computed 
(without regard to the date such increase will actually be posted to the 
account) as follows:

$310,000 x 243/273 =........................................    $275,934
300,000 x 215/273 =.........................................     236,264
300,000 x 184/273 =.........................................     202,198
280,000 x 154/273 =.........................................     157,949
270,000 x 123/273 =.........................................     121,648
260,000 x 93/273 =..........................................      88,571
260,000 x 62/273 =..........................................      59,048
250,000 x 31/273 =..........................................      28,388
240,000 x 1/273=............................................         879
                                                             -----------
                                                              $1,170,879
 

    Example 3. Assume the same facts as in example (1) except that for 
purposes of establishing cost of service the Z Power Commission uses a 
future test year (1975). The rates are contemplated to be in effect for 
1975, 1976, and 1977. Assume further that plant additions, depreciation 
expense, and taxes are projected to the end of 1975 and that the reserve 
for deferred taxes under section 167(l) is $1,300,000 for 1974 and is 
projected to be $4,400,000 at the end of 1975. Assume also that the Z 
Power Commission applies the rate of return to X's 1974 rate base of 
$145,000,000. X and the Z Power Commission through negotiation arrive at 
the level of approved rates. X uses a normalization method of regulated 
accounting only if the settlement agreement, the rate order, or record 
of the proceedings of the Z Power Commission indicates that the Z Power 
Commission did not exclude an amount representing the reserve for 
deferred taxes from X's rate base ($145,000,000) greater than $1,300,000 
plus a pro rata portion of the projected increases and decreases that 
are to be credited or charged to the reserve account for 1975. Assume 
that for 1975 quarterly net increases are projected to be:

1st quarter.................................................    $910,000
2nd quarter.................................................     810,000
3rd quarter.................................................     750,000
4th quarter.................................................     630,000
                                                             -----------
  Total.....................................................  $3,100,000
 


For its regulated books of account X will accrue such increases as of 
the last day of the quarter but as a matter of convenience will credit 
increases or charge decreases to the reserve account on the 15th day of 
the month following the last month of the quarter for which such 
increase or decrease will be accrued. The maximum amount that may be 
excluded from the rate base is $2,591,480 (the amount of the reserve at 
the beginning of the period ($1,300,000) plus a pro rata portion 
($1,291,480) of the $3,100,000 projected increase to be credited to the 
reserve during the period). Such portion is computed (without regard to 
the date such increase will actually be posted to the account) as 
follows:

$910,000 x 276/365=.........................................    $688,110
810,000 x 185/365=..........................................     410,548
750,000 x 93/365=...........................................     191,096
630,000 x 1/365=............................................       1,726
                                                             -----------
                                                              $1,291,480
 

    (i) Flow-through method of regulated accounting. Under section 
167(l)(3)(H), a taxpayer uses a flow-through method of regulated 
accounting with respect to public utility property if it uses the same 
method of depreciation (other than a subsection (l) method) to compute 
its allowance for depreciation under section 167 and to compute its tax 
expense for purposes of reflecting operating results in its regulated 
books of account unless such method is the same method used by the 
taxpayer to determine its depreciation expense for purposes of 
reflecting operating results in its regulated books of account. Except 
as provided in the preceding sentence, the method of depreciation used 
by a taxpayer with respect to public utility property for purposes of 
determining cost of service for ratemaking purposes or rate base for 
ratemaking purposes shall not be considered in determining whether the 
taxpayer used a flow-through method of regulated accounting. A taxpayer 
may establish use of a flow-through method of regulated accounting in 
the same manner that

[[Page 487]]

compliance with normalization requirements in respect of operating books 
of account may be established under paragraph (h)(4) of this section.

[T.D. 7315, 39 FR 20195, June 7, 1974]



Sec.  1.167(l)-2  Public utility property; election as to post-1969 property 
representing growth in capacity.

    (a) In general. Section 167(l)(2) prescribes the methods of 
depreciation which may be used by a taxpayer with respect to its post-
1969 public utility property. Under section 167(l)(2) (A) and (B) the 
taxpayer may use a subsection (l) method of depreciation (as defined in 
section 167(l)(3)(F)) or any other method of depreciation which is 
otherwise allowable under section 167 if, in conjunction with the use of 
such other method, such taxpayer uses the normalization method of 
accounting (as defined in section 167(l)(3)(G)). Paragraph (2)(C) of 
section 167(l) permits a taxpayer which used the flow-through method of 
accounting for its July 1969 accounting period (as these terms are 
defined in section 167(l)(3) (H) and (I), respectively) to use its 
applicable 1968 method of depreciation with respect to certain property. 
Section 167(l)(3)(D) describes the term ``applicable 1968 method''. 
Accordingly, a regulatory agency is not precluded by section 167(l) from 
requiring such a taxpayer subject to its jurisdiction to continue to use 
the flow-through method of accounting unless the taxpayer makes the 
election pursuant to section 167(l)(4)(A) and this section. Whether or 
not the election is made, if such a regulatory agency permits the 
taxpayer to change from the flow-through method of accounting, 
subsection (l)(2) (A) or (B) would apply and such taxpayer could, 
subject to the provisions of section 167(e) and the regulations 
thereunder (relating to change in method), use a subsection (l) method 
of depreciation or, if the taxpayer uses the normalization method of 
accounting, any other method of depreciation otherwise allowable under 
section 167.
    (1) Election. Under subparagraph (A) of section 167(l)(4), if the 
taxpayer so elects, the provisions of paragraph (2)(C) of section 167(l) 
shall not apply to its qualified public utility property (as such term 
is described in paragraph (b) of this section). In such case the 
taxpayer making the election shall use a method of depreciation 
prescribed by section 167(l)(2) (A) or (B) with respect to such 
property.
    (2) Property to which election shall apply. (i) Except as provided 
in subdivision (ii) of this subparagraph the election provided by 
section 167(l)(4)(A) shall apply to all of the qualified public utility 
property of the taxpayer.
    (ii) In the event that the taxpayer wishes the election provided by 
section 167(l)(4)(A) to apply to only a portion of its qualified public 
utility property, it must clearly identify the property to be subject to 
the election in the statement of election described in paragraph (e) of 
this section. Where all property which performs a certain function is 
included within the election, the election shall apply to all future 
acquisitions of qualified public utility property which perform the same 
function. Where only certain property within a functional group of 
property is included within the election, the election shall apply only 
to property which is of the same kind as the included property.
    (iii) The provisions of subdivision (ii) of this subparagraph may be 
illustrated by the following examples:

    Example 1. Corporation A, an electric utility company, wishes to 
have the election provided by section 167(l)(4)(A) apply only with 
respect to its production plant. A statement that the election shall 
apply only with respect to production plant will be sufficient to 
include within the election all of the taxpayer's qualified production 
plant of any kind. All public utility property of the taxpayer other 
than production plant will not be subject to the election.
    Example 2. Corporation B, an electric utility company, wishes to 
have the election provided by section 167(l)(4)(A) apply only with 
respect to nuclear production plant. A statement which clearly indicates 
that only nuclear production plant will be included in the election will 
be sufficient to exclude from the election all public utility property 
other than nuclear production plant.

    (b) Qualified public utility property--(1) Definition. For purposes 
of this section the term ``qualified public utility property'' means 
post-1969 public utility property to which section 167(l)(2)(C) applies, 
or would apply if the election described in section 167(l)(4)(A) had not

[[Page 488]]

been made, to the extent that such property constitutes property which 
increases the productive or operational capacity of the taxpayer with 
respect to the goods or services described in section 167(l)(3)(A) and 
does not represent the replacement of existing capacity. In the event 
that particular assets which are post-1969 public utility property both 
replace existing public utility property and increase the productive or 
operational capacity of the taxpayer, only that portion of each such 
asset which is properly allocable, pursuant to the provisions of 
subparagraph (3)(v) of this paragraph or paragraph (c)(2) of this 
section (as the case may be), to increasing the productive or 
operational capacity of the taxpayer shall be qualified public utility 
property.
    (2) Limitation on use of formula method. A taxpayer which makes the 
election with respect to all of its post-1969 public utility property 
may determine the amount of its qualified public utility property by 
using the formula method described in paragraph (c) of this section or, 
where the taxpayer so chooses, it may use any other method based on 
engineering data which is satisfactory to the Commissioner. A taxpayer 
which chooses to include only a portion of its post-1969 public utility 
property in the election described in paragraph (a)(1) of this section 
shall, in a manner satisfactory to the Commissioner and consistent with 
the provisions of subparagraph (3) of this paragraph, use a method based 
on engineering data. If a taxpayer uses the formula method described in 
paragraph (c) of this section, it must continue to use such method with 
respect to additions made in subsequent taxable years. The taxpayer may 
change from an engineering method to the formula method described in 
paragraph (c) of this section by filing a statement described in 
paragraph (h) of this section if it could have used such formula method 
for the prior taxable year.
    (3) Measuring capacity under an engineering method in the case of a 
general election. (i) The provisions of this subparagraph apply in the 
case of an election made with respect to all of the post-1969 public 
utility property of the taxpayer.
    (ii) A taxpayer which uses a method based on engineering data to 
determine the portion of its additions for a taxable year which 
constitutes qualified public utility property shall make such 
determination with reference to its ``adjusted capacity'' as of the 
first day of the taxable year during which such additions are placed in 
service. For purposes of this subparagraph, the term ``adjusted 
capacity'' means the taxpayer's capacity as of January 1, 1970, adjusted 
upward in the manner described in subdivision (iii) of this subparagraph 
for each taxable year ending after December 31, 1969, and before the 
first day of the taxable year during which the additions described in 
the preceding sentence are placed in service.
    (iii) The adjustment described in this subdivision for each taxable 
year shall be equal to the number of units of capacity by which 
additions for the taxable year of public utility property with respect 
to which the election had been made exceed the number of units of 
capacity of retirements for such taxable year of public utility property 
with respect to which the flow-through method of accounting was being 
used at the time of their retirement. If for any taxable year the 
computation in the preceding sentence results in a negative amount, such 
negative amount shall be taken into account as a reduction in the amount 
of the adjustment (computed without regard to this sentence) in 
succeeding taxable years.
    (iv) The provisions of this subparagraph may be illustrated by the 
following table which assumes that the taxpayer's adjusted capacity as 
of January 1, 1970, was 5,000 units:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                           1                                    2               3               4                5               6               7
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                             Units of
                                                                          Flow-through                       Adjusted         Actual         qualified
                          Year                              Additions      retirements    Net additions    capacity \1\      capacity      additions \1
                                                                                                                                                2\
--------------------------------------------------------------------------------------------------------------------------------------------------------
1970...................................................            1000             700             300             5000            5300             300
1971...................................................             300             500            (200)            5300            5100
1972...................................................             500             200             300             5300            5400             100

[[Page 489]]

 
1973...................................................             400             800            (400)            5400            5000
1974...................................................             600             400             200             5400            5200
1975...................................................             800             300             500             5400            5700             300
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Capacity as of Jan. 1, 1970, plus amounts in column 7 for years prior to the year for which determination is being made.
\2\ Column 6 minus column 5.

    (v) The qualified portion of the basis for depreciation (as defined 
in section 167(g)) of each asset or group of assets (if group or 
composite accounting is used by the taxpayer) subject to the election 
shall be determined using the following ratio:

Qualified portion of basis of asset / Total basis of asset = Units of 
          qualified additions computed in column 7 on chart / Units of 
          capacity of additions computed in column 2 on chart.

    (c) Formula method of determining amount of property subject to 
election--(1) In general. The following formula method may be used to 
determine the amount of qualified public utility property:

    Step 1. Find the total cost (within the meaning of section 1012) to 
the taxpayer of additions during the taxable year of all post-1969 
public utility property with respect to which section 167(l)(2)(C) would 
apply if the election had not been made.
    Step 2. Aggregate the cost (within the meaning of section 1012) to 
the taxpayer of all retirements during the taxable year of public 
utility property with respect to which the flow-through method of 
accounting was being used at the time of their retirement.
    Step 3. Subtract the figure reached in step 2 from the figure 
reached in step 1.


In the event that the figure reached in step 2 exceeds the figure 
reached in step 1 such excess shall be carried forward to the next 
taxable year and shall be aggregated with the cost (within the meaning 
of section 1012) to the taxpayer of all retirements referred to in step 
2 for such next taxable year.
    (2) Allocation of bases. The amount of qualified public utility 
property as determined in accordance with the formula method described 
in subparagraph (1) of this paragraph shall be allocated to the basis 
for depreciation (as defined in section 167(g)) of each asset or group 
of assets (if group or composite accounting is used by the taxpayer) 
subject to the election using the following ratio:

Amount of qualified additions computed in step 3 / Amount of total 
          additions computed in step 1 = Qualified portion of basis of 
          asset / Total basis of asset.

    (d) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. Corporation A, a telephone company subject to the 
jurisdiction of the Federal Communications Commission, elected, pursuant 
to the provisions of section 167(l)(4)(A) and this section, with respect 
to all of its qualified post-1969 public utility property to have the 
provisions of paragraph (2) (C) of section 167(l) not apply. In 1971 the 
Corporation added new underground cable with a cost (within the meaning 
of section 1012) to it of $4 million to its underground cable account. 
In the same year it retired public utility property with a cost (within 
the meaning of section 1012) to Corporation A of $1.5 million. The flow-
through method of accounting was being used with respect to all of the 
retired property at the time of retirement. Using the formula method 
described in paragraph (c) of this section, the amount of qualified 
underground cable would be determined as follows:

 
                                                                 Million
 
Step 1. Aggregate cost of flow-through additions..............      $4.0
Step 2. Cost of all flow-through retirements..................       1.5
                                                               ---------
Step 3. Figure reached in step 1 less figure reached in step 2       2.5
 


The amount of qualified public utility property to which section 
167(l)(2)(C) will not apply is $2.5 million. Pursuant to the provisions 
of paragraph (c)(2) of this section, the amount of qualified public 
utility property would be allocated to the basis for depreciation (as 
defined in section 167(g)) of an asset with a total basis for 
depreciation of $2 million as follows:

$2.5 million (figure in step 3)/$4 million (figure in step 1) = 
          Qualified portion of basis of asset/$2 million Qualified 
          portion of basis of asset = $1.25 million.

[[Page 490]]

    Example 2. In 1972 Corporation A (the corporation described in 
example (1)) added underground cable with a cost (within the meaning of 
section 1012) to it of $1 million. In the same year the cost (within the 
meaning of section 1012) to the corporation of retirements of public 
utility property with respect to which the flow-through method of 
accounting was being used was $3 million. There were no other additions 
or retirements. The amount of qualified public utility property would be 
determined as follows:

 
                                                                Million
 
Step 1. Aggregate cost of flow-through additions.............      $1.0
Step 2. Cost of all flow-through retirements.................       3.0
                                                              ----------
Step 3. Figure reached in step 1 less figure reached in step       (2.0)
 2...........................................................
 


Since retirements of flow-through public utility property for the year 
1972 exceeded additions made during such year, the excess retirements, 
$2.0 million, must be carried forward to be aggregated with retirements 
for 1973.
    Example 3. Corporation B, a gas pipeline company subject to the 
jurisdiction of the Federal Power Commission, made the election provided 
by section 167(l)(4)(A) and this section with respect to all of its 
post-1969 public utility property. Corporation B chose to use an 
engineering data method of determining which property was subject to the 
election provided by this section. In 1970, the corporation replaced a 
portion of its pipeline with respect to which the flow-through method of 
accounting was being used at the time of its retirement which had a peak 
capacity on January 1, 1970, of 100,000 thousand cubic feet (M c.f.) per 
day at a pressure of 14.73 pounds per square inch absolute (p.s.i.a.) 
with pipe with a capacity of 125,000 M c.f. per day at 14.73 p.s.i.a. 
Assuming that there were no other additions or retirements, using an 
engineering data method one-fifth of the new pipeline would be property 
subject to the election of this section effective for its taxable year 
beginning on January 1, 1971.
    Example 4. In 1970 Corporation C (with the same characteristics as 
the corporation described in example (3)) extended its pipeline 5 miles 
further than it extended on January 1, 1970. Assuming that there were no 
other additions or retirements, the entire extension would be property 
subject to the election provided by this section effective for its 
taxable year beginning on January 1, 1971.
    Example 5. As a result of a change of service areas between two 
corporations, in 1970 Corporation D (with the same characteristics as 
the corporation described in example (3)) retired a pipeline running 
north and south and replaced it with a pipeline of equal length and 
capacity running east and west. No part of the pipeline running east and 
west is property subject to the election.

    (e) Manner of making election. The election described in paragraph 
(a) of this section shall be made by filing, in duplicate, with the 
Commissioner of Internal Revenue, Washington, D.C. 20224, Attention, 
T:I:E, a statement of such election.
    (f) Content of statement. The statement described in paragraph (e) 
of this section shall indicate that an election is being made under 
section 167(l) of the Internal Revenue Code of 1954, and it shall 
contain the following information:
    (1) The name, address, and taxpayer identification number of the 
taxpayer,
    (2) Whether the taxpayer will use the formula method of determining 
the amount of its qualified public utility property described in 
paragraph (c) of this section, or an engineering method, and
    (3) Where the taxpayer wishes to include only a portion of its 
public utility property in the election pursuant to the provisions of 
paragraph (a)(2) of this section, a description sufficient to clearly 
identify the property to be included.
    (g) Time for making election. The election permitted by this section 
shall be made by filing the statement described in paragraph (e) of this 
section not later than Monday, June 29, 1970.
    (h) Change of method of determining amount of qualified property. 
Where a taxpayer which has elected pursuant to the provisions of section 
167(l)(4)(A) wishes to change, pursuant to the provisions of paragraph 
(b)(2) of this section, from an engineering data method of determining 
which of its property is qualified public utility property to the 
formula method described in paragraph (c) of this section, it may do so 
by filing a statement to that effect at the time that it files its 
income tax return, with the district director or director of the 
regional service center, with whom the taxpayer's income tax return is 
required to be filed.
    (i) Revocability of election. An election made under section 167(l) 
shall be irrevocable.
    (j) Effective date. The election prescribed by section 167(l)(4)(A) 
and this section shall be effective for taxable

[[Page 491]]

years beginning after December 31, 1970.

[T.D. 7045, 35 FR 8933, June 10, 1970. Redesignated by T.D. 7315, 39 FR 
20195, June 7, 1974]



Sec.  1.167(l)-3  Multiple regulation, asset acquisitions, 
reorganizations, etc.

    (a) Property not entirely subject to jurisdiction of one regulatory 
body--(1) In general. If a taxpayer which uses a method of depreciation 
other than a subsection (l) method of depreciation is required by a 
regulatory body having jurisdiction over less than all of its property 
to use, or not to use, a method of regulated accounting (i.e., 
normalization or flow-through), such taxpayer shall be considered as 
using, or not using, such method of regulated accounting only with 
respect to property subject to the jurisdiction of such regulatory body. 
In the case of property which is contained in a multiple asset account, 
the provisions of Sec.  1.167(a)-7(c) and Sec.  1.167 (a)-11(c)(1)(iv) 
apply to prohibit depreciating a single account by two or more different 
methods.
    (2) Jurisdiction of regulatory body. For purposes of this paragraph, 
a regulatory body is considered to have jurisdiction over property of a 
taxpayer if expenses with respect to the property are included in cost 
of service as determined by the regulatory body for ratemaking purposes 
or for reflecting operating results in its regulated books of account. 
For example, if regulatory body A, having jurisdiction over 60 percent 
of an item of X corporation's public utility property, required X to use 
the flow-through method of regulated accounting in circumstances which 
would bar X from using a method of depreciation under section 167(a) 
other than a subsection (l) method, and if regulatory body B, having 
jurisdiction over the remaining 40 percent of such item of property does 
not so require X to use the flow-through method of regulated accounting 
(or if the remaining 40 percent is not subject to the jurisdiction of 
any regulatory body), then with respect to 60 percent of the adjusted 
basis of the property X is prohibited from using a method of 
depreciation for purposes of section 167(a) other than a subsection (1) 
method. If in such example, A, having jurisdiction over 60 percent of 
X's public utility property, had jurisdiction over 100 percent of a 
particular generator, then with respect to the generator X would be 
prohibited from using a method of depreciation other than a subsection 
(l) method.
    (3) Public utility property subject to more than one regulatory 
body. If a regulatory body having jurisdiction over public utility 
property with respect to the taxpayer's regulated books of account 
requires the taxpayer to reflect its tax expense in such books in the 
manner used by the regulatory body having jurisdiction over the public 
utility property for purposes of determining the taxpayer's cost of 
service for ratemaking purposes, the rules of subparagraphs (1) and (2) 
of this paragraph shall apply.
    (b) Leasing transactions--(1) Leased property. Public utility 
property as defined in paragraph (b) of Sec.  1.167(l)-1 includes 
property which is leased by a taxpayer where the leasing of such 
property is part of the lessor's section 167(l) public utility activity. 
Thus, such leased property qualifies as public utility property even 
though the predominant use of such property by the lessee is in other 
than a section 167(l) public utility activity. Further, leased property 
qualifies as public utility property under section 167(l) even though 
the leasing is not part of the lessor's public utility activity if the 
predominant use of such property by the lessee or any sublessee is in a 
section 167(l) public utility activity. However, the limitations of 
section 167(l) apply to a taxpayer only if such taxpayer is subject to 
the jurisdiction of a regulatory body described in a section 
167(l)(3)(A). For example, if a financial institution purchases property 
which it then leases to a lessee which uses such property predominantly 
in a section 167(l) public utility activity, the property qualifies as 
public utility property. However, because the financial institution's 
rates for leasing the property are not subject to the jurisdiction of a 
regulatory body described in section 167(l)(3)(A), the provisions of 
section 167(l) do not apply to the depreciation deductions taken with 
respect to

[[Page 492]]

the property by the financial institution. For possible application of 
section 167(l) to the lessee, see subparagraph (2) of this paragraph.
    (2) Certain rental payments. Under section 167(l)(5), if a taxpayer 
leases property which is public utility property and the regulatory body 
having jurisdiction over such property for purposes of determining the 
taxpayer's operating results in its regulated books of account or for 
ratemaking purposes allows only an amount of such lessee's expenses with 
respect to the lease which is less than the amount which the taxpayer 
deducts for purposes of its Federal income tax liability, then a portion 
of the difference between such amounts shall not be allowed as a 
deduction by the taxpayer for purposes of its Federal income tax 
liability in such manner and time as the Commissioner or his delegate 
may determine consistent with the principles of Sec.  1.167(l)-1 and 
this section applicable as to when a method of depreciation other than a 
subsection (1) method may be used for purposes of section 167(a).
    (c) Certain partnership arrangements. Under section 167(l)(5), if 
property held by a partnership is not public utility property in the 
hands of the partnership but would be public utility property if an 
election was made under section 761 to be excluded from partnership 
treatment, then section 167(l) shall be applied by treating the partners 
as directly owning the property in proportion to their partnership 
interests.
    (d) Cross reference. See Sec.  1.167(l)-1(c)(1) for treatment of 
certain property as ``pre-1970 public utility property'' and Sec.  
1.167(l)-1(e)(4)(ii) for applicable 1968 method in the case of property 
acquired in certain transactions.

[T.D. 7315, 39 FR 20202, June 7, 1974]



Sec.  1.167(l)-4  Public utility property; election to use 
asset depreciation range system.

    (a) Application of section 167(l) to certain property subject to 
asset depreciation range system. If the taxpayer elects to compute 
depreciation under the asset depreciation range system described in 
Sec.  1.167(a)-11 with respect to certain public utility property placed 
in service after December 31, 1970, see Sec.  1.167(a)-11(b) (6).

(Sec. 167 of the Internal Revenue Code of 1954 (26 U.S.C. 167) and sec. 
7805 of the Internal Revenue Code of 1954 (26 U.S.C. 7805))

[T.D. 7128, 36 FR 11939, June 23, 1971. Redesignated by T.D. 7315, 39 FR 
20203, June 7, 1974]



Sec.  1.167(m)-1  Class lives.

    (a) For rules regarding the election to use the class life system 
authorized by section 167(m), see the provisions of Sec.  1.167(a)-11.

(Sec. 167(m), 85 Stat. 508 (26 U.S.C. 167))

[T.D. 7272, 38 FR 9986, Apr. 23, 1973]



Sec.  1.168-5  Special rules.

    (a) Retirement-replacement-betterment (RRB) property--(1) RRB 
replacement property placed in service before January 1, 1985. (i) 
Except as provided in paragraph (a)(1)(ii) of this section, the recovery 
deduction for the taxable year for retirement-replacement-betterment 
(RRB) replacement property (as defined in paragraph (a)(3) of this 
section) placed in service before January 1, 1985, shall be (in lieu of 
the amount determined under section 168(b)) an amount determined by 
applying to the unadjusted basis (as defined in section 168(d)(1) and 
the regulations thereunder) of such property the applicable percentage 
determined in accordance with the following table:

------------------------------------------------------------------------
                                         And the year the property is
                                             placed in service is:
      If the recovery year is:       -----------------------------------
                                        1981     1982     1983     1984
------------------------------------------------------------------------
                                         The applicable percentage is:
 
1...................................      100       50       33       25
2...................................  .......       50       45       38
3...................................  .......  .......       22       25
4...................................  .......  .......  .......       12
------------------------------------------------------------------------

    (ii) The provisions of paragraph (a)(1)(i) of this section do not 
apply to any taxpayer who did not use the RRB method of depreciation 
under section 167 as of December 31, 1980. In such case, RRB replacement 
property placed in service by the taxpayer after December 31, 1980, 
shall be treated as other 5-year recovery property under section 168.
    (2) RRB replacement property placed in service after December 31, 
1984. RRB replacement property placed in service

[[Page 493]]

after December 31, 1984, is treated as other 5-year recovery property 
under section 168.
    (3) RRB replacement property defined. RRB replacement property, for 
purposes of section 168, means replacement track material (including 
rail, ties, other track material, and ballast) installed by a railroad 
(including a railroad switching or terminal company) if--
    (i) The replacement is made pursuant to a scheduled program for 
replacement.
    (ii) The replacement is made pursuant to observations by 
maintenance-of-way personnel of specific track material needing 
replacement.
    (iii) The replacement is made pursuant to the detection by a rail-
test car of specific track material needing replacement, or
    (iv) The replacement is made as a result of a casualty.

Replacements made as a result of a casualty shall be RRB replacement 
property only to the extent that, in the case of each casualty, the 
replacement cost with respect to the replacement track material exceeds 
$50,000.
    (4) Recovery of adjusted basis of RRB property as of December 31, 
1980. The taxpayer shall recover the adjusted basis of RRB property (as 
defined in section 168(g)(6)) as of December 31, 1980, over a period of 
not less than 5 years and not more than 50 years, using a rate of 
recovery consistent with any method described in section 167(b), 
including the method described in section 167(b)(2), switching to the 
method described in section 167(b)(3) at a time to maximize the 
deduction. For purposes of determining the recovery allowance under this 
subparagraph, salvage value shall be disregarded and, in the case of a 
taxpayer that depreciated RRB property placed in service before January 
1, 1981, using the RRB method consistently for all periods after 
February 28, 1913, the adjusted basis of RRB property is the adjusted 
basis for purposes of determining the deduction for retirements under 
the RRB method, with no adjustment for depreciation sustained prior to 
March 1, 1913.
    (5) RRB property (which is not RRB replacement property) placed in 
service after December 31, 1980. Property placed in service by the 
taxpayer after December 31, 1980, which is not RRB replacement property 
and which, under the taxpayer's method of depreciation as of December 
31, 1980, would have been depreciated by the taxpayer under the RRB 
method, is treated as other property under section 168.
    (b)-(f) [Reserved]

[T.D. 8116, 51 FR 46619, Dec. 24, 1986]



Sec.  1.168(a)-1  Modified accelerated cost recovery system.

    (a) Section 168 determines the depreciation allowance for tangible 
property that is of a character subject to the allowance for 
depreciation provided in section 167(a) and that is placed in service 
after December 31, 1986 (or after July 31, 1986, if the taxpayer made an 
election under section 203(a)(1)(B) of the Tax Reform Act of 1986; 100 
Stat. 2143). Except for property excluded from the application of 
section 168 as a result of section 168(f) or as a result of a 
transitional rule, the provisions of section 168 are mandatory for all 
eligible property. The allowance for depreciation under section 168 
constitutes the amount of depreciation allowable under section 167(a). 
The determination of whether tangible property is property of a 
character subject to the allowance for depreciation is made under 
section 167 and the regulations under section 167.
    (b) This section is applicable on and after February 27, 2004.

[T.D. 9314, 72 FR 9248, Mar. 1, 2007]



Sec.  1.168(b)-1  Definitions.

    (a) Definitions. For purposes of section 168 and the regulations 
under section 168, the following definitions apply:
    (1) Depreciable property is property that is of a character subject 
to the allowance for depreciation as determined under section 167 and 
the regulations under section 167.
    (2) MACRS property is tangible, depreciable property that is placed 
in service after December 31, 1986 (or after July 31, 1986, if the 
taxpayer made an election under section 203(a)(1)(B) of the Tax Reform 
Act of 1986; 100 Stat. 2143) and subject to section 168, except

[[Page 494]]

for property excluded from the application of section 168 as a result of 
section 168(f) or as a result of a transitional rule.
    (3) Unadjusted depreciable basis is the basis of property for 
purposes of section 1011 without regard to any adjustments described in 
section 1016(a)(2) and (3). This basis reflects the reduction in basis 
for the percentage of the taxpayer's use of property for the taxable 
year other than in the taxpayer's trade or business (or for the 
production of income), for any portion of the basis the taxpayer 
properly elects to treat as an expense under section 179, section 179C, 
or any similar provision, and for any adjustments to basis provided by 
other provisions of the Internal Revenue Code and the regulations under 
the Code (other than section 1016(a)(2) and (3)) (for example, a 
reduction in basis by the amount of the disabled access credit pursuant 
to section 44(d)(7)). For property subject to a lease, see section 
167(c)(2).
    (4) Adjusted depreciable basis is the unadjusted depreciable basis 
of the property, as defined in Sec.  1.168(b)-1(a)(3), less the 
adjustments described in section 1016(a)(2) and (3).
    (b) Effective date. This section is applicable on or after February 
27, 2004.

[T.D. 9314, 72 FR 9248, Mar. 1, 2007]



Sec.  1.168(d)-0  Table of contents for the applicable convention rules.

    This section lists the major paragraphs in Sec.  1.168(d)-1.

   Sec.  1.168(d)-1 Applicable conventions--Half-year and mid-quarter 
                              conventions.

    (a) In general.
    (b) Additional rules for determining whether the mid-quarter 
convention applies and for applying the applicable convention.
    (1) Property described in section 168(f).
    (2) Listed property.
    (3) Property placed in service and disposed of in the same taxable 
year.
    (4) Aggregate basis of property.
    (5) Special rules for affiliated groups.
    (6) Special rule for partnerships and S corporations.
    (7) Certain nonrecognition transactions.
    (c) Disposition of property subject to the half-year or mid-quarter 
convention.
    (1) In general.
    (2) Example.
    (d) Effective date.

[T.D. 8444, 57 FR 48981, Oct. 29, 1992]



Sec.  1.168(d)-1  Applicable conventions--half-year 
and mid-quarter conventions.

    (a) In general. Under section 168(d), the half-year convention 
applies to depreciable property (other than certain real property 
described in section 168(d)(2)) placed in service during a taxable year, 
unless the mid-quarter convention applies to the property. Under section 
168(d)(3)(A), the mid-quarter convention applies to depreciable property 
(other than certain real property described in section 168(d)(2)) placed 
in service during a taxable year if the aggregate basis of property 
placed in service during the last three months of the taxable year 
exceeds 40 percent of the aggregate basis of property placed in service 
during the taxable year (``the 40-percent test''). Thus, if the 
depreciable property is placed in service during a taxable year that 
consists of three months or less, the mid-quarter convention applies to 
the property. Under section 168(d)(3)(b)(i), the depreciable basis of 
nonresidential real property, residential rental property, and any 
railroad grading or tunnel bore is disregarded in applying the 40-
percent test. For rules regarding property that is placed in service and 
disposed of in the same taxable year, see paragraph (b)(3) of this 
section. For the definition of ``aggregate basis of property,'' see 
paragraph (b)(4) if this section.
    (b) Additional rules for determining whether the mid-quarter 
convention applies and for applying the applicable convention--(1) 
Property described in section 168(f). In determining whether the 40-
percent test is testified for a taxable year, the depreciable basis of 
property described in section 168(f) (property to which section 168 does 
not apply) is not taken into account.
    (2) Listed property. The depreciable basis of listed property (as 
defined in section 280F(d)(4) and the regulations thereunder) placed in 
service during a taxable year is taken into account (unless otherwise 
excluded) in applying the 40-percent test.
    (3) Property placed in service and disposed of in the same taxable 
year. (i) Under section 168(d)(3)(B)(ii), the depreciable basis of 
property placed in service and disposed of in the same taxable

[[Page 495]]

year is not taken into account in determining whether the 40-percent 
test is satisfied. However, the depreciable basis of property placed in 
service, disposed of, subsequently reacquired, and again placed in 
service, by the taxpayer in the same taxable year must be taken into 
account in applying the 40-percent test, but the basis of the property 
is only taken into account on the later of the dates that the property 
is placed in service by the taxpayer during the taxable year. Further, 
see Sec. Sec.  1.168(i)-6(c)(4)(v)(B) and 1.168(i)-6(f) for rules 
relating to property placed in service and exchanged or involuntarily 
converted during the same taxable year.
    (ii) The applicable convention, as determined under this section, 
applies to all depreciable property (except nonresidential real 
property, residential rental property, and any railroad grading or 
tunnel bore) placed in service by the taxpayer during the taxable year, 
excluding property placed in service and disposed of in the same taxable 
year. However, see Sec. Sec.  1.168(i)-6(c)(4)(v)(A) and 1.168(i)-6(f) 
for rules relating to MACRS property that has a basis determined under 
section 1031(d) or section 1033(b). No depreciation deduction is allowed 
for property placed in service and disposed of during the same taxable 
year. However, see Sec.  1.168(k)-1(f)(1) for rules relating to 
qualified property or 50-percent bonus depreciation property, and Sec.  
1.1400L(b)-1(f)(1) for rules relating to qualified New York Liberty Zone 
property, that is placed in service by the taxpayer in the same taxable 
year in which either a partnership is terminated as a result of a 
technical termination under section 708(b)(1)(B) or the property is 
transferred in a transaction described in section 168(i)(7).
    (4) Aggregate basis of property. For purposes of the 40-percent 
test, the term ``aggregate basis of property'' means the sum of the 
depreciable bases of all items of depreciable property that are taken 
into account in applying the 40-percent test. ``Depreciable basis'' 
means the basis of depreciable property for purposes of determining gain 
under sections 1011 through 1024. The depreciable basis for the taxable 
year the property is placed in service reflects the reduction in basis 
for--
    (i) Any portion of the basis the taxpayer properly elects to treat 
as an expense under section 179;
    (ii) Any adjustment to basis under section 48(q); and
    (iii) The percentage of the taxpayer's use of the property for the 
taxable year other than in the taxpayer's trade or business (or for the 
production of income), but is determined before any reduction for 
depreciation under section 167(a) for that taxable year.
    (5) Special rules for affiliated groups--(i) In the case of a 
consolidated group (as defined in Sec.  1.1502-1(h)), all members of the 
group that are included on the consolidated return are treated as one 
taxpayer for purposes of applying the 40-percent test. Thus, the 
depreciable bases of all property placed in service by members of a 
consolidated group during a consolidated return year are taken into 
account (unless otherwise excluded) in applying the 40-percent test to 
determine whether the mid-quarter convention applies to property placed 
in service by the members during the consolidated return year. The 40-
percent test is applied separately to the depreciable bases of property 
placed in service by any member of an affiliated group that is not 
included in a consolidated return of the taxable year in which the 
property is placed in service.
    (ii) In the case of a corporation formed by a member or members of a 
consolidated group and that is itself a member of the consolidated group 
(``newly-formed subsidiary''), the depreciable bases of property placed 
in service by the newly-formed subsidiary in the consolidated return 
year in which it is formed is included with the depreciable bases of 
property placed in service during the consolidated return year by the 
other members of the consolidated group in applying the 40-percent test. 
If depreciable property is placed in service by a newly-formed 
subsidiary during the consolidated return year in which it was formed, 
the newly-formed subsidiary is considered as being in existence for the 
entire consolidated return year for purposes of applying the applicable 
convention to

[[Page 496]]

determine when the recovery period begins.
    (iii) The provisions of paragraph (b)(5)(ii) of this section are 
illustrated by the following example.

    Example. Assume a member of a consolidated group that files its 
return on a calendar-year basis forms a subsidiary on August 1. The 
subsidiary places depreciable property in service on August 5. If the 
mid-quarter convention applies to property placed in service by the 
members of the consolidated group (including the newly-formed 
subsidiary), the property placed in service by the subsidiary on August 
5 is deemed placed in service on the mid-point of the third quarter of 
the consolidated return year (i.e., August 15). If the mid-quarter 
convention does not apply, the property is deemed placed in service on 
the mid-point of the consolidated return year (i.e., July 1).

    (iv) In the case of a corporation that joins or leaves a 
consolidated group, the depreciable bases of property placed in service 
by the corporation joining or leaving the group during the portion of 
the consolidated return year that the corporation is a member of the 
consolidated group is included with the depreciable bases of property 
placed in service during the consolidated return year by the other 
members in applying the 40-percent test. The depreciable bases of 
property placed in service by the joining or leaving member in the 
taxable year before it joins or after it leaves the consolidated group 
is not taken into account by the consolidated group in applying the 40-
percent test for the consolidated return year. If a corporation leaves a 
consolidated group and joins another consolidated group, each 
consolidated group takes into account, in applying the 40-percent test, 
the depreciable bases of property placed in service by the corporation 
while a member of the group.
    (v) The provisions of paragraph (b)(5)(iv) of this section are 
illustrated by the following example.

    Example. Assume Corporations A and B file a consolidated return on a 
calendar-year basis. Corporation C, also a calendar-year taxpayer, 
enters the consolidated group on July 1 and is included on the 
consolidated return for that taxable year. The depreciable bases of 
property placed in service by C during the period of July 1 to December 
31 is included with the depreciable bases of property placed in service 
by A and B during the entire consolidated return year in applying the 
40-percent test. The depreciable bases of property placed in service by 
C from January 1 to June 30 is not taken into account by the 
consolidated group in applying the 40-percent test. If C was a member of 
another consolidated group during the period from January 1 to June 30, 
that consolidated group would include the depreciable bases of property 
placed in service by C during that period.

    (vi) A corporation that joins or leaves a consolidated group during 
a consolidated year is considered as being a member of the consolidated 
group for the entire consolidated return year for purposes of applying 
the applicable convention to determine when the recovery period begins 
for depreciable property placed in service by the corporation during the 
portion of the consolidated return year that the corporation is a member 
of the group.
    (vii) If depreciable property is placed in service by a corporation 
in the taxable year ending immediately before it joins a consolidated 
group or beginning immediately after it leaves a consolidated group, the 
applicable convention is applied to the property under either the full 
taxable year rules or the short taxable year rules, as applicable.
    (viii) The provisions of paragraphs (d)(5)(vi) and (vii) of this 
section are illustrated by the following example.

    Example. Assume that on July 1, C, a calendar-return corporation, 
joins a consolidated group that files a return on a calendar-year basis. 
The short taxable year rules apply to C for the period of January 1 to 
June 30. However, in applying the applicable convention to determine 
when the recovery period begins for depreciable property placed in 
service for the period of July 1 to December 31, C is considered as 
being a member of the consolidated group for the entire consolidated 
return year. Thus, if the half-year convention applies to depreciable 
property placed in service by the consolidated group (taking into 
account the depreciable bases of property placed in service by C after 
June 30), the property is deemed placed in service on the mid-point of 
the consolidated return year (i.e., July 1, if the group did not have a 
short taxable year).

    (ix) In the case of a transfer of depreciable property between 
members of a consolidated group, the following special rules apply for 
purposes of applying the 40-percent test. Property that is placed in 
service by one member of a

[[Page 497]]

consolidated group and transferred to another member of the same group 
is considered as placed in service on the date that it is placed in 
service by the transferor member, and the date it is placed in service 
by the transferee member is disregarded. In the case of multiple 
transfers of property between members of a consolidated group, the 
property is considered as placed in service on the date that the first 
member places the property in service, and the dates it is placed in 
service by other members are disregarded. The depreciable basis of the 
transferred property that is taken into account in applying the 40-
percent test is the depreciable basis of the property in the hands of 
the transferor member (as determined under paragraph (b)(4) of this 
section), or, in the case of multiple transfers of property between 
members, the depreciable basis in the hands of the first member that 
placed the property in service.
    (x) The provisions of paragraph (b)(5)(ix) of this section are 
illustrated by the following example.

    Example. Assume the ABC consolidated group files its return on a 
calendar-year basis. A, a member of the consolidated group, purchases 
depreciable property costing $50,000 and places the property in service 
on January 5, 1991. On December 1, 1991, the property is transferred for 
$75,000 to B, another member of the consolidated group. In applying the 
40-percent test to the members of the consolidated group for 1991, the 
property is considered as placed in service on January 5, the date that 
A placed the property in service, and the depreciable basis of the 
property that is taken into account is $50,000.

    (6) Special rule for partnerships and S corporations. In the case of 
property placed in service by a partnership or an S corporation, the 40-
percent test is generally applied at the partnership or corporate level. 
However, if a partnership or an S corporation is formed or availed of 
for the principal purpose of either avoiding the application of the mid-
quarter convention or having the mid-quarter convention apply where it 
otherwise would not, the 40-percent test is applied at the partner, 
shareholder, or other appropriate level.
    (7) Certain nonrecognition transaction--(i) Except as provided in 
paragraph (b)(6) of this section, if depreciable property is transferred 
in a transaction described in section 168(i)(7)(B)(i) (other than in a 
transaction between members of a consolidated group) in the same taxable 
year that the property is placed in service by the transferor, the 40-
percent test is applied by treating the transferred property as placed 
in service by the transferee on the date of transfer. Thus, if the 
aggregate basis of property (including the transferred property) placed 
in service by the transferee during the last three months of its taxable 
year exceeds 40 percent of the aggregate basis of property (including 
the transferred property) placed in service by the transferee during the 
taxable year, the mid-quarter convention applies to the transferee's 
depreciable property, including the transferred property. The 
depreciable basis of the transferred property is not taken into account 
by the transferor in applying the 40-percent test for the taxable year 
that the transferor placed the property in service.
    (ii) In applying the applicable convention to determine when the 
recovery period for the transferred property begins, the date on which 
the transferor placed the property in service must be used. Thus, for 
example, if the mid-quarter convention applies, the recovery period for 
the transferred property begins on the mid-point of the quarter of the 
taxable year that the transferor placed the property in service. If the 
transferor placed the transferred property in service in a short taxable 
year, then for purposes of applying the applicable convention and 
allocating the depreciation deduction between the transferor and the 
transferee, the transferor is treated as having a full 12-month taxable 
year commencing on the first day of the short taxable year. The 
depreciation deduction for the transferor's taxable year in which the 
property was placed in service is allocated between the transferor and 
the transferee based on the number of months in the transferor's taxable 
year that each party held the property in service. For purposes of 
allocating the depreciation deduction, the transferor takes into account 
the month in which the property was placed in service but does not take 
into account the

[[Page 498]]

month in which the property was transferred. The transferee is allocated 
the remaining portion of the depreciation deduction for the transferor's 
taxable year in which the property was transferred. For the remainder of 
the transferee's current taxable year (if the transferee has a different 
taxable year than the transferor) and for subsequent taxable years, the 
depreciation deduction for the transferee is calculated by allocating to 
the transferee's taxable year the depreciation attributable to each 
recovery year, or portion thereof, that falls within the transferee's 
taxable year.
    (iii) If the applicable convention for the transferred property has 
not been determined by the time the transferor files its income tax 
return for the year of transfer because the transferee's taxable year 
has not ended, the transferor may use either the mid-quarter or the 
half-year convention in determining the depreciation deduction for the 
property. However, the transferor must specify on the depreciation form 
filed for the taxable year that the applicable convention has not been 
determined for the property. If the transferee determines that a 
different convention applies to the transferred property, the transferor 
should redetermine the depreciation deduction on the property, and, 
within the period of limitation, should file an amended income tax 
return for the taxable year and pay any additional tax due plus 
interest.
    (iv) The provisions of the paragraph (b)(7) are illustrated by the 
following example.

    Example. (i) During 1991, C, a calendar-year taxpayer, purchases 
satellite equipment costing $100,000, and computer equipment costing 
$15,000. The satellite equipment is placed in service in January, and 
the computer equipment in February. On October 1, C transfers the 
computer equipment to Z Partnership in a transaction described in 
section 721. During 1991, Z, a calendar-year partnership, purchases 30 
office desks for a total of $15,000. The desks are placed in service in 
June. These are the only items of depreciable property placed in service 
by C and Z during 1991.
    (ii) In applying the 40-percent test, because C transferred the 
computer equipment in a transaction described in section 168(i)(7)(B)(i) 
in the same taxable year that C placed it in service, the computer 
equipment is treated as placed in service by the transferee, Z, on the 
date of transfer, October 1. The 40-percent test is satisfied with 
respect to Z, because the computer equipment is placed in service during 
the last three months of Z's taxable year and its basis ($15,000) 
exceeds 40 percent of the aggregate basis of property placed in service 
by Z during the taxable year (desks and computer equipment with an 
aggregate basis of $30,000).
    (iii) In applying the mid-quarter convention to determine when the 
computer equipment is deemed to be placed in service, the date on which 
C placed the property in service is used. Accordingly, because C placed 
the computer equipment in service during the first quarter of its 
taxable year, the computer equipment is deemed placed in service on 
February 15, 1991, the mid-point of the first quarter of C's taxable 
year. The depreciation deduction allowable for C's 1991 taxable year, 
$5,250 ($15,000 x 40 percent x 10.\5/12\), is allocated between C and Z 
based on the number of months in C's taxable year that C and Z held the 
property in service. Thus, because the property was in service for 11 
months during C's 1991 taxable year and C held it for 8 of those 11 
months, C is allocated $3,818 (\8/11\ x $5,250). Z is allocated $1,432, 
the remaining \3/11\ of the $5,250 depreciation deduction for C's 1991 
taxable year. For 1992, Z's depreciation deduction for the computer 
equipment is $3,900, the sum of the remaining 1.5 months of depreciation 
deduction for the first recovery year and 10.5 months of depreciation 
deduction for the second recovery year (($15,000 x 40 percent x 1.\5/
12\) + ($9,000 x 40 [percent x 10.\5/12\)).

    (c) Disposition of property subject to the half-year or mid-quarter 
convention--(1) In general. If depreciable property is subject to the 
half-year (or mid-quarter) convention in the taxable year in which it is 
placed in service, it also is subject to the half-year (or mid-quarter) 
convention in the taxable year in which it is disposed of.
    (2) Example. The provisions of paragraph (c)(1) of this section are 
illustrated by the following example.

    Example. In October 1991, B, a calendar-year taxpayer, purchases and 
places in service a light general purpose truck costing $10,000. B does 
not elect to expense any part of the cost of the truck, and this is the 
only item of depreciable property placed in service by B during 1991. 
The 40-percent test is satisfied and the mid-quarter convention applies, 
because the truck is placed in service during the last three months of 
the taxable year and no other assets are placed in service in that year. 
In April 1993 (prior to the end of the truck's recovery period), B sells 
the truck. The mid-quarter convention applies in

[[Page 499]]

determining the depreciation deduction for the truck in 1993, the year 
of disposition.

    (d) Effective dates--(1) In general. This section applies to 
depreciable property placed in service in taxable years ending after 
January 30, 1991. For depreciable property placed in service after 
December 31, 1986, in taxable years ending on or before January 30, 
1991, a taxpayer may use a method other than the method provided in this 
section in applying the 40-percent test and the applicable convention, 
provided the method is reasonable and is consistently applied to the 
taxpayer's property.
    (2) Qualified property, 50-percent bonus depreciation property, or 
qualified New York Liberty Zone property. This section also applies to 
qualified property under section 168(k)(2) or qualified New York Liberty 
Zone property under section 1400L(b) acquired by a taxpayer after 
September 10, 2001, and to 50-percent bonus depreciation property under 
section 168(k)(4) acquired by a taxpayer after May 5, 2003.
    (3) Like-kind exchanges and involuntary conversions. The last 
sentence in paragraph (b)(3)(i) and the second sentence in paragraph 
(b)(3)(ii) of this section apply to exchanges to which section 1031 
applies, and involuntary conversions to which section 1033 applies, of 
MACRS property for which the time of disposition and the time of 
replacement both occur after February 27, 2004.

[T.D. 8444, 57 FR 48981, Oct. 29, 1992, as amended by T.D. 9091, 68 FR 
52991, Sept. 8, 2003; T.D. 9115, 69 FR 9533, Mar. 1, 2004; T.D. 9283, 71 
FR 51737, Aug. 31, 2006; T.D. 9314, 72 FR 9248, Mar. 1, 2007]



Sec.  1.168(h)-1  Like-kind exchanges involving tax-exempt use property.

    (a) Scope. (1) This section applies with respect to a direct or 
indirect transfer of property among related persons, including transfers 
made through a qualified intermediary (as defined in Sec.  1.1031(k)-
1(g)(4)) or other unrelated person, (a transfer) if--
    (i) Section 1031 applies to any party to the transfer or to any 
related transaction; and
    (ii) A principal purpose of the transfer or any related transaction 
is to avoid or limit the application of the alternative depreciation 
system (within the meaning of section 168(g)).
    (2) For purposes of this section, a person is related to another 
person if they bear a relationship specified in section 267(b) or 
section 707(b)(1).
    (b) Allowable depreciation deduction for property subject to this 
section--(1) In general. Property (tainted property) transferred 
directly or indirectly to a taxpayer by a related person (related party) 
as part of, or in connection with, a transaction in which the related 
party receives tax-exempt use property (related tax-exempt use property) 
will, if the tainted property is subject to an allowance for 
depreciation, be treated in the same manner as the related tax-exempt 
use property for purposes of determining the allowable depreciation 
deduction under section 167(a). Under this paragraph (b), the tainted 
property is depreciated by the taxpayer over the remaining recovery 
period of, and using the same depreciation method and convention as that 
of, the related tax-exempt use property.
    (2) Limitations--(i) Taxpayer's basis in related tax-exempt use 
property. The rules of this paragraph (b) apply only with respect to so 
much of the taxpayer's basis in the tainted property as does not exceed 
the taxpayer's adjusted basis in the related tax-exempt use property 
prior to the transfer. Any excess of the taxpayer's basis in the tainted 
property over its adjusted basis in the related tax-exempt use property 
prior to the transfer is treated as property to which this section does 
not apply. This paragraph (b)(2)(i) does not apply if the related tax-
exempt use property is not acquired from the taxpayer (e.g., if the 
taxpayer acquires the tainted property for cash but section 1031 
nevertheless applies to the related party because the transfer involves 
a qualified intermediary).
    (ii) Application of section 168(i)(7). This section does not apply 
to so much of the taxpayer's basis in the tainted property as is subject 
to section 168(i)(7).
    (c) Related tax-exempt use property. (1) For purposes of paragraph 
(b) of this section, related tax-exempt use property includes--

[[Page 500]]

    (i) Property that is tax-exempt use property (as defined in section 
168(h)) at the time of the transfer; and
    (ii) Property that does not become tax-exempt use property until 
after the transfer if, at the time of the transfer, it was intended that 
the property become tax-exempt use property.
    (2) For purposes of determining the remaining recovery period of the 
related tax-exempt use property in the circumstances described in 
paragraph (c)(1)(ii) of this section, the related tax-exempt use 
property will be treated as having, prior to the transfer, a lease term 
equal to the term of any lease that causes such property to become tax-
exempt use property.
    (d) Examples. The following examples illustrate the application of 
this section. The examples do not address common law doctrines or other 
authorities that may apply to recharacterize or alter the effects of the 
transactions described therein. Unless otherwise indicated, parties to 
the transactions are not related to one another.

    Example 1. (i) X owns all of the stock of two subsidiaries, B and Z. 
X, B and Z do not file a consolidated federal income tax return. On May 
5, 1995, B purchases an aircraft (FA) for $1 million and leases it to a 
foreign airline whose income is not subject to United States taxation 
and which is a tax-exempt entity as defined in section 168(h)(2). On the 
same date, Z owns an aircraft (DA) with a fair market value of $1 
million, which has been, and continues to be, leased to an airline that 
is a United States taxpayer. Z's adjusted basis in DA is $0. The next 
day, at a time when each aircraft is still worth $1 million, B transfers 
FA to Z (subject to the lease to the foreign airline) in exchange for DA 
(subject to the lease to the airline that is a United States taxpayer). 
Z realizes gain of $1 million on the exchange, but that gain is not 
recognized pursuant to section 1031(a) because the exchange is of like-
kind properties. Assume that a principal purpose of the transfer of DA 
to B or of FA to Z is to avoid the application of the alternative 
depreciation system. Following the exchange, Z has a $0 basis in FA 
pursuant to section 1031(d). B has a $1 million basis in DA.
    (ii) B has acquired property from Z, a related person; Z's gain is 
not recognized pursuant to section 1031(a); Z has received tax-exempt 
use property as part of the transaction; and a principal purpose of the 
transfer of DA to B or of FA to Z is to avoid the application of the 
alternative depreciation system. Accordingly, the transaction is within 
the scope of this section. Pursuant to paragraph (b) of this section, B 
must recover its $1 million basis in DA over the remaining recovery 
period of, and using the same depreciation method and convention as that 
of, FA, the related tax-exempt use property.
    (iii) If FA did not become tax-exempt use property until after the 
exchange, it would still be related tax-exempt use property and 
paragraph (b) of this section would apply if, at the time of the 
exchange, it was intended that FA become tax-exempt use property.
    Example 2. (i) X owns all of the stock of two subsidiaries, B and Z. 
X, B and Z do not file a consolidated federal income tax return. B and Z 
each own identical aircraft. B's aircraft (FA) is leased to a tax-exempt 
entity as defined in section 168(h)(2) and has a fair market value of $1 
million and an adjusted basis of $500,000. Z's aircraft (DA) is leased 
to a United States taxpayer and has a fair market value of $1 million 
and an adjusted basis of $10,000. On May 1, 1995, B and Z exchange 
aircraft, subject to their respective leases. B realizes gain of 
$500,000 and Z realizes gain of $990,000, but neither person recognizes 
gain because of the operation of section 1031(a). Moreover, assume that 
a principal purpose of the transfer of DA to B or of FA to Z is to avoid 
the application of the alternative depreciation system.
    (ii) As in Example 1, B has acquired property from Z, a related 
person; Z's gain is not recognized pursuant to section 1031(a); Z has 
received tax-exempt use property as part of the transaction; and a 
principal purpose of the transfer of DA to B or of FA to Z is to avoid 
the application of the alternative depreciation system. Thus, the 
transaction is within the scope of this section even though B has held 
tax-exempt use property for a period of time and, during that time, has 
used the alternative depreciation system with respect to such property. 
Pursuant to paragraph (b) of this section, B, which has a substituted 
basis determined pursuant to section 1031(d) of $500,000 in DA, must 
depreciate the aircraft over the remaining recovery period of FA, using 
the same depreciation method and convention. Z holds tax-exempt use 
property with a basis of $10,000, which must be depreciated under the 
alternative depreciation system.
    (iii) Assume the same facts as in paragraph (i) of this Example 2, 
except that B and Z are members of an affiliated group that files a 
consolidated federal income tax return. Of B's $500,000 basis in DA, 
$10,000 is subject to section 168(i)(7) and therefore not subject to 
this section. The remaining $490,000 of basis is subject to this 
section. But see Sec.  1.1502-80(f) making section 1031 inapplicable to 
intercompany transactions occurring in consolidated return years 
beginning on or after July 12, 1995.


[[Page 501]]


    (e) Effective date. This section applies to transfers made on or 
after April 20, 1995.

[T.D. 8667, 61 FR 18676, Apr. 29, 1996]



Sec.  1.168(i)-0  Table of contents for the general asset account rules.

    This section lists the major paragraphs contained in Sec.  1.168(i)-
1.

                Sec.  1.168(i)-1 General asset accounts.

    (a) Scope.
    (b) Definitions.
    (1) Unadjusted depreciable basis.
    (2) Unadjusted depreciable basis of the general asset account.
    (3) Adjusted depreciable basis of the general asset account.
    (4) Building.
    (5) Expensed cost.
    (6) Mass assets.
    (7) Portion of an asset.
    (8) Remaining adjusted depreciable basis of the general asset 
account.
    (9) Structural component.
    (c) Establishment of general asset accounts.
    (1) Assets eligible for general asset accounts.
    (i) General rules.
    (ii) Special rules for assets generating foreign source income.
    (2) Grouping assets in general asset accounts.
    (i) General rules.
    (ii) Special rules.
    (3) Examples.
    (d) Determination of depreciation allowance.
    (1) In general.
    (2) Assets in general asset account are eligible for additional 
first year depreciation deduction.
    (3) No assets in general asset account are eligible for additional 
first year depreciation deduction.
    (4) Special rule for passenger automobiles.
    (e) Dispositions from a general asset account.
    (1) Scope and definition.
    (i) In general.
    (ii) Disposition of a portion of an asset.
    (2) General rules for a disposition.
    (i) No immediate recovery of basis.
    (ii) Treatment of amount realized.
    (iii) Effect of disposition on a general asset account.
    (iv) Coordination with nonrecognition provisions.
    (v) Manner of disposition.
    (vi) Disposition by transfer to a supplies account.
    (vii) Leasehold improvements.
    (viii) Determination of asset disposed of.
    (ix) Examples.
    (3) Special rules.
    (i) In general.
    (ii) Disposition of all assets remaining in a general asset account.
    (iii) Disposition of an asset in a qualifying disposition.
    (iv) Transactions subject to section 168(i)(7).
    (v) Transactions subject to section 1031 or 1033.
    (vi) Technical termination of a partnership.
    (vii) Anti-abuse rule.
    (f) Assets generating foreign source income.
    (1) In general.
    (2) Source of ordinary income, gain, or loss.
    (i) Source determined by allocation and apportionment of 
depreciation allowed.
    (ii) Formula for determining foreign source income, gain, or loss.
    (3) Section 904(d) separate categories.
    (g) Assets subject to recapture.
    (h) Changes in use.
    (1) Conversion to any personal use.
    (2) Change in use results in a different recovery period and/or 
depreciation method.
    (i) No effect on general asset account election.
    (ii) Asset is removed from the general asset account.
    (iii) New general asset account is established.
    (i) Redetermination of basis.
    (j) Identification of disposed or converted asset.
    (k) Effect of adjustments on prior dispositions.
    (l) Election.
    (1) Irrevocable election.
    (2) Time for making election.
    (3) Manner of making election.
    (m) Effective/applicability dates.

[T.D. 8566, 59 FR 51371, Oct. 11, 1994, as amended by T.D. 9115, 69 FR 
9534, Mar. 1, 2004; T.D. 9132, 69 FR 33842, June 17, 2004; T.D. 9314, 72 
FR 9249, Mar. 1, 2007; T.D. 9564, 76 FR 81085, Dec. 27, 2011; 77 FR 
75016, Dec. 19, 2012; T.D. 9689, 79 FR 48667, Aug. 18, 2014]



Sec.  1.168(i)-1  General asset accounts.

    (a) Scope. This section provides rules for general asset accounts 
under section 168(i)(4). The provisions of this section apply only to 
assets for which an election has been made under paragraph (l) of this 
section.
    (b) Definitions. For purposes of this section, the following 
definitions apply:
    (1) Unadjusted depreciable basis has the same meaning given such 
term in Sec.  1.168(b)-1(a)(3).

[[Page 502]]

    (2) Unadjusted depreciable basis of the general asset account is the 
sum of the unadjusted depreciable bases of all assets included in the 
general asset account.
    (3) Adjusted depreciable basis of the general asset account is the 
unadjusted depreciable basis of the general asset account less the 
adjustments to basis described in section 1016(a)(2) and (3).
    (4) Building has the same meaning as that term is defined in Sec.  
1.48-1(e)(1).
    (5) Expensed cost is the amount of any allowable credit or deduction 
treated as a deduction allowable for depreciation or amortization for 
purposes of section 1245 (for example, a credit allowable under section 
30 or a deduction allowable under section 179, section 179A, or section 
190). Expensed cost does not include any additional first year 
depreciation deduction.
    (6) Mass assets is a mass or group of individual items of 
depreciable assets--
    (i) That are not necessarily homogenous;
    (ii) Each of which is minor in value relative to the total value of 
the mass or group;
    (iii) Numerous in quantity;
    (iv) Usually accounted for only on a total dollar or quantity basis;
    (v) With respect to which separate identification is impracticable; 
and
    (vi) Placed in service in the same taxable year.
    (7) Portion of an asset is any part of an asset that is less than 
the entire asset as determined under paragraph (e)(2)(viii) of this 
section.
    (8) Remaining adjusted depreciable basis of the general asset 
account is the unadjusted depreciable basis of the general asset account 
less the amount of the additional first year depreciation deduction 
allowed or allowable, whichever is greater, for the general asset 
account.
    (9) Structural component has the same meaning as that term is 
defined in Sec.  1.48-1(e)(2).
    (c) Establishment of general asset accounts--(1) Assets eligible for 
general asset accounts--(i) General rules. Assets that are subject to 
either the general depreciation system of section 168(a) or the 
alternative depreciation system of section 168(g) may be accounted for 
in one or more general asset accounts. An asset is included in a general 
asset account only to the extent of the asset's unadjusted depreciable 
basis. However, an asset is not to be included in a general asset 
account if the asset is used both in a trade or business or for the 
production of income and in a personal activity at any time during the 
taxable year in which the asset is placed in service by the taxpayer or 
if the asset is placed in service and disposed of during the same 
taxable year.
    (ii) Special rules for assets generating foreign source income. (A) 
Assets that generate foreign source income, both United States and 
foreign source income, or combined gross income of a foreign sales 
corporation (as defined in former section 922), domestic international 
sales corporation (as defined in section 992(a)), or possession 
corporation (as defined in section 936) and its related supplier may be 
included in a general asset account if the requirements of paragraph 
(c)(2)(i) of this section are satisfied. If, however, the inclusion of 
these assets in a general asset account results in a substantial 
distortion of income, the Commissioner may disregard the general asset 
account election and make any reallocations of income or expense 
necessary to clearly reflect income.
    (B) A general asset account shall be treated as a single asset for 
purposes of applying the rules in Sec.  1.861-9T(g)(3) (relating to 
allocation and apportionment of interest expense under the asset 
method). A general asset account that generates income in more than one 
grouping of income (statutory and residual) is a multiple category asset 
(as defined in Sec.  1.861-9T(g)(3)(ii)), and the income yield from the 
general asset account must be determined by applying the rules for 
multiple category assets as if the general asset account were a single 
asset.
    (2) Grouping assets in general asset accounts--(i) General rules. If 
a taxpayer makes the election under paragraph (l) of this section, 
assets that are subject to the election are grouped into one or more 
general asset accounts. Assets that are eligible to be grouped into a 
single general asset account may be divided into more than one general 
asset account. Each general asset account must include only assets 
that--

[[Page 503]]

    (A) Have the same applicable depreciation method;
    (B) Have the same applicable recovery period;
    (C) Have the same applicable convention; and
    (D) Are placed in service by the taxpayer in the same taxable year.
    (ii) Special rules. In addition to the general rules in paragraph 
(c)(2)(i) of this section, the following rules apply when establishing 
general asset accounts--
    (A) Assets subject to the mid-quarter convention may only be grouped 
into a general asset account with assets that are placed in service in 
the same quarter of the taxable year;
    (B) Assets subject to the mid-month convention may only be grouped 
into a general asset account with assets that are placed in service in 
the same month of the taxable year;
    (C) Passenger automobiles for which the depreciation allowance is 
limited under section 280F(a) must be grouped into a separate general 
asset account;
    (D) Assets not eligible for any additional first year depreciation 
deduction, including assets for which the taxpayer elected not to deduct 
the additional first year depreciation, provided by, for example, 
section 168(k), section 168(l), section 168(m), section 168(n), section 
1400L(b), or section 1400N(d), must be grouped into a separate general 
asset account;
    (E) Assets eligible for the additional first year depreciation 
deduction may only be grouped into a general asset account with assets 
for which the taxpayer claimed the same percentage of the additional 
first year depreciation (for example, 30 percent, 50 percent, or 100 
percent);
    (F) Except for passenger automobiles described in paragraph 
(c)(2)(ii)(C) of this section, listed property (as defined in section 
280F(d)(4)) must be grouped into a separate general asset account;
    (G) Assets for which the depreciation allowance for the placed-in-
service year is not determined by using an optional depreciation table 
(for further guidance, see section 8 of Rev. Proc. 87-57, 1987-2 CB 687, 
693 (see Sec.  601.601(d)(2) of this chapter)) must be grouped into a 
separate general asset account;
    (H) Mass assets that are or will be subject to paragraph 
(j)(2)(i)(D) of this section (disposed of or converted mass asset is 
identified by a mortality dispersion table) must be grouped into a 
separate general asset account; and
    (I) Assets subject to paragraph (h)(2)(iii)(A) of this section 
(change in use results in a shorter recovery period or a more 
accelerated depreciation method) for which the depreciation allowance 
for the year of change (as defined in Sec.  1.168(i)-4(a)) is not 
determined by using an optional depreciation table must be grouped into 
a separate general asset account.
    (3) Examples. The following examples illustrate the application of 
this paragraph (c):

    Example 1. In 2014, J, a proprietorship with a calendar year-end, 
purchases and places in service one item of equipment that costs 
$550,000. This equipment is section 179 property and also is 5-year 
property under section 168(e). On its Federal tax return for 2014, J 
makes an election under section 179 to expense $25,000 of the 
equipment's cost and makes an election under paragraph (l) of this 
section to include the equipment in a general asset account. As a 
result, the unadjusted depreciable basis of the equipment is $525,000. 
In accordance with paragraph (c)(1) of this section, J must include only 
$525,000 of the equipment's cost in the general asset account.
    Example 2. In 2014, K, a proprietorship with a calendar year-end, 
purchases and places in service 100 items of equipment. All of these 
items are 5-year property under section 168(e), are not listed property, 
and are not eligible for any additional first year depreciation 
deduction. On its Federal tax return for 2014, K does not make an 
election under section 179 to expense the cost of any of the 100 items 
of equipment and does make an election under paragraph (l) of this 
section to include the 100 items of equipment in a general asset 
account. K depreciates its 5-year property placed in service in 2014 
using the optional depreciation table that corresponds with the general 
depreciation system, the 200-percent declining balance method, a 5-year 
recovery period, and the half-year convention. In accordance with 
paragraph (c)(2) of this section, K includes all of the 100 items of 
equipment in one general asset account.
    Example 3. The facts are the same as in Example 2, except that K 
decides not to include all of the 100 items of equipment in one general 
asset account. Instead and in accordance with paragraph (c)(2) of this 
section, K establishes 100 general asset accounts and includes one item 
of equipment in each general asset account.

[[Page 504]]

    Example 4. L, a calendar-year corporation, is a wholesale 
distributer. In 2014, L places in service the following properties for 
use in its wholesale distribution business: Computers, automobiles, and 
forklifts. On its Federal tax return for 2014, L does not make an 
election under section 179 to expense the cost of any of these items of 
equipment and does make an election under paragraph (l) of this section 
to include all of these items of equipment in a general asset account. 
All of these items are 5-year property under section 168(e) and are not 
eligible for any additional first year depreciation deduction. The 
computers are listed property, and the automobiles are listed property 
and are subject to section 280F(a). L depreciates its 5-year property 
placed in service in 2014 using the optional depreciation table that 
corresponds with the general depreciation system, the 200-percent 
declining balance method, a 5-year recovery period, and the half-year 
convention. Although the computers, automobiles, and forklifts are 5-
year property, L cannot include all of them in one general asset account 
because the computers and automobiles are listed property. Further, even 
though the computers and automobiles are listed property, L cannot 
include them in one general asset account because the automobiles also 
are subject to section 280F(a). In accordance with paragraph (c)(2) of 
this section, L establishes three general asset accounts: One for the 
computers, one for the automobiles, and one for the forklifts.
    Example 5. M, a fiscal-year corporation with a taxable year ending 
June 30, purchases and places in service ten items of new equipment in 
October 2014, and purchases and places in service five other items of 
new equipment in February 2015. On its Federal tax return for the 
taxable year ending June 30, 2015, M does not make an election under 
section 179 to expense the cost of any of these items of equipment and 
does make an election under paragraph (l) of this section to include all 
of these items of equipment in a general asset account. All of these 
items of equipment are 7-year property under section 168(e), are not 
listed property, and are property described in section 168(k)(2)(B). All 
of the ten items of equipment placed in service in October 2014 are 
eligible for the 50-percent additional first year depreciation deduction 
provided by section 168(k)(1). All of the five items of equipment placed 
in service in February 2015 are not eligible for any additional first 
year depreciation deduction. M depreciates its 7-year property placed in 
service for the taxable year ending June 30, 2015, using the optional 
depreciation table that corresponds with the general depreciation 
system, the 200-percent declining balance method, a 7-year recovery 
period, and the half-year convention. Although the 15 items of equipment 
are depreciated using the same depreciation method, recovery period, and 
convention, M cannot include all of them in one general asset account 
because some of items of equipment are not eligible for any additional 
first year depreciation deduction. In accordance with paragraph (c)(2) 
of this section, M establishes two general asset accounts: one for the 
ten items of equipment eligible for the 50-percent additional first year 
depreciation deduction and one for the five items of equipment not 
eligible for any additional first year depreciation deduction.

    (d) Determination of depreciation allowance--(1) In general. 
Depreciation allowances are determined for each general asset account. 
The depreciation allowances must be recorded in a depreciation reserve 
account for each general asset account. The allowance for depreciation 
under this section constitutes the amount of depreciation allowable 
under section 167(a).
    (2) Assets in general asset account are eligible for additional 
first year depreciation deduction. If all the assets in a general asset 
account are eligible for the additional first year depreciation 
deduction, the taxpayer first must determine the allowable additional 
first year depreciation deduction for the general asset account for the 
placed-in-service year and then must determine the amount otherwise 
allowable as a depreciation deduction for the general asset account for 
the placed-in-service year and any subsequent taxable year. The 
allowable additional first year depreciation deduction for the general 
asset account for the placed-in-service year is determined by 
multiplying the unadjusted depreciable basis of the general asset 
account by the additional first year depreciation deduction percentage 
applicable to the assets in the account (for example, 30 percent, 50 
percent, or 100 percent). The remaining adjusted depreciable basis of 
the general asset account then is depreciated using the applicable 
depreciation method, recovery period, and convention for the assets in 
the account.
    (3) No assets in general asset account are eligible for additional 
first year depreciation deduction. If none of the assets in a general 
asset account are eligible for the additional first year depreciation 
deduction, the taxpayer must determine the allowable depreciation 
deduction for the general asset account for the placed-in-service year 
and any subsequent taxable year by using the

[[Page 505]]

applicable depreciation method, recovery period, and convention for the 
assets in the account.
    (4) Special rule for passenger automobiles. For purposes of applying 
section 280F(a), the depreciation allowance for a general asset account 
established for passenger automobiles is limited for each taxable year 
to the amount prescribed in section 280F(a) multiplied by the excess of 
the number of automobiles originally included in the account over the 
number of automobiles disposed of during the taxable year or in any 
prior taxable year in a transaction described in paragraph (e)(3)(iii) 
(disposition of an asset in a qualifying disposition), paragraph 
(e)(3)(iv) (transactions subject to section 168(i)(7)), paragraph 
(e)(3)(v) (transactions subject to section 1031 or section 1033), 
paragraph (e)(3)(vi) (technical termination of a partnership), paragraph 
(e)(3)(vii) (anti-abuse rule), paragraph (g) (assets subject to 
recapture), or paragraph (h)(1) (conversion to any personal use) of this 
section.
    (e) Dispositions from a general asset account--(1) Scope and 
definition--(i) In general. This paragraph (e) provides rules applicable 
to dispositions of assets included in a general asset account. For 
purposes of this paragraph (e), an asset in a general asset account is 
disposed of when ownership of the asset is transferred or when the asset 
is permanently withdrawn from use either in the taxpayer's trade or 
business or in the production of income. A disposition includes the 
sale, exchange, retirement, physical abandonment, or destruction of an 
asset. A disposition also occurs when an asset is transferred to a 
supplies, scrap, or similar account, or when a portion of an asset is 
disposed of as described in paragraph (e)(1)(ii) of this section. If a 
structural component, or a portion thereof, of a building is disposed of 
in a disposition described in paragraph (e)(1)(ii) of this section, a 
disposition also includes the disposition of such structural component 
or such portion thereof.
    (ii) Disposition of a portion of an asset. For purposes of applying 
paragraph (e) of this section, a disposition includes a disposition of a 
portion of an asset in a general asset account as a result of a casualty 
event described in section 165, a disposition of a portion of an asset 
in a general asset account for which gain, determined without regard to 
section 1245 or section 1250, is not recognized in whole or in part 
under section 1031 or section 1033, a transfer of a portion of an asset 
in a general asset account in a transaction described in section 
168(i)(7)(B), a sale of a portion of an asset in a general asset 
account, or a disposition of a portion of an asset in a general asset 
account in a transaction described in paragraph (e)(3)(vii)(B) of this 
section. For other transactions, a disposition includes a disposition of 
a portion of an asset in a general asset account only if the taxpayer 
makes the election under paragraph (e)(3)(ii) of this section to 
terminate the general asset account in which that disposed portion is 
included or makes the election under paragraph (e)(3)(iii) of this 
section for that disposed portion.
    (2) General rules for a disposition--(i) No immediate recovery of 
basis. Except as provided in paragraph (e)(3) of this section, 
immediately before a disposition of any asset in a general asset account 
or a disposition of a portion of such asset as described in paragraph 
(e)(1)(ii) of this section, the asset or the portion of the asset, as 
applicable, is treated as having an adjusted depreciable basis (as 
defined in Sec.  1.168(b)-1(a)(4)) of zero for purposes of section 1011. 
Therefore, no loss is realized upon the disposition of an asset from the 
general asset account or upon the disposition of a portion of such asset 
as described in paragraph (e)(1)(ii) of this section. Similarly, where 
an asset or a portion of an asset, as applicable, is disposed of by 
transfer to a supplies, scrap, or similar account, the basis of the 
asset or the portion of the asset, as applicable, in the supplies, 
scrap, or similar account will be zero.
    (ii) Treatment of amount realized. Any amount realized on a 
disposition is recognized as ordinary income, notwithstanding any other 
provision of subtitle A of the Internal Revenue Code (Code), to the 
extent the sum of the unadjusted depreciable basis of the general asset 
account and any expensed cost (as defined in paragraph (b)(5) of this 
section) for assets in the account

[[Page 506]]

exceeds any amounts previously recognized as ordinary income upon the 
disposition of other assets in the account or upon the disposition of 
portions of such assets as described in paragraph (e)(1)(ii) of this 
section. The recognition and character of any excess amount realized are 
determined under other applicable provisions of the Code other than 
sections 1245 and 1250 or provisions of the Code that treat gain on a 
disposition as subject to section 1245 or section 1250.
    (iii) Effect of disposition on a general asset account. Except as 
provided in paragraph (e)(3) of this section, the unadjusted depreciable 
basis and the depreciation reserve of the general asset account are not 
affected as a result of a disposition of an asset from the general asset 
account or of a disposition of a portion of such asset as described in 
paragraph (e)(1)(ii) of this section.
    (iv) Coordination with nonrecognition provisions. For purposes of 
determining the basis of an asset or a portion of an asset, as 
applicable, acquired in a transaction, other than a transaction 
described in paragraph (e)(3)(iv) (pertaining to transactions subject to 
section 168(i)(7)), paragraph (e)(3)(v) (pertaining to transactions 
subject to section 1031 or section 1033), and paragraph (e)(3)(vi) 
(pertaining to technical terminations of partnerships) of this section, 
to which a nonrecognition section of the Code applies, determined 
without regard to this section, the amount of ordinary income recognized 
under this paragraph (e)(2) is treated as the amount of gain recognized 
on the disposition.
    (v) Manner of disposition. The manner of disposition (for example, 
normal retirement, abnormal retirement, ordinary retirement, or 
extraordinary retirement) is not taken into account in determining 
whether a disposition occurs or gain or loss is recognized.
    (vi) Disposition by transfer to a supplies account. If a taxpayer 
made an election under Sec.  1.162-3(d) to treat the cost of any rotable 
spare part, temporary spare part, or standby emergency spare part (as 
defined in Sec.  1.162-3(c)) as a capital expenditure subject to the 
allowance for depreciation and also made an election under paragraph (l) 
of this section to include that rotable, temporary, or standby emergency 
spare part in a general asset account, the taxpayer can dispose of the 
rotable, temporary, or standby emergency spare part by transferring it 
to a supplies account only if the taxpayer has obtained the consent of 
the Commissioner to revoke the Sec.  1.162-3(d) election. If a taxpayer 
made an election under Sec.  1.162-3T(d) to treat the cost of any 
material and supply (as defined in Sec.  1.162-3T(c)(1)) as a capital 
expenditure subject to the allowance for depreciation and also made an 
election under paragraph (l) of this section to include that material 
and supply in a general asset account, the taxpayer can dispose of the 
material and supply by transferring it to a supplies account only if the 
taxpayer has obtained the consent of the Commissioner to revoke the 
Sec.  1.162-3T(d) election. See Sec.  1.162-3(d)(3) for the procedures 
for revoking a Sec.  1.162-3(d) or a Sec.  1.162-3T(d) election.
    (vii) Leasehold improvements. The rules of paragraph (e) of this 
section also apply to--
    (A) A lessor of leased property that made an improvement to that 
property for the lessee of the property, has a depreciable basis in the 
improvement, made an election under paragraph (l) of this section to 
include the improvement in a general asset account, and disposes of the 
improvement, or disposes of a portion of the improvement as described in 
paragraph (e)(1)(ii) of this section, before or upon the termination of 
the lease with the lessee. See section 168(i)(8)(B); and
    (B) A lessee of leased property that made an improvement to that 
property, has a depreciable basis in the improvement, made an election 
under paragraph (l) of this section to include the improvement in a 
general asset account, and disposes of the improvement, or disposes of a 
portion of the improvement as described in paragraph (e)(1)(ii) of this 
section, before or upon the termination of the lease.
    (viii) Determination of asset disposed of--(A) General rules. For 
purposes of applying paragraph (e) of this section to the disposition of 
an asset in a general asset account, instead of the disposition of the 
general asset account, the facts and circumstances of each

[[Page 507]]

disposition are considered in determining what is the appropriate asset 
disposed of. The asset for disposition purposes may not consist of items 
placed in service by the taxpayer on different dates, without taking 
into account the applicable convention. For purposes of determining what 
is the appropriate asset disposed of, the unit of property determination 
under Sec.  1.263(a)-3(e) or in published guidance in the Internal 
Revenue Bulletin under section 263(a) (see Sec.  601.601(d)(2) of this 
chapter) does not apply.
    (B) Special rules. In addition to the general rules in paragraph 
(e)(2)(viii)(A) of this section, the following rules apply for purposes 
of applying paragraph (e) of this section to the disposition of an asset 
in a general asset account instead of the disposition of the general 
asset account:
    (1) Each building, including its structural components, is the 
asset, except as provided in Sec.  1.1250-1(a)(2)(ii) or in paragraph 
(e)(2)(viii)(B)(2) or (4) of this section.
    (2) If a building has two or more condominium or cooperative units, 
each condominium or cooperative unit, including its structural 
components, is the asset, except as provided in Sec.  1.1250-1(a)(2)(ii) 
or in paragraph (e)(2)(viii)(B)(4) of this section.
    (3) If a taxpayer properly includes an item in one of the asset 
classes 00.11 through 00.4 of Rev. Proc. 87-56 (1987-2 CB 674) (see 
Sec.  601.601(d)(2) of this chapter) or properly classifies an item in 
one of the categories under section 168(e)(3), except for a category 
that includes buildings or structural components (for example, retail 
motor fuels outlet, qualified leasehold improvement property, qualified 
restaurant property, and qualified retail improvement property), each 
item is the asset, provided that paragraph (e)(2)(viii)(B)(4) of this 
section does not apply to the item. For example, each desk is the asset, 
each computer is the asset, and each qualified smart electric meter is 
the asset.
    (4) If the taxpayer places in service an improvement or addition to 
an asset after the taxpayer placed the asset in service, the improvement 
or addition and, if applicable, its structural components are a separate 
asset.
    (ix) Examples. The following examples illustrate the application of 
this paragraph (e)(2):

    Example 1. A, a calendar-year partnership, maintains one general 
asset account for one office building that cost $10 million. A discovers 
a leak in the roof of the building and decides to replace the entire 
roof. The roof is a structural component of the building. In accordance 
with paragraph (e)(2)(viii)(B)(1) of this section, the office building, 
including its structural components, is the asset for disposition 
purposes. The retirement of the replaced roof is not a disposition of a 
portion of an asset as described in paragraph (e)(1)(ii) of this 
section. Thus, the retirement of the replaced roof is not a disposition 
under paragraph (e)(1) of this section. As a result, A continues to 
depreciate the $10 million cost of the general asset account. If A must 
capitalize the amount paid for the replacement roof pursuant to Sec.  
1.263(a)-3, the replacement roof is a separate asset for disposition 
purposes pursuant to paragraph (e)(2)(viii)(B)(4) of this section and 
for depreciation purposes pursuant to section 168(i)(6).
    Example 2. B, a calendar-year commercial airline company, maintains 
one general asset account for five aircraft that cost a total of $500 
million. These aircraft are described in asset class 45.0 of Rev. Proc. 
87-56. B replaces the existing engines on one of the aircraft with new 
engines. Assume each aircraft is a unit of property as determined under 
Sec.  1.263(a)-3(e)(3) and each engine of an aircraft is a major 
component or substantial structural part of the aircraft as determined 
under Sec.  1.263(a)-3(k)(6). Assume also that B treats each aircraft as 
the asset for disposition purposes in accordance with paragraph 
(e)(2)(viii) of this section. The retirement of the replaced engines is 
not a disposition of a portion of an asset as described in paragraph 
(e)(1)(ii) of this section. Thus, the retirement of the replaced engines 
is not a disposition under paragraph (e)(1) of this section. As a 
result, B continues to depreciate the $500 million cost of the general 
asset account. If B must capitalize the amount paid for the replacement 
engines pursuant to Sec.  1.263(a)-3, the replacement engines are a 
separate asset for disposition purposes pursuant to paragraph 
(e)(2)(viii)(B)(4) of this section and for depreciation purposes 
pursuant to section 168(i)(6).
    Example 3. (i) R, a calendar-year corporation, maintains one general 
asset account for ten machines. The machines cost a total of $10,000 and 
are placed in service in June 2014. Of the ten machines, one machine 
costs $8,200 and nine machines cost a total of $1,800. Assume R 
depreciates this general asset account using the optional depreciation 
table that corresponds with the general

[[Page 508]]

depreciation system, the 200-percent declining balance method, a 5-year 
recovery period, and a half-year convention. R does not make a section 
179 election for any of the machines, and all of the machines are not 
eligible for any additional first year depreciation deduction. As of 
January 1, 2015, the depreciation reserve of the account is $2,000 
($10,000 x 20%).
    (ii) On February 8, 2015, R sells the machine that cost $8,200 to an 
unrelated party for $9,000. Under paragraph (e)(2)(i) of this section, 
this machine has an adjusted depreciable basis of zero.
    (iii) On its 2015 tax return, R recognizes the amount realized of 
$9,000 as ordinary income because such amount does not exceed the 
unadjusted depreciable basis of the general asset account ($10,000), 
plus any expensed cost for assets in the account ($0), less amounts 
previously recognized as ordinary income ($0). Moreover, the unadjusted 
depreciable basis and depreciation reserve of the account are not 
affected by the disposition of the machine. Thus, the depreciation 
allowance for the account in 2015 is $3,200 ($10,000 x 32%).
    Example 4. (i) The facts are the same as in Example 3. In addition, 
on June 4, 2016, R sells seven machines to an unrelated party for a 
total of $1,100. In accordance with paragraph (e)(2)(i) of this section, 
these machines have an adjusted depreciable basis of zero.
    (ii) On its 2016 tax return, R recognizes $1,000 as ordinary income 
(the unadjusted depreciable basis of $10,000, plus the expensed cost of 
$0, less the amount of $9,000 previously recognized as ordinary income). 
The recognition and character of the excess amount realized of $100 
($1,100-$1,000) are determined under applicable provisions of the Code 
other than section 1245 (such as section 1231). Moreover, the unadjusted 
depreciable basis and depreciation reserve of the account are not 
affected by the disposition of the machines. Thus, the depreciation 
allowance for the account in 2016 is $1,920 ($10,000 x 19.2%).

    (3) Special rules--(i) In general. This paragraph (e)(3) provides 
the rules for terminating general asset account treatment upon certain 
dispositions. While the rules under paragraphs (e)(3)(ii) and (iii) of 
this section are optional rules, the rules under paragraphs (e)(3)(iv), 
(v), (vi), and (vii) of this section are mandatory rules. A taxpayer 
elects to apply paragraph (e)(3)(ii) or (iii) of this section by 
reporting the gain, loss, or other deduction on the taxpayer's timely 
filed original Federal tax return, including extensions, for the taxable 
year in which the disposition occurs. However, if the loss is on account 
of the demolition of a structure to which section 280B and Sec.  1.280B-
1 apply, a taxpayer elects to apply paragraph (e)(3)(ii) or (iii) of 
this section by ending depreciation for the structure at the time of the 
disposition of the structure, taking into account the convention 
applicable to the general asset account in which the demolished 
structure was included, and reporting the amount of depreciation for 
that structure for the taxable year in which the disposition occurs on 
the taxpayer's timely filed original Federal tax return, including 
extensions, for that taxable year. A taxpayer may revoke the election to 
apply paragraph (e)(3)(ii) or (iii) of this section only by filing a 
request for a private letter ruling and obtaining the Commissioner's 
consent to revoke the election. The Commissioner may grant a request to 
revoke this election if the taxpayer acted reasonably and in good faith, 
and the revocation will not prejudice the interests of the Government. 
See generally Sec.  301.9100-3 of this chapter. The election to apply 
paragraph (e)(3)(ii) or (iii) of this section may not be made or revoked 
through the filing of an application for change in accounting method. 
For purposes of applying paragraphs (e)(3)(iii) through (vii) of this 
section, see paragraph (j) of this section for identifying an asset 
disposed of and its unadjusted depreciable basis. Solely for purposes of 
applying paragraphs (e)(3)(iii), (e)(3)(iv)(C), (e)(3)(v)(B), and 
(e)(3)(vii) of this section, the term asset is:
    (A) The asset as determined under paragraph (e)(2)(viii) of this 
section; or
    (B) The portion of such asset that is disposed of in a disposition 
described in paragraph (e)(1)(ii) of this section.
    (ii) Disposition of all assets remaining in a general asset 
account--(A) Optional termination of a general asset account. Upon the 
disposition of all of the assets, the last asset, or the remaining 
portion of the last asset in a general asset account, a taxpayer may 
apply this paragraph (e)(3)(ii) to recover the adjusted depreciable 
basis of the general asset account rather than having paragraph (e)(2) 
of this section apply. Under this paragraph (e)(3)(ii), the general 
asset account terminates and the amount of gain or loss for the general

[[Page 509]]

asset account is determined under section 1001(a) by taking into account 
the adjusted depreciable basis of the general asset account at the time 
of the disposition, as determined under the applicable convention for 
the general asset account. Whether and to what extent gain or loss is 
recognized is determined under other applicable provisions of the Code, 
including section 280B and Sec.  1.280B-1. The character of the gain or 
loss is determined under other applicable provisions of the Code, except 
that the amount of gain subject to section 1245 is limited to the excess 
of the depreciation allowed or allowable for the general asset account, 
including any expensed cost, over any amounts previously recognized as 
ordinary income under paragraph (e)(2) of this section, and the amount 
of gain subject to section 1250 is limited to the excess of the 
additional depreciation allowed or allowable for the general asset 
account, over any amounts previously recognized as ordinary income under 
paragraph (e)(2) of this section.
    (B) Examples. The following examples illustrate the application of 
this paragraph (e)(3)(ii):

    Example 1. (i) T, a calendar-year corporation, maintains a general 
asset account for 1,000 calculators. The calculators cost a total of 
$60,000 and are placed in service in 2014. Assume T depreciates this 
general asset account using the optional depreciation table that 
corresponds with the general depreciation system, the 200-percent 
declining balance method, a 5-year recovery period, and a half-year 
convention. T does not make a section 179 election for any of the 
calculators, and all of the calculators are not eligible for any 
additional first year depreciation deduction. In 2015, T sells 200 of 
the calculators to an unrelated party for a total of $10,000 and 
recognizes the $10,000 as ordinary income in accordance with paragraph 
(e)(2) of this section.
    (ii) On March 26, 2016, T sells the remaining calculators in the 
general asset account to an unrelated party for $35,000. T elects to 
apply paragraph (e)(3)(ii) of this section. As a result, the account 
terminates and gain or loss is determined for the account.
    (iii) On the date of disposition, the adjusted depreciable basis of 
the account is $23,040 (unadjusted depreciable basis of $60,000 less the 
depreciation allowed or allowable of $36,960). Thus, in 2016, T 
recognizes gain of $11,960 (amount realized of $35,000 less the adjusted 
depreciable basis of $23,040). The gain of $11,960 is subject to section 
1245 to the extent of the depreciation allowed or allowable for the 
account, plus the expensed cost for assets in the account, less the 
amounts previously recognized as ordinary income ($36,960 + $0 - $10,000 
= $26,960). As a result, the entire gain of $11,960 is subject to 
section 1245.
    Example 2. (i) J, a calendar-year corporation, maintains a general 
asset account for one item of equipment. This equipment costs $2,000 and 
is placed in service in 2014. Assume J depreciates this general asset 
account using the optional depreciation table that corresponds with the 
general depreciation system, the 200-percent declining balance method, a 
5-year recovery period, and a half-year convention. J does not make a 
section 179 election for the equipment, and it is not eligible for any 
additional first year depreciation deduction. In June 2016, J sells the 
equipment to an unrelated party for $1,000. J elects to apply paragraph 
(e)(3)(ii) of this section. As a result, the account terminates and gain 
or loss is determined for the account.
    (ii) On the date of disposition, the adjusted depreciable basis of 
the account is $768 (unadjusted depreciable basis of $2,000 less the 
depreciation allowed or allowable of $1,232). Thus, in 2016, J 
recognizes gain of $232 (amount realized of $1,000 less the adjusted 
depreciable basis of $768). The gain of $232 is subject to section 1245 
to the extent of the depreciation allowed or allowable for the account, 
plus the expensed cost for assets in the account, less the amounts 
previously recognized as ordinary income ($1,232 + $0 - $0 = $1,232).As 
a result, the entire gain of $232 is subject to section 1245.

    (iii) Disposition of an asset in a qualifying disposition--(A) 
Optional determination of the amount of gain, loss, or other deduction. 
In the case of a qualifying disposition (described in paragraph 
(e)(3)(iii)(B) of this section) of an asset, a taxpayer may elect to 
apply this paragraph (e)(3)(iii) rather than having paragraph (e)(2) of 
this section apply. Under this paragraph (e)(3)(iii), general asset 
account treatment for the asset terminates as of the first day of the 
taxable year in which the qualifying disposition occurs, and the amount 
of gain, loss, or other deduction for the asset is determined under 
Sec.  1.168(i)-8 by taking into account the asset's adjusted depreciable 
basis at the time of the disposition. The adjusted depreciable basis of 
the asset at the time of the disposition, as determined under the 
applicable convention for the general asset account in which the asset 
was included, equals the

[[Page 510]]

unadjusted depreciable basis of the asset less the greater of the 
depreciation allowed or allowable for the asset. The allowable 
depreciation is computed by using the depreciation method, recovery 
period, and convention applicable to the general asset account in which 
the asset was included and by including the portion of the additional 
first year depreciation deduction claimed for the general asset account 
that is attributable to the asset disposed of. Whether and to what 
extent gain, loss, or other deduction is recognized is determined under 
other applicable provisions of the Code, including section 280B and 
Sec.  1.280B-1. The character of the gain, loss, or other deduction is 
determined under other applicable provisions of the Code, except that 
the amount of gain subject to section 1245 or section 1250 is limited to 
the lesser of--
    (1) The depreciation allowed or allowable for the asset, including 
any expensed cost or, in the case of section 1250 property, the 
additional depreciation allowed or allowable for the asset; or
    (2) The excess of--
    (i) The original unadjusted depreciable basis of the general asset 
account plus, in the case of section 1245 property originally included 
in the general asset account, any expensed cost; over
    (ii) The cumulative amounts of gain previously recognized as 
ordinary income under either paragraph (e)(2) of this section or section 
1245 or section 1250.
    (B) Qualifying dispositions. A qualifying disposition is a 
disposition that does not involve all the assets, the last asset, or the 
remaining portion of the last asset remaining in a general asset account 
and that is--
    (1) A direct result of a fire, storm, shipwreck, or other casualty, 
or from theft;
    (2) A charitable contribution for which a deduction is allowable 
under section 170;
    (3) A direct result of a cessation, termination, or disposition of a 
business, manufacturing or other income producing process, operation, 
facility, plant, or other unit, other than by transfer to a supplies, 
scrap, or similar account; or
    (4) A transaction, other than a transaction described in paragraph 
(e)(3)(iv) (pertaining to transactions subject to section 168(i)(7)), 
paragraph (e)(3)(v) (pertaining to transactions subject to section 1031 
or section 1033), paragraph (e)(3)(vi) (pertaining to technical 
terminations of partnerships), or paragraph (e)(3)(vii) (anti-abuse 
rule) of this section, to which a nonrecognition section of the Internal 
Revenue Code applies (determined without regard to this section).
    (C) Effect of a qualifying disposition on a general asset account. 
If the taxpayer elects to apply this paragraph (e)(3)(iii) to a 
qualifying disposition of an asset, then--
    (1) The asset is removed from the general asset account as of the 
first day of the taxable year in which the qualifying disposition 
occurs. For that taxable year, the taxpayer accounts for the asset in a 
single asset account in accordance with the rules under Sec.  1.168(i)-
7(b);
    (2) The unadjusted depreciable basis of the general asset account is 
reduced by the unadjusted depreciable basis of the asset as of the first 
day of the taxable year in which the disposition occurs;
    (3) The depreciation reserve of the general asset account is reduced 
by the greater of the depreciation allowed or allowable for the asset as 
of the end of the taxable year immediately preceding the year of 
disposition. The allowable depreciation is computed by using the 
depreciation method, recovery period, and convention applicable to the 
general asset account in which the asset was included and by including 
the portion of the additional first year depreciation deduction claimed 
for the general asset account that is attributable to the asset disposed 
of; and
    (4) For purposes of determining the amount of gain realized on 
subsequent dispositions that is subject to ordinary income treatment 
under paragraph (e)(2)(ii) of this section, the amount of any expensed 
cost with respect to the asset is disregarded.
    (D) Examples. The following examples illustrate the application of 
this paragraph (e)(3)(iii):


[[Page 511]]


    Example 1. (i) Z, a calendar-year corporation, maintains one general 
asset account for 12 machines. Each machine costs $15,000 and is placed 
in service in 2014. Of the 12 machines, nine machines that cost a total 
of $135,000 are used in Z's Kentucky plant, and three machines that cost 
a total of $45,000 are used in Z's Ohio plant. Assume Z depreciates this 
general asset account using the optional depreciation table that 
corresponds with the general depreciation system, the 200-percent 
declining balance method, a 5-year recovery period, and the half-year 
convention. Z does not make a section 179 election for any of the 
machines, and all of the machines are not eligible for any additional 
first year depreciation deduction. As of December 31, 2015, the 
depreciation reserve for the account is $93,600.
    (ii) On May 27, 2016, Z sells its entire manufacturing plant in Ohio 
to an unrelated party. The sales proceeds allocated to each of the three 
machines at the Ohio plant is $5,000. This transaction is a qualifying 
disposition under paragraph (e)(3)(iii)(B)(3) of this section, and Z 
elects to apply paragraph (e)(3)(iii) of this section.
    (iii) For Z's 2016 return, the depreciation allowance for the 
account is computed as follows. As of December 31, 2015, the 
depreciation allowed or allowable for the three machines at the Ohio 
plant is $23,400. Thus, as of January 1, 2016, the unadjusted 
depreciable basis of the account is reduced from $180,000 to $135,000 
($180,000 less the unadjusted depreciable basis of $45,000 for the three 
machines), and, as of December 31, 2015, the depreciation reserve of the 
account is decreased from $93,600 to $70,200 ($93,600 less the 
depreciation allowed or allowable of $23,400 for the three machines as 
of December 31, 2015). Consequently, the depreciation allowance for the 
account in 2016 is $25,920 ($135,000 x 19.2%).
    (iv) For Z's 2016 return, gain or loss for each of the three 
machines at the Ohio plant is determined as follows. The depreciation 
allowed or allowable in 2016 for each machine is $1,440 (($15,000 x 
19.2%)/2). Thus, the adjusted depreciable basis of each machine under 
section 1011 is $5,760 (the adjusted depreciable basis of $7,200 removed 
from the account less the depreciation allowed or allowable of $1,440 in 
2016). As a result, the loss recognized in 2016 for each machine is $760 
($5,000 - $5,760), which is subject to section 1231.
    Example 2. (i) A, a calendar-year partnership, maintains one general 
asset account for one office building that cost $20 million and was 
placed in service in July 2011. A depreciates this general asset account 
using the optional depreciation table that corresponds with the general 
depreciation system, the straight-line method, a 39-year recovery 
period, and the mid-month convention. As of January 1, 2014, the 
depreciation reserve for the account is $1,261,000.
    (ii) In May 2014, a tornado occurs where the building is located and 
damages the roof of the building. A decides to replace the entire roof. 
The roof is replaced in June 2014. The roof is a structural component of 
the building. Because the roof was damaged as a result of a casualty 
event described in section 165, the partial disposition rule provided 
under paragraph (e)(1)(ii) of this section applies to the roof. Although 
the office building, including its structural components, is the asset 
for disposition purposes, the partial disposition rule provides that the 
retirement of the replaced roof is a disposition under paragraph (e)(1) 
of this section. This retirement is a qualifying disposition under 
paragraph (e)(3)(iii)(B)(1) of this section, and A elects to apply 
paragraph (e)(3)(iii) of this section for the retirement of the damaged 
roof.
    (iii) Of the $20 million cost of the office building, assume $1 
million is the cost of the retired roof.
    (iv) For A's 2014 return, the depreciation allowance for the account 
is computed as follows. As of December 31, 2013, the depreciation 
allowed or allowable for the retired roof is $63,050. Thus, as of 
January 1, 2014, the unadjusted depreciable basis of the account is 
reduced from $20,000,000 to $19,000,000 ($20,000,000 less the unadjusted 
depreciable basis of $1,000,000 for the retired roof), and the 
depreciation reserve of the account is decreased from $1,261,000 to 
$1,197,950 ($1,261,000 less the depreciation allowed or allowable of 
$63,050 for the retired roof as of December 31, 2013). Consequently, the 
depreciation allowance for the account in 2014 is $487,160 ($19,000,000 
x 2.564%).
    (v) For A's 2014 return, gain or loss for the retired roof is 
determined as follows. The depreciation allowed or allowable in 2014 for 
the retired roof is $11,752 (($1,000,000 x 2.564%) x 5.5/12). Thus, the 
adjusted depreciable basis of the retired roof under section 1011 is 
$925,198 (the adjusted depreciable basis of $936,950 removed from the 
account less the depreciation allowed or allowable of $11,752 in 2014). 
As a result, the loss recognized in 2014 for the retired roof is 
$925,198, which is subject to section 1231.
    (vi) If A must capitalize the amount paid for the replacement roof 
under Sec.  1.263(a)-3, the replacement roof is a separate asset for 
depreciation purposes pursuant to section 168(i)(6). If A includes the 
replacement roof in a general asset account, the replacement roof is a 
separate asset for disposition purposes pursuant to paragraph 
(e)(2)(viii)(B)(4) of this section. If A includes the replacement roof 
in a single asset account or a multiple asset account under Sec.  
1.168(i)-7, the replacement roof is a separate asset for disposition 
purposes pursuant to Sec.  1.168(i)-8(c)(4)(ii)(D).


[[Page 512]]


    (iv) Transactions subject to section 168(i)(7)--(A) In general. If a 
taxpayer transfers one or more assets, or a portion of such asset, in a 
general asset account in a transaction described in section 168(i)(7)(B) 
(pertaining to treatment of transferees in certain nonrecognition 
transactions), the taxpayer (the transferor) and the transferee must 
apply this paragraph (e)(3)(iv) to the asset or the portion of such 
asset, instead of applying paragraph (e)(2), (e)(3)(ii), or (e)(3)(iii) 
of this section. The transferee is bound by the transferor's election 
under paragraph (l) of this section for the portion of the transferee's 
basis in the asset or the portion of such asset that does not exceed the 
transferor's adjusted depreciable basis of the general asset account or 
the asset or the portion of such asset, as applicable, as determined 
under paragraph (e)(3)(iv)(B)(2) or (C)(2) of this section, as 
applicable.
    (B) All assets remaining in general asset account are transferred. 
If a taxpayer transfers all the assets, the last asset, or the remaining 
portion of the last asset in a general asset account in a transaction 
described in section 168(i)(7)(B)--
    (1) The taxpayer (the transferor) must terminate the general asset 
account on the date of the transfer. The allowable depreciation 
deduction for the general asset account for the transferor's taxable 
year in which the section 168(i)(7)(B) transaction occurs is computed by 
using the depreciation method, recovery period, and convention 
applicable to the general asset account. This allowable depreciation 
deduction is allocated between the transferor and the transferee on a 
monthly basis. This allocation is made in accordance with the rules in 
Sec.  1.168(d)-1(b)(7)(ii) for allocating the depreciation deduction 
between the transferor and the transferee;
    (2) The transferee must establish a new general asset account for 
all the assets, the last asset, or the remaining portion of the last 
asset, in the taxable year in which the section 168(i)(7)(B) transaction 
occurs for the portion of its basis in the assets that does not exceed 
the transferor's adjusted depreciable basis of the general asset account 
in which all the assets, the last asset, or the remaining portion of the 
last asset, were included. The transferor's adjusted depreciable basis 
of this general asset account is equal to the adjusted depreciable basis 
of that account as of the beginning of the transferor's taxable year in 
which the transaction occurs, decreased by the amount of depreciation 
allocable to the transferor for the year of the transfer, as determined 
under paragraph (e)(3)(iv)(B)(1) of this section. The transferee is 
treated as the transferor for purposes of computing the allowable 
depreciation deduction for the new general asset account under section 
168. The new general asset account must be established in accordance 
with the rules in paragraph (c) of this section, except that the 
unadjusted depreciable bases of all the assets, the last asset, or the 
remaining portion of the last asset, and the greater of the depreciation 
allowed or allowable for all the assets, the last asset, or the 
remaining portion of the last asset, including the amount of 
depreciation for the transferred assets that is allocable to the 
transferor for the year of the transfer, are included in the newly 
established general asset account. Consequently, this general asset 
account in the year of the transfer will have a beginning balance for 
both the unadjusted depreciable basis and the depreciation reserve of 
the general asset account; and
    (3) For purposes of section 168 and this section, the transferee 
treats the portion of its basis in the assets that exceeds the 
transferor's adjusted depreciable basis of the general asset account in 
which all the assets, the last asset, or the remaining portion of the 
last asset, were included, as determined under paragraph 
(e)(3)(iv)(B)(2) of this section, as a separate asset that the 
transferee placed in service on the date of the transfer. The transferee 
accounts for this asset under Sec.  1.168(i)-7 or may make an election 
under paragraph (l) of this section to include the asset in a general 
asset account.
    (C) Not all assets remaining in general asset account are 
transferred. If a taxpayer transfers an asset in a general asset account 
in a transaction described in section 168(i)(7)(B) and if paragraph 
(e)(3)(iv)(B) of this section does not apply to this asset--

[[Page 513]]

    (1) The taxpayer (the transferor) must remove the transferred asset 
from the general asset account in which the asset is included, as of the 
first day of the taxable year in which the section 168(i)(7)(B) 
transaction occurs. In addition, the adjustments to the general asset 
account described in paragraphs (e)(3)(iii)(C)(2) through (4) of this 
section must be made. The allowable depreciation deduction for the asset 
for the transferor's taxable year in which the section 168(i)(7)(B) 
transaction occurs is computed by using the depreciation method, 
recovery period, and convention applicable to the general asset account 
in which the asset was included. This allowable depreciation deduction 
is allocated between the transferor and the transferee on a monthly 
basis. This allocation is made in accordance with the rules in Sec.  
1.168(d)-1(b)(7)(ii) for allocating the depreciation deduction between 
the transferor and the transferee;
    (2) The transferee must establish a new general asset account for 
the asset in the taxable year in which the section 168(i)(7)(B) 
transaction occurs for the portion of its basis in the asset that does 
not exceed the transferor's adjusted depreciable basis of the asset. The 
transferor's adjusted depreciable basis of this asset is equal to the 
adjusted depreciable basis of the asset as of the beginning of the 
transferor's taxable year in which the transaction occurs, decreased by 
the amount of depreciation allocable to the transferor for the year of 
the transfer, as determined under paragraph (e)(3)(iv)(C)(1) of this 
section. The transferee is treated as the transferor for purposes of 
computing the allowable depreciation deduction for the new general asset 
account under section 168. The new general asset account must be 
established in accordance with the rules in paragraph (c) of this 
section, except that the unadjusted depreciable basis of the asset, and 
the greater of the depreciation allowed or allowable for the asset, 
including the amount of depreciation for the transferred asset that is 
allocable to the transferor for the year of the transfer, are included 
in the newly established general asset account. Consequently, this 
general asset account in the year of the transfer will have a beginning 
balance for both the unadjusted depreciable basis and the depreciation 
reserve of the general asset account; and
    (3) For purposes of section 168 and this section, the transferee 
treats the portion of its basis in the asset that exceeds the 
transferor's adjusted depreciable basis of the asset, as determined 
under paragraph (e)(3)(iv)(C)(2) of this section, as a separate asset 
that the transferee placed in service on the date of the transfer. The 
transferee accounts for this asset under Sec.  1.168(i)-7 or may make an 
election under paragraph (l) of this section to include the asset in a 
general asset account.
    (v) Transactions subject to section 1031 or section 1033--(A) Like-
kind exchange or involuntary conversion of all assets remaining in a 
general asset account. If all the assets, the last asset, or the 
remaining portion of the last asset in a general asset account are 
transferred by a taxpayer in a like-kind exchange (as defined under 
Sec.  1.168-6(b)(11)) or in an involuntary conversion (as defined under 
Sec.  1.168-6(b)(12)), the taxpayer must apply this paragraph 
(e)(3)(v)(A) instead of applying paragraph (e)(2), (e)(3)(ii), or 
(e)(3)(iii) of this section. Under this paragraph (e)(3)(v)(A), the 
general asset account terminates as of the first day of the year of 
disposition (as defined in Sec.  1.168(i)-6(b)(5)) and--
    (1) The amount of gain or loss for the general asset account is 
determined under section 1001(a) by taking into account the adjusted 
depreciable basis of the general asset account at the time of 
disposition (as defined in Sec.  1.168(i)-6(b)(3)). The depreciation 
allowance for the general asset account in the year of disposition is 
determined in the same manner as the depreciation allowance for the 
relinquished MACRS property (as defined in Sec.  1.168(i)-6(b)(2)) in 
the year of disposition is determined under Sec.  1.168(i)-6. The 
recognition and character of gain or loss are determined in accordance 
with paragraph (e)(3)(ii)(A) of this section, notwithstanding that 
paragraph (e)(3)(ii) of this section is an optional rule; and
    (2) The adjusted depreciable basis of the general asset account at 
the time of disposition is treated as the adjusted depreciable basis of 
the relinquished MACRS property.

[[Page 514]]

    (B) Like-kind exchange or involuntary conversion of less than all 
assets remaining in a general asset account. If an asset in a general 
asset account is transferred by a taxpayer in a like-kind exchange or in 
an involuntary conversion and if paragraph (e)(3)(v)(A) of this section 
does not apply to this asset, the taxpayer must apply this paragraph 
(e)(3)(v)(B) instead of applying paragraph (e)(2), (e)(3)(ii), or 
(e)(3)(iii) of this section. Under this paragraph (e)(3)(v)(B), general 
asset account treatment for the asset terminates as of the first day of 
the year of disposition (as defined in Sec.  1.168(i)-6(b)(5)), and--
    (1) The amount of gain or loss for the asset is determined by taking 
into account the asset's adjusted depreciable basis at the time of 
disposition (as defined in Sec.  1.168(i)-6(b)(3)). The adjusted 
depreciable basis of the asset at the time of disposition equals the 
unadjusted depreciable basis of the asset less the greater of the 
depreciation allowed or allowable for the asset. The allowable 
depreciation is computed by using the depreciation method, recovery 
period, and convention applicable to the general asset account in which 
the asset was included and by including the portion of the additional 
first year depreciation deduction claimed for the general asset account 
that is attributable to the relinquished asset. The depreciation 
allowance for the asset in the year of disposition is determined in the 
same manner as the depreciation allowance for the relinquished MACRS 
property (as defined in Sec.  1.168(i)-6(b)(2)) in the year of 
disposition is determined under Sec.  1.168(i)-6. The recognition and 
character of the gain or loss are determined in accordance with 
paragraph (e)(3)(iii)(A) of this section, notwithstanding that paragraph 
(e)(3)(iii) of this section is an optional rule; and
    (2) As of the first day of the year of disposition, the taxpayer 
must remove the relinquished asset from the general asset account and 
make the adjustments to the general asset account described in 
paragraphs (e)(3)(iii)(C)(2) through (4) of this section.
    (vi) Technical termination of a partnership. In the case of a 
technical termination of a partnership under section 708(b)(1)(B), the 
terminated partnership must apply this paragraph (e)(3)(vi) instead of 
applying paragraph (e)(2), (e)(3)(ii), or (e)(3)(iii) of this section. 
Under this paragraph (e)(3)(vi), all of the terminated partnership's 
general asset accounts terminate as of the date of its termination under 
section 708(b)(1)(B). The terminated partnership computes the allowable 
depreciation deduction for each of its general asset accounts for the 
taxable year in which the technical termination occurs by using the 
depreciation method, recovery period, and convention applicable to the 
general asset account. The new partnership is not bound by the 
terminated partnership's election under paragraph (l) of this section.
    (vii) Anti-abuse rule--(A) In general. If an asset in a general 
asset account is disposed of by a taxpayer in a transaction described in 
paragraph (e)(3)(vii)(B) of this section, general asset account 
treatment for the asset terminates as of the first day of the taxable 
year in which the disposition occurs. Consequently, the taxpayer must 
determine the amount of gain, loss, or other deduction attributable to 
the disposition in the manner described in paragraph (e)(3)(iii)(A) of 
this section, notwithstanding that paragraph (e)(3)(iii)(A) of this 
section is an optional rule, and must make the adjustments to the 
general asset account described in paragraphs (e)(3)(iii)(C)(1) through 
(4) of this section.
    (B) Abusive transactions. A transaction is described in this 
paragraph (e)(3)(vii)(B) if the transaction is not described in 
paragraph (e)(3)(iv), (e)(3)(v), or (e)(3)(vi) of this section, and if 
the transaction is entered into, or made, with a principal purpose of 
achieving a tax benefit or result that would not be available absent an 
election under this section. Examples of these types of transactions 
include--
    (1) A transaction entered into with a principal purpose of shifting 
income or deductions among taxpayers in a manner that would not be 
possible absent an election under this section to take advantage of 
differing effective tax rates among the taxpayers; or
    (2) An election made under this section with a principal purpose of 
disposing of an asset from a general asset

[[Page 515]]

account to utilize an expiring net operating loss or credit if the 
transaction is not a bona fide disposition. The fact that a taxpayer 
with a net operating loss carryover or a credit carryover transfers an 
asset to a related person or transfers an asset pursuant to an 
arrangement where the asset continues to be used or is available for use 
by the taxpayer pursuant to a lease or otherwise indicates, absent 
strong evidence to the contrary, that the transaction is described in 
this paragraph (e)(3)(vii)(B).
    (f) Assets generating foreign source income--(1) In general. This 
paragraph (f) provides the rules for determining the source of any 
income, gain, or loss recognized, and the appropriate section 904(d) 
separate limitation category or categories for any foreign source 
income, gain, or loss recognized on a disposition (within the meaning of 
paragraph (e)(1) of this section) of an asset in a general asset account 
that consists of assets generating both United States and foreign source 
income. These rules apply only to a disposition to which paragraph 
(e)(2) (general disposition rules), paragraph (e)(3)(ii) (disposition of 
all assets remaining in a general asset account), paragraph (e)(3)(iii) 
(disposition of an asset in a qualifying disposition), paragraph 
(e)(3)(v) (transactions subject to section 1031 or section 1033), or 
paragraph (e)(3)(vii) (anti-abuse rule) of this section applies. Solely 
for purposes of applying this paragraph (f), the term asset is:
    (i) The asset as determined under paragraph (e)(2)(viii) of this 
section; or
    (ii) The portion of such asset that is disposed of in a disposition 
described in paragraph (e)(1)(ii) of this section.
    (2) Source of ordinary income, gain, or loss--(i) Source determined 
by allocation and apportionment of depreciation allowed. The amount of 
any ordinary income, gain, or loss that is recognized on the disposition 
of an asset in a general asset account must be apportioned between 
United States and foreign sources based on the allocation and 
apportionment of the--
    (A) Depreciation allowed for the general asset account as of the end 
of the taxable year in which the disposition occurs if paragraph (e)(2) 
of this section applies to the disposition;
    (B) Depreciation allowed for the general asset account as of the 
time of disposition if the taxpayer applies paragraph (e)(3)(ii) of this 
section to the disposition of all assets, the last asset, or the 
remaining portion of the last asset, in the general asset account, or if 
all the assets, the last asset, or the remaining portion of the last 
asset, in the general asset account are disposed of in a transaction 
described in paragraph (e)(3)(v)(A) of this section; or
    (C) Depreciation allowed for the asset disposed of for only the 
taxable year in which the disposition occurs if the taxpayer applies 
paragraph (e)(3)(iii) of this section to the disposition of the asset in 
a qualifying disposition, if the asset is disposed of in a transaction 
described in paragraph (e)(3)(v)(B) of this section (like-kind exchange 
or involuntary conversion), or if the asset is disposed of in a 
transaction described in paragraph (e)(3)(vii) of this section (anti-
abuse rule).
    (ii) Formula for determining foreign source income, gain, or loss. 
The amount of ordinary income, gain, or loss recognized on the 
disposition that shall be treated as foreign source income, gain, or 
loss must be determined under the formula in this paragraph (f)(2)(ii). 
For purposes of this formula, the allowed depreciation deductions are 
determined for the applicable time period provided in paragraph 
(f)(2)(i) of this section. The formula is:

[[Page 516]]



Foreign Source Income, Gain, or                =   Total Ordinary Income,             X   Allowed Depreciation
 Loss from The Disposition of an                    Gain, or Loss from the                 Deductions Allocated
 Asset.                                             Disposition of an                      and Apportioned to
                                                    Asset.                                 Foreign Source Income/
                                                                                           Total Allowed
                                                                                           Depreciation
                                                                                           Deductions for the
                                                                                           General Asset Account
                                                                                           or for the Asset
                                                                                           Disposed of (as
                                                                                           applicable).
 

    (3) Section 904(d) separate categories. If the assets in the general 
asset account generate foreign source income in more than one separate 
category under section 904(d)(1) or another section of the Code (for 
example, income treated as foreign source income under section 
904(g)(10)), or under a United States income tax treaty that requires 
the foreign tax credit limitation to be determined separately for 
specified types of income, the amount of foreign source income, gain, or 
loss from the disposition of an asset, as determined under the formula 
in paragraph (f)(2)(ii) of this section, must be allocated and 
apportioned to the applicable separate category or categories under the 
formula in this paragraph (f)(3). For purposes of this formula, the 
allowed depreciation deductions are determined for the applicable time 
period provided in paragraph (f)(2)(i) of this section. The formula is:

Foreign Source Income, Gain, or                =   Foreign Source Income,             X    Allowed Depreciation
 Loss in a Separate Category.                       Gain, or Loss from The                 Deductions Allocated
                                                    Disposition of an                      and Apportioned to a
                                                    Asset.                                 Separate Category/
                                                                                           Total Allowed
                                                                                           Depreciation
                                                                                           Deductions and
                                                                                           Apportioned to
                                                                                           Foreign Source
                                                                                           Income.
 

    (g) Assets subject to recapture. If the basis of an asset in a 
general asset account is increased as a result of the recapture of any 
allowable credit or deduction (for example, the basis adjustment for the 
recapture amount under section 30(e)(5), 50(c)(2), 168(l)(6), 168(n)(4), 
179(d)(10), 179A(e)(4), or 1400N(d)(5)), general asset account treatment 
for the asset terminates as of the first day of the taxable year in 
which the recapture event occurs. Consequently, the taxpayer must remove 
the asset from the general asset account as of that day and must make 
the adjustments to the general asset account described in paragraphs 
(e)(3)(iii)(C)(2) through (4) of this section.
    (h) Changes in use--(1) Conversion to any personal use. An asset in 
a general asset account becomes ineligible for general asset account 
treatment if a taxpayer uses the asset in any personal activity during a 
taxable year. Upon a conversion to any personal use, the taxpayer must 
remove the asset from the general asset account as of the first day of 
the taxable year in which the change in use occurs (the year of change) 
and must make the adjustments to the general asset account described in 
paragraphs (e)(3)(iii)(C)(2) through (4) of this section.
    (2) Change in use results in a different recovery period and/or 
depreciation method--(i) No effect on general asset account election. A 
change in the use described in Sec.  1.168(i)-4(d) (change in use 
results in a different recovery period or depreciation method) of an 
asset in a general asset account shall not cause or permit the 
revocation of the election made under this section.

[[Page 517]]

    (ii) Asset is removed from the general asset account. Upon a change 
in the use described in Sec.  1.168(i)-4(d), the taxpayer must remove 
the asset from the general asset account as of the first day of the year 
of change (as defined in Sec.  1.168(i)-4(a)) and must make the 
adjustments to the general asset account described in paragraphs 
(e)(3)(iii)(C)(2) through (4) of this section. If, however, the result 
of the change in use is described in Sec.  1.168(i)-4(d)(3) (change in 
use results in a shorter recovery period or a more accelerated 
depreciation method) and the taxpayer elects to treat the asset as 
though the change in use had not occurred pursuant to Sec.  1.168(i)-
4(d)(3)(ii), no adjustment is made to the general asset account upon the 
change in use.
    (iii) New general asset account is established--(A) Change in use 
results in a shorter recovery period or a more accelerated depreciation 
method. If the result of the change in use is described in Sec.  
1.168(i)-4(d)(3) (change in use results in a shorter recovery period or 
a more accelerated depreciation method) and adjustments to the general 
asset account are made pursuant to paragraph (h)(2)(ii) of this section, 
the taxpayer must establish a new general asset account for the asset in 
the year of change in accordance with the rules in paragraph (c) of this 
section, except that the adjusted depreciable basis of the asset as of 
the first day of the year of change is included in the general asset 
account. For purposes of paragraph (c)(2) of this section, the 
applicable depreciation method, recovery period, and convention are 
determined under Sec.  1.168(i)-4(d)(3)(i).
    (B) Change in use results in a longer recovery period or a slower 
depreciation method. If the result of the change in use is described in 
Sec.  1.168(i)-4(d)(4) (change in use results in a longer recovery 
period or a slower depreciation method), the taxpayer must establish a 
separate general asset account for the asset in the year of change in 
accordance with the rules in paragraph (c) of this section, except that 
the unadjusted depreciable basis of the asset, and the greater of the 
depreciation of the asset allowed or allowable in accordance with 
section 1016(a)(2), as of the first day of the year of change are 
included in the newly established general asset account. Consequently, 
this general asset account as of the first day of the year of change 
will have a beginning balance for both the unadjusted depreciable basis 
and the depreciation reserve of the general asset account. For purposes 
of paragraph (c)(2) of this section, the applicable depreciation method, 
recovery period, and convention are determined under Sec.  1.168(i)-
4(d)(4)(ii).
    (i) Redetermination of basis. If, after the placed-in-service year, 
the unadjusted depreciable basis of an asset in a general asset account 
is redetermined due to a transaction other than that described in 
paragraph (g) of this section (for example, due to contingent purchase 
price or discharge of indebtedness), the taxpayer's election under 
paragraph (l) of this section for the asset also applies to the increase 
or decrease in basis resulting from the redetermination. For the taxable 
year in which the increase or decrease in basis occurs, the taxpayer 
must establish a new general asset account for the amount of the 
increase or decrease in basis in accordance with the rules in paragraph 
(c) of this section. For purposes of paragraph (c)(2) of this section, 
the applicable recovery period for the increase or decrease in basis is 
the recovery period of the asset remaining as of the beginning of the 
taxable year in which the increase or decrease in basis occurs, the 
applicable depreciation method and applicable convention for the 
increase or decrease in basis are the same depreciation method and 
convention applicable to the asset that applies for the taxable year in 
which the increase or decrease in basis occurs, and the increase or 
decrease in basis is deemed to be placed in service in the same taxable 
year as the asset.
    (j) Identification of disposed or converted asset--(1) In general. 
The rules of this paragraph (j) apply when an asset in a general asset 
account is disposed of or converted in a transaction described in 
paragraph (e)(3)(iii) (disposition of an asset in a qualifying 
disposition), paragraph (e)(3)(iv)(B) (transactions subject to section 
168(i)(7)), paragraph (e)(3)(v)(B) (transactions subject to section 1031 
or section 1033), paragraph (e)(3)(vii) (anti-abuse rule),

[[Page 518]]

paragraph (g) (assets subject to recapture), or paragraph (h)(1) 
(conversion to any personal use) of this section.
    (2) Identifying which asset is disposed of or converted--(i) In 
general. For purposes of identifying which asset in a general asset 
account is disposed of or converted, a taxpayer must identify the 
disposed of or converted asset by using--
    (A) The specific identification method of accounting. Under this 
method of accounting, the taxpayer can determine the particular taxable 
year in which the disposed of or converted asset was placed in service 
by the taxpayer;
    (B) A first-in, first-out method of accounting if the taxpayer can 
readily determine from its records the total dispositions of assets with 
the same recovery period during the taxable year but the taxpayer cannot 
readily determine from its records the unadjusted depreciable basis of 
the disposed of or converted asset. Under this method of accounting, the 
taxpayer identifies the general asset account with the earliest placed-
in-service year that has the same recovery period as the disposed of or 
converted asset and that has assets at the beginning of the taxable year 
of the disposition or conversion, and the taxpayer treats the disposed 
of or converted asset as being from that general asset account. To 
determine which general asset account has assets at the beginning of the 
taxable year of the disposition or conversion, the taxpayer reduces the 
number of assets originally included in the account by the number of 
assets disposed of or converted in any prior taxable year in a 
transaction to which this paragraph (j) applies;
    (C) A modified first-in, first-out method of accounting if the 
taxpayer can readily determine from its records the total dispositions 
of assets with the same recovery period during the taxable year and the 
unadjusted depreciable basis of the disposed of or converted asset. 
Under this method of accounting, the taxpayer identifies the general 
asset account with the earliest placed-in-service year that has the same 
recovery period as the disposed of or converted asset and that has 
assets at the beginning of the taxable year of the disposition or 
conversion with the same unadjusted depreciable basis as the disposed of 
or converted asset, and the taxpayer treats the disposed of or converted 
asset as being from that general asset account. To determine which 
general asset account has assets at the beginning of the taxable year of 
the disposition or conversion, the taxpayer reduces the number of assets 
originally included in the account by the number of assets disposed of 
or converted in any prior taxable year in a transaction to which this 
paragraph (j) applies;
    (D) A mortality dispersion table if the asset is a mass asset 
accounted for in a separate general asset account in accordance with 
paragraph (c)(2)(ii)(H) of this section and if the taxpayer can readily 
determine from its records the total dispositions of assets with the 
same recovery period during the taxable year. The mortality dispersion 
table must be based upon an acceptable sampling of the taxpayer's actual 
disposition and conversion experience for mass assets or other 
acceptable statistical or engineering techniques. To use a mortality 
dispersion table, the taxpayer must adopt recordkeeping practices 
consistent with the taxpayer's prior practices and consonant with good 
accounting and engineering practices; or
    (E) Any other method as the Secretary may designate by publication 
in the Federal Register or in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2) of this chapter) on or after September 19, 2013. See 
paragraph (j)(2)(iii) of this section regarding the last-in, first-out 
method of accounting.
    (ii) Disposition of a portion of an asset. If a taxpayer disposes of 
a portion of an asset and paragraph (e)(1)(ii) of this section applies 
to that disposition, the taxpayer may identify the asset by using any 
applicable method provided in paragraph (j)(2)(i) of this section, after 
taking into account paragraph (j)(2)(iii) of this section.
    (iii) Last-in, first-out method of accounting. For purposes of 
paragraph (j)(2) of this section, a last-in, first-out method of 
accounting may not be used. Examples of a last-in, first-out method of 
accounting include the taxpayer identifying the general asset account 
with the most recent placed-in-service year that has the same recovery 
period

[[Page 519]]

as the disposed of or converted asset and that has assets at the 
beginning of the taxable year of the disposition or conversion, and the 
taxpayer treating the disposed of or converted asset as being from that 
general asset account, or the taxpayer treating the disposed portion of 
an asset as being from the general asset account with the most recent 
placed-in-service year that has assets that are the same as the asset of 
which the disposed portion is a part.
    (3) Basis of disposed of or converted asset. (i) Solely for purposes 
of this paragraph (j)(3), the term asset is the asset as determined 
under paragraph (e)(2)(viii) of this section or the portion of such 
asset that is disposed of in a disposition described in paragraph 
(e)(1)(ii) of this section. After identifying which asset in a general 
asset account is disposed of or converted, the taxpayer must determine 
the unadjusted depreciable basis of, and the depreciation allowed or 
allowable for, the disposed of or converted asset. If it is 
impracticable from the taxpayer's records to determine the unadjusted 
depreciable basis of the disposed of or converted asset, the taxpayer 
may use any reasonable method that is consistently applied to all assets 
in the same general asset account for purposes of determining the 
unadjusted depreciable basis of the disposed of or converted asset in 
that general asset account. Examples of a reasonable method include, but 
are not limited to, the following:
    (A) If the replacement asset is a restoration (as defined in Sec.  
1.263(a)-3(k)), and is not a betterment (as defined in Sec.  1.263(a)-
3(j)) or an adaptation to a new or different use (as defined in Sec.  
1.263(a)-3(l)), discounting the cost of the replacement asset to its 
placed-in-service year cost using the Producer Price Index for Finished 
Goods or its successor, the Producer Price Index for Final Demand, or 
any other index designated by guidance in the Internal Revenue Bulletin 
(see Sec.  601.601(d)(2) of this chapter) for purposes of this paragraph 
(j)(3);
    (B) A pro rata allocation of the unadjusted depreciable basis of the 
general asset account based on the replacement cost of the disposed 
asset and the replacement cost of all of the assets in the general asset 
account; and
    (C) A study allocating the cost of the asset to its individual 
components.
    (ii) The depreciation allowable for the disposed of or converted 
asset is computed by using the depreciation method, recovery period, and 
convention applicable to the general asset account in which the disposed 
of or converted asset was included and by including the additional first 
year depreciation deduction claimed for the disposed of or converted 
asset.
    (k) Effect of adjustments on prior dispositions. The adjustments to 
a general asset account under paragraph (e)(3)(iii), (e)(3)(iv), 
(e)(3)(v), (e)(3)(vii), (g), or (h) of this section have no effect on 
the recognition and character of prior dispositions subject to paragraph 
(e)(2) of this section.
    (l) Election--(1) Irrevocable election. If a taxpayer makes an 
election under this paragraph (l), the taxpayer consents to, and agrees 
to apply, all of the provisions of this section to the assets included 
in a general asset account. Except as provided in paragraph 
(c)(1)(ii)(A), (e)(3), (g), or (h) of this section or except as 
otherwise expressly provided by other guidance published in the Internal 
Revenue Bulletin (see Sec.  601.601(d)(2) of this chapter), an election 
made under this section is irrevocable and will be binding on the 
taxpayer for computing taxable income for the taxable year for which the 
election is made and for all subsequent taxable years. An election under 
this paragraph (l) is made separately by each person owning an asset to 
which this section applies (for example, by each member of a 
consolidated group, at the partnership level and not by the partner 
separately, or at the S corporation level and not by the shareholder 
separately).
    (l)(2) Time for making election. The election to apply this section 
shall be made on the taxpayer's timely filed (including extensions) 
income tax return for the taxable year in which the assets included in 
the general asset account are placed in service by the taxpayer.
    (3) Manner of making election. In the year of election, a taxpayer 
makes the election under this section by typing or

[[Page 520]]

legibly printing at the top of the Form 4562, ``GENERAL ASSET ACCOUNT 
ELECTION MADE UNDER SECTION 168(i)(4),'' or in the manner provided for 
on Form 4562 and its instructions. The taxpayer shall maintain records 
(for example, ``General Asset Account 1--all 1995 additions in asset 
class 00.11 for Salt Lake City, Utah facility'') that identify the 
assets included in each general asset account, that establish the 
unadjusted depreciable basis and depreciation reserve of the general 
asset account, and that reflect the amount realized during the taxable 
year upon dispositions from each general asset account. (But see section 
179(c) and Sec.  1.179-5 for the recordkeeping requirements for section 
179 property.) The taxpayer's recordkeeping practices should be 
consistently applied to the general asset accounts. If Form 4562 is 
revised or renumbered, any reference in this section to that form shall 
be treated as a reference to the revised or renumbered form.
    (m) Effective/applicability dates--(1) In general. This section 
applies to taxable years beginning on or after January 1, 2014. Except 
as provided in paragraphs (m)(2), (m)(3), and (m)(4) of this section, 
Sec.  1.168(i)-1 as contained in 26 CFR part 1 edition revised as of 
April 1, 2011, applies to taxable years beginning before January 1, 
2014.
    (2) Early application of this section. A taxpayer may choose to 
apply the provisions of this section to taxable years beginning on or 
after January 1, 2012.
    (3) Early application of regulation project REG-110732-13. A 
taxpayer may rely on the provisions of this section in regulation 
project REG-110732-13 (2013-43 IRB 404) (see Sec.  601.601(d)(2) of this 
chapter) for taxable years beginning on or after January 1, 2012. 
However, a taxpayer may not rely on the provisions of this section in 
regulation project REG-110732-13 for taxable years beginning on or after 
January 1, 2014.
    (4) Optional application of TD 9564. A taxpayer may choose to apply 
Sec.  1.168(i)-1T as contained in 26 CFR part 1 edition revised as of 
April 1, 2014, to taxable years beginning on or after January 1, 2012. 
However, a taxpayer may not apply Sec.  1.168(i)-1T as contained in 26 
CFR part 1 edition revised as of April 1, 2014, to taxable years 
beginning on or after January 1, 2014.
    (5) Change in method of accounting. A change to comply with this 
section for depreciable assets placed in service in a taxable year 
ending on or after December 30, 2003, is a change in method of 
accounting to which the provisions of section 446(e) and the regulations 
under section 446(e) apply. A taxpayer also may treat a change to comply 
with this section for depreciable assets placed in service in a taxable 
year ending before December 30, 2003, as a change in method of 
accounting to which the provisions of section 446(e) and the regulations 
under section 446(e) apply. This paragraph (m)(5) does not apply to a 
change to comply with paragraph (e)(3)(ii), (e)(3)(iii), or (l) of this 
section, except as otherwise expressly provided by other guidance 
published in the Internal Revenue Bulletin (see Sec.  601.601(d)(2) of 
this chapter).

[T.D. 8566, 59 FR 51371, Oct. 11, 1994; 59 FR 64849, Dec. 16, 1994, as 
amended by T.D. 9115, 69 FR 9534, Mar. 1, 2004; T.D. 9132, 69 FR 33842, 
June 17, 2004; T.D. 9314, 72 FR 9249, Mar. 1, 2007; T.D. 9564, 76 FR 
81086, Dec. 27, 2011; 77 FR 75016, Dec. 19, 2012; T.D. 9689, 79 FR 
48667, Aug. 18, 2014; 79 FR 78697, Dec. 31, 2014]



Sec.  1.168(i)-2  Lease term.

    (a) In general. For purposes of section 168, a lease term is 
determined under all the facts and circumstances. Paragraph (b) of this 
section and Sec.  1.168(j)-1T, Q&A 17, describe certain circumstances 
that will result in a period of time not included in the stated duration 
of an original lease (additional period) nevertheless being included in 
the lease term. These rules do not prevent the inclusion of an 
additional period in the lease term in other circumstances.
    (b) Lessee retains financial obligation--(1) In general. An 
additional period of time during which a lessee may not continue to be 
the lessee will nevertheless be included in the lease term if the lessee 
(or a related person)--
    (i) Has agreed that one or both of them will or could be obligated 
to make a payment of rent or a payment in the nature of rent with 
respect to such period; or
    (ii) Has assumed or retained any risk of loss with respect to the 
property for such period (including, for example, by

[[Page 521]]

holding a note secured by the property).
    (2) Payments in the nature of rent. For purposes of paragraph 
(b)(1)(i) of this section, a payment in the nature of rent includes a 
payment intended to substitute for rent or to fund or supplement the 
rental payments of another. For example, a payment in the nature of rent 
includes a payment of any kind (whether denominated as supplemental 
rent, as liquidated damages, or otherwise) that is required to be made 
in the event that--
    (i) The leased property is not leased for the additional period;
    (ii) The leased property is leased for the additional period under 
terms that do not satisfy specified terms and conditions;
    (iii) There is a failure to make a payment of rent with respect to 
such additional period; or
    (iv) Circumstances similar to those described in paragraph (b)(2) 
(i), (ii), or (iii) of this section occur.
    (3) De minimis rule. For the purposes of this paragraph (b), 
obligations to make de minimis payments will be disregarded.
    (c) Multiple leases or subleases. If property is subject to more 
than one lease (including any sublease) entered into as part of a single 
transaction (or a series of related transactions), the lease term 
includes all periods described in one or more of such leases. For 
example, if one taxable corporation leases property to another taxable 
corporation for a 20-year term and, as part of the same transaction, the 
lessee subleases the property to a tax-exempt entity for a 10-year term, 
then the lease term of the property for purposes of section 168 is 20 
years. During the period of tax-exempt use, the property must be 
depreciated under the alternative depreciation system using the straight 
line method over the greater of its class life or 25 years (125 percent 
of the 20-year lease term).
    (d) Related person. For purposes of paragraph (b) of this section, a 
person is related to the lessee if such person is described in section 
168(h)(4).
    (e) Changes in status. Section 168(i)(5) (changes in status) applies 
if an additional period is included in a lease term under this section 
and the leased property ceases to be tax-exempt use property for such 
additional period.
    (f) Example. The following example illustrates the principles of 
this section. The example does not address common law doctrines or other 
authorities that may apply to cause an additional period to be included 
in the lease term or to recharacterize a lease as a conditional sale or 
otherwise for federal income tax purposes. Unless otherwise indicated, 
parties to the transactions are not related to one another.

    Example. Financial obligation with respect to an additional period. 
(i) Facts. X, a taxable corporation, and Y, a foreign airline whose 
income is not subject to United States taxation, enter into a lease 
agreement under which X agrees to lease an aircraft to Y for a period of 
10 years. The lease agreement provides that, at the end of the lease 
period, Y is obligated to find a subsequent lessee (replacement lessee) 
to enter into a subsequent lease (replacement lease) of the aircraft 
from X for an additional 10-year period. The provisions of the lease 
agreement require that any replacement lessee be unrelated to Y and that 
it not be a tax-exempt entity as defined in section 168(h)(2). The 
provisions of the lease agreement also set forth the basic terms and 
conditions of the replacement lease, including its duration and the 
required rental payments. In the event Y fails to secure a replacement 
lease, the lease agreement requires Y to make a payment to X in an 
amount determined under the lease agreement.
    (ii) Application of this section. The lease agreement between X and 
Y obligates Y to make a payment in the event the aircraft is not leased 
for the period commencing after the initial 10-year lease period and 
ending on the date the replacement lease is scheduled to end. 
Accordingly, pursuant to paragraph (b) of this section, the term of the 
lease between X and Y includes such additional period, and the lease 
term is 20 years for purposes of section 168.
    (iii) Facts modified. Assume the same facts as in paragraph (i) of 
this Example, except that Y is required to guarantee the payment of 
rentals under the 10-year replacement lease and to make a payment to X 
equal to the present value of any excess of the replacement lease rental 
payments specified in the lease agreement between X and Y, over the 
rental payments actually agreed to be paid by the replacement lessee. 
Pursuant to paragraph (b) of this section, the term of the lease between 
X and Y includes the additional period, and the lease term is 20 years 
for purposes of section 168.

[[Page 522]]

    (iv) Changes in status. If, upon the conclusion of the stated 
duration of the lease between X and Y, the aircraft either is returned 
to X or leased to a replacement lessee that is not a tax-exempt entity 
as defined in section 168(h)(2), the subsequent method of depreciation 
will be determined pursuant to section 168(i)(5).

    (g) Effective date--(1) In general. Except as provided in paragraph 
(g)(2) of this section, this section applies to leases entered into on 
or after April 20, 1995.
    (2) Special rules. Paragraphs (b)(1)(ii) and (c) of this section 
apply to leases entered into after April 26, 1996.

[T.D. 8667, 61 FR 18677, Apr. 29, 1996]



Sec.  1.168(i)-3  Treatment of excess deferred income tax reserve 
upon disposition of deregulated public utility property.

    (a) Scope--(1) In general. This section provides rules for the 
application of section 203(e) of the Tax Reform Act of 1986, Public Law 
99-514 (100 Stat. 2146) to a taxpayer with respect to public utility 
property (within the meaning of section 168(i)(10)) that ceases, whether 
by disposition, deregulation, or otherwise, to be public utility 
property with respect to the taxpayer and that is not described in 
paragraph (a)(2) of this section (deregulated public utility property).
    (2) Exceptions. This section does not apply to the following 
property:
    (i) Property that ceases to be public utility property with respect 
to the taxpayer on account of an ordinary retirement within the meaning 
of Sec.  1.167(a)-11(d)(3)(ii).
    (ii) Property transferred by the taxpayer if after the transfer the 
property is public utility property of the transferee and the taxpayer's 
excess tax reserve with respect to the property (within the meaning of 
section 203(e) of the Tax Reform Act of 1986) is treated as an excess 
tax reserve of the transferee with respect to the property.
    (b) Amount of reduction. If public utility property of a taxpayer 
becomes deregulated public utility property to which this section 
applies, the reduction in the taxpayer's excess tax reserve permitted 
under section 203(e) of the Tax Reform Act of 1986 is equal to the 
amount by which the reserve could be reduced under that provision if all 
such property had remained public utility property of the taxpayer and 
the taxpayer had continued use of its normalization method of accounting 
with respect to such property.
    (c) Cross reference. See Sec.  1.46-6(k) for rules relating to the 
treatment of accumulated deferred investment tax credits when utilities 
dispose of regulated public utility property.
    (d) Effective/applicability dates--(1) In general. Except as 
provided in paragraph (d)(2) of this section, this section applies to 
public utility property that becomes deregulated public utility property 
after December 21, 2005.
    (2) Property that becomes public utility property of the transferee. 
This section does not apply to property that becomes deregulated public 
utility property with respect to a taxpayer on account of a transfer on 
or before March 20, 2008 if after the transfer the property is public 
utility property of the transferee.
    (3) Application of regulation project (REG-104385-01). A reduction 
in the taxpayer's excess deferred income tax reserve will be treated as 
ratable if it is consistent with the proposed rules in regulation 
project (REG-104385-01) (68 FR 10190) March 4, 2003, and occurs during 
the period beginning on March 5, 2003, and ending on the earlier of--
    (i) The last date on which the utility's rates are determined under 
the rate order in effect on December 21, 2005; or
    (ii) December 21, 2007.

[T.D. 9387, 73 FR 14937, Mar. 20, 2008]



Sec.  1.168(i)-4  Changes in use.

    (a) Scope. This section provides the rules for determining the 
depreciation allowance for MACRS property (as defined in Sec.  1.168(b)-
1T(a)(2)) for which the use changes in the hands of the same taxpayer 
(change in the use). The allowance for depreciation under this section 
constitutes the amount of depreciation allowable under section 167(a) 
for the year of change and any subsequent taxable year. For purposes of 
this section, the year of change is the taxable year in which a change 
in the use occurs.

[[Page 523]]

    (b) Conversion to business or income-producing use--(1) Depreciation 
deduction allowable. This paragraph (b) applies to property that is 
converted from personal use to use in a taxpayer's trade or business, or 
for the production of income, during a taxable year. This conversion 
includes property that was previously used by the taxpayer for personal 
purposes, including real property (other than land) that is acquired 
before 1987 and converted from personal use to business or income-
producing use after 1986, and depreciable property that was previously 
used by a tax-exempt entity before the entity changed to a taxable 
entity. Except as otherwise provided by the Internal Revenue Code or 
regulations under the Internal Revenue Code, upon a conversion to 
business or income-producing use, the depreciation allowance for the 
year of change and any subsequent taxable year is determined as though 
the property is placed in service by the taxpayer on the date on which 
the conversion occurs. Thus, except as otherwise provided by the 
Internal Revenue Code or regulations under the Internal Revenue Code, 
the taxpayer must use any applicable depreciation method, recovery 
period, and convention prescribed under section 168 for the property in 
the year of change, consistent with any election made under section 168 
by the taxpayer for that year (see, for example, section 168(b)(5)). See 
Sec. Sec.  1.168(k)-1T(f)(6)(iii) and 1.1400L(b)-1T(f)(6) for the 
additional first year depreciation deduction rules applicable to a 
conversion to business or income-producing use. The depreciable basis of 
the property for the year of change is the lesser of its fair market 
value or its adjusted depreciable basis (as defined in Sec.  1.168(b)-
1T(a)(4)), as applicable, at the time of the conversion to business or 
income-producing use.
    (2) Example. The application of this paragraph (b) is illustrated by 
the following example:

    Example. A, a calendar-year taxpayer, purchases a house in 1985 that 
she occupies as her principal residence. In February 2004, A ceases to 
occupy the house and converts it to residential rental property. At the 
time of the conversion to residential rental property, the house's fair 
market value (excluding land) is $130,000 and adjusted depreciable basis 
attributable to the house (excluding land) is $150,000. Pursuant to this 
paragraph (b), A is considered to have placed in service residential 
rental property in February 2004 with a depreciable basis of $130,000. A 
depreciates the residential rental property under the general 
depreciation system by using the straight-line method, a 27.5-year 
recovery period, and the mid-month convention. Pursuant to Sec. Sec.  
1.168(k)-1T(f)(6)(iii)(B) or 1.1400L(b)-1T(f)(6), this property is not 
eligible for the additional first year depreciation deduction provided 
by section 168(k) or section 1400L(b). Thus, the depreciation allowance 
for the house for 2004 is $4,137, after taking into account the mid-
month convention (($130,000 adjusted depreciable basis multiplied by the 
applicable depreciation rate of 3.636% (1/27.5)) multiplied by the mid-
month convention fraction of 10.5/12). The amount of depreciation 
computed under section 168, however, may be limited under other 
provisions of the Internal Revenue Code, such as, section 280A.

    (c) Conversion to personal use. The conversion of MACRS property 
from business or income-producing use to personal use during a taxable 
year is treated as a disposition of the property in that taxable year. 
The depreciation allowance for MACRS property for the year of change in 
which the property is treated as being disposed of is determined by 
first multiplying the adjusted depreciable basis of the property as of 
the first day of the year of change by the applicable depreciation rate 
for that taxable year (for further guidance, for example, see section 6 
of Rev. Proc. 87-57 (1987-2 C. B. 687, 692) (see Sec.  
601.601(d)(2)(ii)(b) of this chapter)). This amount is then multiplied 
by a fraction, the numerator of which is the number of months (including 
fractions of months) the property is deemed to be placed in service 
during the year of change (taking into account the applicable 
convention) and the denominator of which is 12. No depreciation 
deduction is allowable for MACRS property placed in service and disposed 
of in the same taxable year. See Sec. Sec.  1.168(k)-1T(f)(6)(ii) and 
1.1400L(b)-1T(f)(6) for the additional first year depreciation deduction 
rules applicable to property placed in service and converted to personal 
use in the same taxable year. Upon the conversion to personal use, no 
gain, loss, or depreciation recapture

[[Page 524]]

under section 1245 or section 1250 is recognized. However, the 
provisions of section 1245 or section 1250 apply to any disposition of 
the converted property by the taxpayer at a later date. For listed 
property (as defined in section 280F(d)(4)), see section 280F(b)(2) for 
the recapture of excess depreciation upon the conversion to personal 
use.
    (d) Change in the use results in a different recovery period and/or 
depreciation method--(1) In general. This paragraph (d) applies to a 
change in the use of MACRS property during a taxable year subsequent to 
the placed-in-service year, if the property continues to be MACRS 
property owned by the same taxpayer and, as a result of the change in 
the use, has a different recovery period, a different depreciation 
method, or both. For example, this paragraph (d) applies to MACRS 
property that--
    (i) Begins or ceases to be used predominantly outside the United 
States;
    (ii) Results in a reclassification of the property under section 
168(e) due to a change in the use of the property; or
    (iii) Begins or ceases to be tax-exempt use property (as defined in 
section 168(h)).
    (2) Determination of change in the use--(i) In general. Except as 
provided in paragraph (d)(2)(ii) of this section, a change in the use of 
MACRS property occurs when the primary use of the MACRS property in the 
taxable year is different from its primary use in the immediately 
preceding taxable year. The primary use of MACRS property may be 
determined in any reasonable manner that is consistently applied to the 
taxpayer's MACRS property.
    (ii) Alternative depreciation system property--(A) Property used 
within or outside the United States. A change in the use of MACRS 
property occurs when a taxpayer begins or ceases to use MACRS property 
predominantly outside the United States during the taxable year. The 
determination of whether MACRS property is used predominantly outside 
the United States is made in accordance with the test in Sec.  1.48-
1(g)(1)(i) for determining predominant use.
    (B) Tax-exempt bond financed property. A change in the use of MACRS 
property occurs when the property changes to tax-exempt bond financed 
property, as described in section 168(g)(1)(C) and (g)(5), during the 
taxable year. For purposes of this paragraph (d), MACRS property changes 
to tax-exempt bond financed property when a tax-exempt bond is first 
issued after the MACRS property is placed in service. MACRS property 
continues to be tax-exempt bond financed property in the hands of the 
taxpayer even if the tax-exempt bond (including any refunding issue) is 
no longer outstanding or is redeemed.
    (C) Other mandatory alternative depreciation system property. A 
change in the use of MACRS property occurs when the property changes to, 
or changes from, property described in section 168(g)(1)(B) (tax-exempt 
use property) or (D) (imported property covered by an Executive order) 
during the taxable year.
    (iii) Change in the use deemed to occur on first day of the year of 
change. If a change in the use of MACRS property occurs under this 
paragraph (d)(2), the depreciation allowance for that MACRS property for 
the year of change is determined as though the use of the MACRS property 
changed on the first day of the year of change.
    (3) Change in the use results in a shorter recovery period and/or a 
more accelerated depreciation method--(i) Treated as placed in service 
in the year of change--(A) In general. If a change in the use results in 
the MACRS property changing to a shorter recovery period and/or a 
depreciation method that is more accelerated than the method used for 
the MACRS property before the change in the use, the depreciation 
allowances beginning in the year of change are determined as though the 
MACRS property is placed in service by the taxpayer in the year of 
change.
    (B) Computation of depreciation allowance. The depreciation 
allowances for the MACRS property for any 12-month taxable year 
beginning with the year of change are determined by multiplying the 
adjusted depreciable basis of the MACRS property as of the first day of 
each taxable year by the applicable depreciation rate for each taxable 
year. In determining the applicable depreciation rate for the year of 
change and subsequent taxable years, the taxpayer must use any 
applicable depreciation method and recovery period prescribed

[[Page 525]]

under section 168 for the MACRS property in the year of change, 
consistent with any election made under section 168 by the taxpayer for 
that year (see, for example, section 168(b)(5)). If there is a change in 
the use of MACRS property, the applicable convention that applies to the 
MACRS property is the same as the convention that applied before the 
change in the use of the MACRS property. However, the depreciation 
allowance for the year of change for the MACRS property is determined 
without applying the applicable convention, unless the MACRS property is 
disposed of during the year of change. See paragraph (d)(5) of this 
section for the rules relating to the computation of the depreciation 
allowance under the optional depreciation tables. If the year of change 
or any subsequent taxable year is less than 12 months, the depreciation 
allowance determined under this paragraph (d)(3)(i) must be adjusted for 
a short taxable year (for further guidance, for example, see Rev. Proc. 
89-15 (1989-1 C.B. 816) (see Sec.  601.601(d)(2)(ii)(b) of this 
chapter)).
    (C) Special rules. MACRS property affected by this paragraph 
(d)(3)(i) is not eligible in the year of change for the election 
provided under section 168(f)(1), 179, or 1400L(f), or for the 
additional first year depreciation deduction provided in section 168(k) 
or 1400L(b). See Sec. Sec.  1.168(k)-1T(f)(6)(iv) and 1.1400L(b)-
1T(f)(6) for other additional first year depreciation deduction rules 
applicable to a change in the use of MACRS property subsequent to its 
placed-in-service year. For purposes of determining whether the mid-
quarter convention applies to other MACRS property placed in service 
during the year of change, the unadjusted depreciable basis (as defined 
in Sec.  1.168(b)-1T(a)(3)) or the adjusted depreciable basis of MACRS 
property affected by this paragraph (d)(3)(i) is not taken into account.
    (ii) Option to disregard the change in the use. In lieu of applying 
paragraph (d)(3)(i) of this section, the taxpayer may elect to determine 
the depreciation allowance as though the change in the use had not 
occurred. The taxpayer elects this option by claiming on the taxpayer's 
timely filed (including extensions) Federal income tax return for the 
year of change the depreciation allowance for the property as though the 
change in the use had not occurred. See paragraph (g)(2) of this section 
for the manner for revoking this election.
    (4) Change in the use results in a longer recovery period and/or a 
slower depreciation method--(i) Treated as originally placed in service 
with longer recovery period and/or slower depreciation method. If a 
change in the use results in a longer recovery period and/or a 
depreciation method for the MACRS property that is less accelerated than 
the method used for the MACRS property before the change in the use, the 
depreciation allowances beginning with the year of change are determined 
as though the MACRS property had been originally placed in service by 
the taxpayer with the longer recovery period and/or the slower 
depreciation method. MACRS property affected by this paragraph (d)(4) is 
not eligible in the year of change for the election provided under 
section 168(f)(1), 179, or 1400L(f), or for the additional first year 
depreciation deduction provided in section 168(k) or 1400L(b). See 
Sec. Sec.  1.168(k)-1T(f)(6)(iv) and 1.1400L(b)-1T(f)(6) for other 
additional first year depreciation deduction rules applicable to a 
change in the use of MACRS property subsequent to its placed-in-service 
year.
    (ii) Computation of the depreciation allowance. The depreciation 
allowances for the MACRS property for any 12-month taxable year 
beginning with the year of change are determined by multiplying the 
adjusted depreciable basis of the MACRS property as of the first day of 
each taxable year by the applicable depreciation rate for each taxable 
year. If there is a change in the use of MACRS property, the applicable 
convention that applies to the MACRS property is the same as the 
convention that applied before the change in the use of the MACRS 
property. If the year of change or any subsequent taxable year is less 
than 12 months, the depreciation allowance determined under this 
paragraph (d)(4)(ii) must be adjusted for a short taxable year (for 
further guidance, for example, see Rev. Proc. 89-15 (1989-1 C.B. 816) 
(see Sec.  601.601(d)(2)(ii)(b) of this chapter)). See paragraph (d)(5) 
of this section for the

[[Page 526]]

rules relating to the computation of the depreciation allowance under 
the optional depreciation tables. In determining the applicable 
depreciation rate for the year of change and any subsequent taxable 
year--
    (A) The applicable depreciation method is the depreciation method 
that would apply in the year of change and any subsequent taxable year 
for the MACRS property had the taxpayer used the longer recovery period 
and/or the slower depreciation method in the placed-in-service year of 
the property. If the 200-or 150-percent declining balance method would 
have applied in the placed-in-service year but the method would have 
switched to the straight line method in the year of change or any prior 
taxable year, the applicable depreciation method beginning with the year 
of change is the straight line method; and
    (B) The applicable recovery period is either--
    (1) The longer recovery period resulting from the change in the use 
if the applicable depreciation method is the 200-or 150-percent 
declining balance method (as determined under paragraph (d)(4)(ii)(A) of 
this section) unless the recovery period did not change as a result of 
the change in the use, in which case the applicable recovery period is 
the same recovery period that applied before the change in the use; or
    (2) The number of years remaining as of the beginning of each 
taxable year (taking into account the applicable convention) had the 
taxpayer used the longer recovery period in the placed-in-service year 
of the property if the applicable depreciation method is the straight 
line method (as determined under paragraph (d)(4)(ii)(A) of this 
section) unless the recovery period did not change as a result of the 
change in the use, in which case the applicable recovery period is the 
number of years remaining as of the beginning of each taxable year 
(taking into account the applicable convention) based on the recovery 
period that applied before the change in the use.
    (5) Using optional depreciation tables--(i) Taxpayer not bound by 
prior use of table. If a taxpayer used an optional depreciation table 
for the MACRS property before a change in the use, the taxpayer is not 
bound to use the appropriate new table for that MACRS property beginning 
in the year of change (for further guidance, for example, see section 8 
of Rev. Proc. 87-57 (1987-2 C.B. 687, 693) (see Sec.  
601.601(d)(2)(ii)(b) of this chapter)). If a taxpayer did not use an 
optional depreciation table for MACRS property before a change in the 
use and the change in the use results in a shorter recovery period and/
or a more accelerated depreciation method (as described in paragraph 
(d)(3)(i) of this section), the taxpayer may use the appropriate new 
table for that MACRS property beginning in the year of change. If a 
taxpayer chooses not to use the optional depreciation table, the 
depreciation allowances for the MACRS property beginning in the year of 
change are determined under paragraph (d)(3)(i) or (4) of this section, 
as applicable.
    (ii) Taxpayer chooses to use optional depreciation table after a 
change in the use. If a taxpayer chooses to use an optional depreciation 
table for the MACRS property after a change in the use, the depreciation 
allowances for the MACRS property for any 12-month taxable year 
beginning with the year of change are determined as follows:
    (A) Change in the use results in a shorter recovery period and/or a 
more accelerated depreciation method. If a change in the use results in 
a shorter recovery period and/or a more accelerated depreciation method 
(as described in paragraph (d)(3)(i) of this section), the depreciation 
allowances for the MACRS property for any 12-month taxable year 
beginning with the year of change are determined by multiplying the 
adjusted depreciable basis of the MACRS property as of the first day of 
the year of change by the annual depreciation rate for each recovery 
year (expressed as a decimal equivalent) specified in the appropriate 
optional depreciation table. The appropriate optional depreciation table 
for the MACRS property is based on the depreciation system, depreciation 
method, recovery period, and convention applicable to the MACRS property 
in the year of change as determined under paragraph (d)(3)(i) of this 
section. The depreciation allowance for the year of change for the

[[Page 527]]

MACRS property is determined by taking into account the applicable 
convention (which is already factored into the optional depreciation 
tables). If the year of change or any subsequent taxable year is less 
than 12 months, the depreciation allowance determined under this 
paragraph (d)(5)(ii)(A) must be adjusted for a short taxable year (for 
further guidance, for example, see Rev. Proc. 89-15 (1989-1 C.B. 816) 
(see Sec.  601.601(d)(2)(ii)(b) of this chapter)).
    (B) Change in the use results in a longer recovery period and/or a 
slower depreciation method--(1) Determination of the appropriate 
optional depreciation table. If a change in the use results in a longer 
recovery period and/or a slower depreciation method (as described in 
paragraph (d)(4)(i) of this section), the depreciation allowances for 
the MACRS property for any 12-month taxable year beginning with the year 
of change are determined by choosing the optional depreciation table 
that corresponds to the depreciation system, depreciation method, 
recovery period, and convention that would have applied to the MACRS 
property in the placed-in-service year had that property been originally 
placed in service by the taxpayer with the longer recovery period and/or 
the slower depreciation method. If there is a change in the use of MACRS 
property, the applicable convention that applies to the MACRS property 
is the same as the convention that applied before the change in the use 
of the MACRS property. If the year of change or any subsequent taxable 
year is less than 12 months, the depreciation allowance determined under 
this paragraph (d)(5)(ii)(B) must be adjusted for a short taxable year 
(for further guidance, for example, see Rev. Proc. 89-15 (1989-1 C.B. 
816) (see Sec.  601.601(d)(2)(ii)(b) of this chapter)).
    (2) Computation of the depreciation allowance. The depreciation 
allowances for the MACRS property for any 12-month taxable year 
beginning with the year of change are computed by first determining the 
appropriate recovery year in the table identified under paragraph 
(d)(5)(ii)(B)(1) of this section. The appropriate recovery year for the 
year of change is the year that corresponds to the year of change. For 
example, if the recovery year for the year of change would have been 
Year 4 in the table that applied before the change in the use of the 
MACRS property, then the recovery year for the year of change is Year 4 
in the table identified under paragraph (d)(5)(ii)(B)(1) of this 
section. Next, the annual depreciation rate (expressed as a decimal 
equivalent) for each recovery year is multiplied by a transaction 
coefficient. The transaction coefficient is the formula (1 / (1-x)) 
where x equals the sum of the annual depreciation rates from the table 
identified under paragraph (d)(5)(ii)(B)(1) of this section (expressed 
as a decimal equivalent) for the taxable years beginning with the 
placed-in-service year of the MACRS property through the taxable year 
immediately prior to the year of change. The product of the annual 
depreciation rate and the transaction coefficient is multiplied by the 
adjusted depreciable basis of the MACRS property as of the beginning of 
the year of change.
    (6) Examples. The application of this paragraph (d) is illustrated 
by the following examples:

    Example 1. Change in the use results in a shorter recovery period 
and/or a more accelerated depreciation method and optional depreciation 
table is not used. (i) X, a calendar-year corporation, places in service 
in 1999 equipment at a cost of $100,000 and uses this equipment from 
1999 through 2003 primarily in its A business. X depreciates the 
equipment for 1999 through 2003 under the general depreciation system as 
7-year property by using the 200-percent declining balance method (which 
switched to the straight-line method in 2003), a 7-year recovery period, 
and a half-year convention. Beginning in 2004, X primarily uses the 
equipment in its B business. As a result, the classification of the 
equipment under section 168(e) changes from 7-year property to 5-year 
property and the recovery period of the equipment under the general 
depreciation system changes from 7 years to 5 years. The depreciation 
method does not change. On January 1, 2004, the adjusted depreciable 
basis of the equipment is $22,311. X depreciates its 5-year recovery 
property placed in service in 2004 under the general depreciation system 
by using the 200-percent declining balance method and a 5-year recovery 
period. X does not use the optional depreciation tables.
    (ii) Under paragraph (d)(3)(i) of this section, X's allowable 
depreciation deduction for the equipment for 2004 and subsequent taxable 
years is determined as though X placed the equipment in service in 2004 
for

[[Page 528]]

use primarily in its B business. The depreciable basis of the equipment 
as of January 1, 2004, is $22,311 (the adjusted depreciable basis at 
January 1, 2004). Because X does not use the optional depreciation 
tables, the depreciation allowance for 2004 (the deemed placed-in-
service year) for this equipment only is computed without taking into 
account the half-year convention. Pursuant to paragraph (d)(3)(i)(C) of 
this section, this equipment is not eligible for the additional first 
year depreciation deduction provided by section 168(k) or section 
1400L(b). Thus, X's allowable depreciation deduction for the equipment 
for 2004 is $8,924 ($22,311 adjusted depreciable basis at January 1, 
2004, multiplied by the applicable depreciation rate of 40% (200/5)). 
X's allowable depreciation deduction for the equipment for 2005 is 
$5,355 ($13,387 adjusted depreciable basis at January 1, 2005, 
multiplied by the applicable depreciation rate of 40% (200/5)).
    (iii) Alternatively, under paragraph (d)(3)(ii) of this section, X 
may elect to disregard the change in the use and, as a result, may 
continue to treat the equipment as though it is used primarily in its A 
business. If the election is made, X's allowable depreciation deduction 
for the equipment for 2004 is $8,924 ($22,311 adjusted depreciable basis 
at January 1, 2004, multiplied by the applicable depreciation rate of 
40% (1/2.5 years remaining at January 1, 2004)). X's allowable 
depreciation deduction for the equipment for 2005 is $8,925 ($13,387 
adjusted depreciable basis at January 1, 2005, multiplied by the 
applicable depreciation rate of 66.67% (1/1.5 years remaining at January 
1, 2005)).
    Example 2. Change in the use results in a shorter recovery period 
and/or a more accelerated depreciation method and optional depreciation 
table is used. (i) Same facts as in Example 1, except that X used the 
optional depreciation tables for computing depreciation for 1999 through 
2003. Pursuant to paragraph (d)(5) of this section, X chooses to 
continue to use the optional depreciation table for the equipment. X 
does not make the election provided in paragraph (d)(3)(ii) of this 
section to disregard the change in use.
    (ii) In accordance with paragraph (d)(5)(ii)(A) of this section, X 
must first identify the appropriate optional depreciation table for the 
equipment. This table is table 1 in Rev. Proc. 87-57 because the 
equipment will be depreciated in the year of change (2004) under the 
general depreciation system using the 200-percent declining balance 
method, a 5-year recovery period, and the half-year convention (which is 
the convention that applied to the equipment in 1999). Pursuant to 
paragraph (d)(3)(i)(C) of this section, this equipment is not eligible 
for the additional first year depreciation deduction provided by section 
168(k) or section 1400L(b). For 2004, X multiplies its adjusted 
depreciable basis in the equipment as of January 1, 2004, of $22,311, by 
the annual depreciation rate in table 1 for recovery year 1 for a 5-year 
recovery period (.20), to determine the depreciation allowance of 
$4,462. For 2005, X multiplies its adjusted depreciable basis in the 
equipment as of January 1, 2004, of $22,311, by the annual depreciation 
rate in table 1 for recovery year 2 for a 5-year recovery period (.32), 
to determine the depreciation allowance of $7,140.
    Example 3. Change in the use results in a longer recovery period 
and/or a slower depreciation method. (i) Y, a calendar-year corporation, 
places in service in January 2002, equipment at a cost of $100,000 and 
uses this equipment in 2002 and 2003 only within the United States. Y 
elects not to deduct the additional first year depreciation under 
section 168(k). Y depreciates the equipment for 2002 and 2003 under the 
general depreciation system by using the 200-percent declining balance 
method, a 5-year recovery period, and a half-year convention. Beginning 
in 2004, Y uses the equipment predominantly outside the United States. 
As a result of this change in the use, the equipment is subject to the 
alternative depreciation system beginning in 2004. Under the alternative 
depreciation system, the equipment is depreciated by using the straight 
line method and a 9-year recovery period. The adjusted depreciable basis 
of the equipment at January 1, 2004, is $48,000.
    (ii) Pursuant to paragraph (d)(4) of this section, Y's allowable 
depreciation deduction for 2004 and subsequent taxable years is 
determined as though the equipment had been placed in service in January 
2002, as property used predominantly outside the United States. Further, 
pursuant to paragraph (d)(4)(i) of this section, the equipment is not 
eligible in 2004 for the additional first year depreciation deduction 
provided by section 168(k) or section 1400L(b). In determining the 
applicable depreciation rate for 2004, the applicable depreciation 
method is the straight line method and the applicable recovery period is 
7.5 years, which is the number of years remaining at January 1, 2004, 
for property placed in service in 2002 with a 9-year recovery period 
(taking into account the half-year convention). Thus, the depreciation 
allowance for 2004 is $6,398 ($48,000 adjusted depreciable basis at 
January 1, 2004, multiplied by the applicable depreciation rate of 
13.33% (1/7.5 years)). The depreciation allowance for 2005 is $6,398 
($41,602 adjusted depreciable basis at January 1, 2005, multiplied by 
the applicable depreciation rate of 15.38% (1/6.5 years remaining at 
January 1, 2005)).
    Example 4. Change in the use results in a longer recovery period 
and/or a slower depreciation method and optional depreciation table is 
used. (i) Same facts as in Example 3, except that Y used the optional 
depreciation tables for computing depreciation in 2002 and 2003. 
Pursuant to paragraph (d)(5) of this section,

[[Page 529]]

Y chooses to continue to use the optional depreciation table for the 
equipment. Further, pursuant to paragraph (d)(4)(i) of this section, the 
equipment is not eligible in 2004 for the additional first year 
depreciation deduction provided by section 168(k) or section 1400L(b).
    (ii) In accordance with paragraph (d)(5)(ii)(B) of this section, Y 
must first determine the appropriate optional depreciation table for the 
equipment pursuant to paragraph (d)(5)(ii)(B)(1) of this section. This 
table is table 8 in Rev. Proc. 87-57, which corresponds to the 
alternative depreciation system, the straight line method, a 9-year 
recovery period, and the half-year convention (because Y depreciated 5-
year property in 2002 using a half-year convention). Next, Y must 
determine the appropriate recovery year in table 8. Because the year of 
change is 2004, the depreciation allowance for the equipment for 2004 is 
determined using recovery year 3 of table 8. For 2004, Y multiplies its 
adjusted depreciable basis in the equipment as of January 1, 2004, of 
$48,000, by the product of the annual depreciation rate in table 8 for 
recovery year 3 for a 9-year recovery period (.1111) and the transaction 
coefficient of 1.200 [1/(1-(.0556 (table 8 for recovery year 1 for a 9-
year recovery period) + .1111 (table 8 for recovery year 2 for a 9-year 
recovery period)))], to determine the depreciation allowance of $6,399. 
For 2005, Y multiplies its adjusted depreciable basis in the equipment 
as of January 1, 2004, of $48,000, by the product of the annual 
depreciation rate in table 8 for recovery year 4 for a 9-year recovery 
period (.1111) and the transaction coefficient (1.200), to determine the 
depreciation allowance of $6,399.

    (e) Change in the use of MACRS property during the placed-in-service 
year--(1) In general. Except as provided in paragraph (e)(2) of this 
section, if a change in the use of MACRS property occurs during the 
placed-in-service year and the property continues to be MACRS property 
owned by the same taxpayer, the depreciation allowance for that property 
for the placed-in-service year is determined by its primary use during 
that year. The primary use of MACRS property may be determined in any 
reasonable manner that is consistently applied to the taxpayer's MACRS 
property. For purposes of this paragraph (e), the determination of 
whether the mid-quarter convention applies to any MACRS property placed 
in service during the year of change is made in accordance with Sec.  
1.168(d)-1.
    (2) Alternative depreciation system property--(i) Property used 
within and outside the United States. The depreciation allowance for the 
placed-in-service year for MACRS property that is used within and 
outside the United States is determined by its predominant use during 
that year. The determination of whether MACRS property is used 
predominantly outside the United States during the placed-in-service 
year shall be made in accordance with the test in Sec.  1.48-1(g)(1)(i) 
for determining predominant use.
    (ii) Tax-exempt bond financed property. The depreciation allowance 
for the placed-in-service year for MACRS property that changes to tax-
exempt bond financed property, as described in section 168(g)(1)(C) and 
(g)(5), during that taxable year is determined under the alternative 
depreciation system. For purposes of this paragraph (e), MACRS property 
changes to tax-exempt bond financed property when a tax-exempt bond is 
first issued after the MACRS property is placed in service. MACRS 
property continues to be tax-exempt bond financed property in the hands 
of the taxpayer even if the tax-exempt bond (including any refunding 
issue) is not outstanding at, or is redeemed by, the end of the placed-
in-service year.
    (iii) Other mandatory alternative depreciation system property. The 
depreciation allowance for the placed-in-service year for MACRS property 
that changes to, or changes from, property described in section 
168(g)(1)(B) (tax-exempt use property) or (D) (imported property covered 
by an Executive order) during that taxable year is determined under--
    (A) The alternative depreciation system if the MACRS property is 
described in section 168(g)(1)(B) or (D) at the end of the placed-in-
service year; or
    (B) The general depreciation system if the MACRS property is not 
described in section 168(g)(1)(B) or (D) at the end of the placed-in-
service year, unless other provisions of the Internal Revenue Code or 
regulations under the Internal Revenue Code require the depreciation 
allowance for that MACRS property to be determined under the alternative 
depreciation system (for example, section 168(g)(7)).

[[Page 530]]

    (3) Examples. The application of this paragraph (e) is illustrated 
by the following examples:

    Example 1. (i) Z, a utility and calendar-year corporation, acquires 
and places in service on January 1, 2004, equipment at a cost of 
$100,000. Z uses this equipment in its combustion turbine production 
plant for 4 months and then uses the equipment in its steam production 
plant for the remainder of 2004. Z's combustion turbine production plant 
assets are classified as 15-year property and are depreciated by Z under 
the general depreciation system using a 15-year recovery period and the 
150-percent declining balance method of depreciation. Z's steam 
production plant assets are classified as 20-year property and are 
depreciated by Z under the general depreciation system using a 20-year 
recovery period and the 150-percent declining balance method of 
depreciation. Z uses the optional depreciation tables. The equipment is 
50-percent bonus depreciation property for purposes of section 168(k).
    (ii) Pursuant to this paragraph (e), Z must determine depreciation 
based on the primary use of the equipment during the placed-in-service 
year. Z has consistently determined the primary use of all of its MACRS 
properties by comparing the number of full months in the taxable year 
during which a MACRS property is used in one manner with the number of 
full months in that taxable year during which that MACRS property is 
used in another manner. Applying this approach, Z determines the 
depreciation allowance for the equipment for 2004 is based on the 
equipment being classified as 20-year property because the equipment was 
used by Z in its steam production plant for 8 months in 2004. If the 
half-year convention applies in 2004, the appropriate optional 
depreciation table is table 1 in Rev. Proc. 87-57, which is the table 
for MACRS property subject to the general depreciation system, the 150-
percent declining balance method, a 20-year recovery period, and the 
half-year convention. Thus, the depreciation allowance for the equipment 
for 2004 is $51,875, which is the total of $50,000 for the 50-percent 
additional first year depreciation deduction allowable (the unadjusted 
depreciable basis of $100,000 multiplied by .50), plus $1,875 for the 
2004 depreciation allowance on the remaining adjusted depreciable basis 
of $50,000 [(the unadjusted depreciable basis of $100,000 less the 
additional first year depreciation deduction of $50,000) multiplied by 
the annual depreciation rate of .0375 in table 1 for recovery year 1 for 
a 20-year recovery period].
    Example 2. T , a calendar year corporation, places in service on 
January 1, 2004, several computers at a total cost of $100,000. T uses 
these computers within the United States for 3 months in 2004 and then 
moves and uses the computers outside the United States for the remainder 
of 2004. Pursuant to Sec.  1.48-1(g)(1)(i), the computers are considered 
as used predominantly outside the United States in 2004. As a result, 
for 2004, the computers are required to be depreciated under the 
alternative depreciation system of section 168(g) with a recovery period 
of 5 years pursuant to section 168(g)(3)(C). T uses the optional 
depreciation tables. If the half-year convention applies in 2004, the 
appropriate optional depreciation table is table 8 in Rev. Proc. 87-57, 
which is the table for MACRS property subject to the alternative 
depreciation system, the straight line method, a 5-year recovery period, 
and the half-year convention. Thus, the depreciation allowance for the 
computers for 2004 is $10,000, which is equal to the unadjusted 
depreciable basis of $100,000 multiplied by the annual depreciation rate 
of .10 in table 8 for recovery year 1 for a 5-year recovery period. 
Because the computers are required to be depreciated under the 
alternative depreciation system in their placed-in-service year, 
pursuant to section 168(k)(2)(C)(i) and Sec.  1.168(k)-1T(b)(2)(ii), the 
computers are not eligible for the additional first year depreciation 
deduction provided by section 168(k).

    (f) No change in accounting method. A change in computing the 
depreciation allowance in the year of change for property subject to 
this section is not a change in method of accounting under section 
446(e). See Sec.  1.446-1(e)(2)(ii)(d)(3)(ii).
    (g) Effective dates--(1) In general. This section applies to any 
change in the use of MACRS property in a taxable year ending on or after 
June 17, 2004. For any change in the use of MACRS property after 
December 31, 1986, in a taxable year ending before June 17, 2004, the 
Internal Revenue Service will allow any reasonable method of 
depreciating the property under section 168 in the year of change and 
the subsequent taxable years that is consistently applied to any 
property for which the use changes in the hands of the same taxpayer or 
the taxpayer may choose, on a property-by-property basis, to apply the 
provisions of this section.
    (2) Change in method of accounting--(i) In general. If a taxpayer 
adopted a method of accounting for depreciation due to a change in the 
use of MACRS property in a taxable year ending on or after December 30, 
2003, and the method adopted is not in accordance with the method of 
accounting for depreciation provided in this section, a change

[[Page 531]]

to the method of accounting for depreciation provided in this section is 
a change in the method of accounting to which the provisions of sections 
446(e) and 481 and the regulations under sections 446(e) and 481 apply. 
Also, a revocation of the election provided in paragraph (d)(3)(ii) of 
this section to disregard a change in the use is a change in method of 
accounting to which the provisions of sections 446(e) and 481 and the 
regulations under sections 446(e) and 481 apply. However, if a taxpayer 
adopted a method of accounting for depreciation due to a change in the 
use of MACRS property after December 31, 1986, in a taxable year ending 
before December 30, 2003, and the method adopted is not in accordance 
with the method of accounting for depreciation provided in this section, 
the taxpayer may treat the change to the method of accounting for 
depreciation provided in this section as a change in method of 
accounting to which the provisions of sections 446(e) and 481 and the 
regulations under sections 446(e) and 481 apply.
    (ii) Automatic consent to change method of accounting. A taxpayer 
changing its method of accounting in accordance with this paragraph 
(g)(2) must follow the applicable administrative procedures issued under 
Sec.  1.446-1(e)(3)(ii) for obtaining the Commissioner's automatic 
consent to a change in method of accounting (for further guidance, for 
example, see Rev. Proc. 2002-9 (2002-1 C.B. 327), (see Sec.  
601.601(d)(2)(ii)(b) of this chapter)). Any change in method of 
accounting made under this paragraph (g)(2) must be made using an 
adjustment under section 481(a). For purposes of Form 3115, Application 
for Change in Accounting Method, the designated number for the automatic 
accounting method change authorized by this paragraph (g)(2) is ``88.'' 
If Form 3115 is revised or renumbered, any reference in this section to 
that form is treated as a reference to the revised or renumbered form.

[T.D. 9132, 69 FR 33843, June 17, 2004, as amended by T.D. 9307, 71 FR 
78068, Dec. 28, 2006]



Sec.  1.168(i)-5  Table of contents.

    This section lists the major paragraphs contained in Sec.  1.168(i)-
6.

    Sec.  1.168(i)-6 Like-kind exchanges and involuntary conversions.

    (a) Scope.
    (b) Definitions.
    (1) Replacement MACRS property.
    (2) Relinquished MACRS property.
    (3) Time of disposition.
    (4) Time of replacement.
    (5) Year of disposition.
    (6) Year of replacement.
    (7) Exchanged basis.
    (8) Excess basis.
    (9) Depreciable exchanged basis.
    (10) Depreciable excess basis.
    (11) Like-kind exchange.
    (12) Involuntary conversion.
    (c) Determination of depreciation allowance.
    (1) Computation of the depreciation allowance for depreciable 
exchanged basis beginning in the year of replacement.
    (i) In general.
    (ii) Applicable recovery period, depreciation method, and 
convention.
    (2) Effect of depreciation treatment of the replacement MACRS 
property by previous owners of the acquired property.
    (3) Recovery period and/or depreciation method of the properties are 
the same, or both are not the same.
    (i) In general.
    (ii) Both the recovery period and the depreciation method are the 
same.
    (iii) Either the recovery period or the depreciation method is the 
same, or both are not the same.
    (4) Recovery period or depreciation method of the properties is not 
the same.
    (i) Longer recovery period.
    (ii) Shorter recovery period.
    (iii) Less accelerated depreciation method.
    (iv) More accelerated depreciation method.
    (v) Convention.
    (A) Either the relinquished MACRS property or the replacement MACRS 
property is mid-month property.
    (B) Neither the relinquished MACRS property nor the replacement 
MACRS property is mid-month property.
    (5) Year of disposition and year of replacement.
    (i) Relinquished MACRS property.
    (A) General rule.
    (B) Special rule.
    (ii) Replacement MACRS property.
    (A) Remaining recovery period of the replacement MACRS property.
    (B) Year of replacement is 12 months.
    (iii) Year of disposition or year of replacement is less than 12 
months.
    (iv) Deferred transactions.
    (A) In general.
    (B) Allowable depreciation for a qualified intermediary.
    (v) Remaining recovery period.
    (6) Examples.

[[Page 532]]

    (d) Special rules for determining depreciation allowances.
    (1) Excess basis.
    (i) In general.
    (ii) Example.
    (2) Depreciable and nondepreciable property.
    (3) Depreciation limitations for automobiles.
    (i) In general.
    (ii) Order in which limitations on depreciation under section 
280F(a) are applied.
    (iii) Examples.
    (4) Involuntary conversion for which the replacement MACRS property 
is acquired and placed in service before disposition of relinquished 
MACRS property.
    (e) Use of optional depreciation tables.
    (1) Taxpayer not bound by prior use of table.
    (2) Determination of the depreciation deduction.
    (i) Relinquished MACRS property.
    (ii) Replacement MACRS property.
    (A) Determination of the appropriate optional depreciation table.
    (B) Calculating the depreciation deduction for the replacement MACRS 
property.
    (iii) Unrecovered basis.
    (3) Excess basis.
    (4) Examples.
    (f) Mid-quarter convention.
    (1) Exchanged basis.
    (2) Excess basis.
    (3) Depreciable property acquired for nondepreciable property.
    (g) Section 179 election.
    (h) Additional first year depreciation deduction.
    (i) Elections.
    (1) Election not to apply this section.
    (2) Election to treat certain replacement property as MACRS 
property.
    (j) Time and manner of making election under paragraph (i)(1) of 
this section.
    (1) In general.
    (2) Time for making election.
    (3) Manner of making election.
    (4) Revocation.
    (k) Effective date.
    (1) In general.
    (2) Application to pre-effective date like-kind exchanges and 
involuntary conversions.
    (3) Like-kind exchanges and involuntary conversions where the 
taxpayer made the election under section 168(f)(1) for the relinquished 
property.

[T.D. 9314, 72 FR 9250, Mar. 1, 2007]



Sec.  1.168(i)-6  Like-kind exchanges and involuntary conversions.

    (a) Scope. This section provides the rules for determining the 
depreciation allowance for MACRS property acquired in a like-kind 
exchange or an involuntary conversion, including a like-kind exchange or 
an involuntary conversion of MACRS property that is exchanged or 
replaced with other MACRS property in a transaction between members of 
the same affiliated group. The allowance for depreciation under this 
section constitutes the amount of depreciation allowable under section 
167(a) for the year of replacement and any subsequent taxable year for 
the replacement MACRS property and for the year of disposition of the 
relinquished MACRS property. The provisions of this section apply only 
to MACRS property to which Sec.  1.168(h)-1 (like-kind exchanges of tax-
exempt use property) does not apply. Additionally, paragraphs (c) 
through (f) of this section apply only to MACRS property for which an 
election under paragraph (i) of this section has not been made.
    (b) Definitions. For purposes of this section, the following 
definitions apply:
    (1) Replacement MACRS property is MACRS property (as defined in 
Sec.  1.168(b)-1(a)(2)) in the hands of the acquiring taxpayer that is 
acquired for other MACRS property in a like-kind exchange or an 
involuntary conversion.
    (2) Relinquished MACRS property is MACRS property that is 
transferred by the taxpayer in a like-kind exchange, or in an 
involuntary conversion.
    (3) Time of disposition is when the disposition of the relinquished 
MACRS property takes place under the convention, as determined under 
Sec.  1.168(d)-1, that applies to the relinquished MACRS property.
    (4) Time of replacement is the later of--
    (i) When the replacement MACRS property is placed in service under 
the convention, as determined under this section, that applies to the 
replacement MACRS property; or
    (ii) The time of disposition of the exchanged or involuntarily 
converted property.
    (5) Year of disposition is the taxable year that includes the time 
of disposition.
    (6) Year of replacement is the taxable year that includes the time 
of replacement.
    (7) Exchanged basis is determined after the depreciation deductions 
for

[[Page 533]]

the year of disposition are determined under paragraph (c)(5)(i) of this 
section and is the lesser of--
    (i) The basis in the replacement MACRS property, as determined under 
section 1031(d) and the regulations under section 1031(d) or section 
1033(b) and the regulations under section 1033(b); or
    (ii) The adjusted depreciable basis (as defined in Sec.  1.168(b)-
1(a)(4)) of the relinquished MACRS property.
    (8) Excess basis is any excess of the basis in the replacement MACRS 
property, as determined under section 1031(d) and the regulations under 
section 1031(d) or section 1033(b) and the regulations under section 
1033(b), over the exchanged basis as determined under paragraph (b)(7) 
of this section.
    (9) Depreciable exchanged basis is the exchanged basis as determined 
under paragraph (b)(7) of this section reduced by--
    (i) The percentage of such basis attributable to the taxpayer's use 
of property for the taxable year other than in the taxpayer's trade or 
business (or for the production of income); and
    (ii) Any adjustments to basis provided by other provisions of the 
Internal Revenue Code (Code) and the regulations under the Code 
(including section 1016(a)(2) and (3), for example, depreciation 
deductions in the year of replacement allowable under section 168(k) or 
1400L(b)).
    (10) Depreciable excess basis is the excess basis as determined 
under paragraph (b)(8) of this section reduced by--
    (i) The percentage of such basis attributable to the taxpayer's use 
of property for the taxable year other than in the taxpayer's trade or 
business (or for the production of income);
    (ii) Any portion of the basis the taxpayer properly elects to treat 
as an expense under section 179; and
    (iii) Any adjustments to basis provided by other provisions of the 
Code and the regulations under the Code (including section 1016(a)(2) 
and (3), for example, depreciation deductions in the year of replacement 
allowable under section 168(k) or 1400L(b)).
    (11) Like-kind exchange is an exchange of property in a transaction 
to which section 1031(a)(1), (b), or (c) applies.
    (12) Involuntary conversion is a transaction described in section 
1033(a)(1) or (2) that resulted in the nonrecognition of any part of the 
gain realized as the result of the conversion.
    (c) Determination of depreciation allowance--(1) Computation of the 
depreciation allowance for depreciable exchanged basis beginning in the 
year of replacement--(i) In general. This paragraph (c) provides rules 
for determining the applicable recovery period, the applicable 
depreciation method, and the applicable convention used to determine the 
depreciation allowances for the depreciable exchanged basis beginning in 
the year of replacement. See paragraph (c)(5) of this section for rules 
relating to the computation of the depreciation allowance for the year 
of disposition and for the year of replacement. See paragraph (d)(1) of 
this section for rules relating to the computation of the depreciation 
allowance for depreciable excess basis. See paragraph (d)(4) of this 
section if the replacement MACRS property is acquired before disposition 
of the relinquished MACRS property in a transaction to which section 
1033 applies. See paragraph (e) of this section for rules relating to 
the computation of the depreciation allowance using the optional 
depreciation tables.
    (ii) Applicable recovery period, depreciation method, and 
convention. The recovery period, depreciation method, and convention 
determined under this paragraph (c) are the only permissible methods of 
accounting for MACRS property within the scope of this section unless 
the taxpayer makes the election under paragraph (i) of this section not 
to apply this section.
    (2) Effect of depreciation treatment of the replacement MACRS 
property by previous owners of the acquired property. If replacement 
MACRS property is acquired by a taxpayer in a like-kind exchange or an 
involuntary conversion, the depreciation treatment of the replacement 
MACRS property by previous owners has no effect on the determination of 
depreciation allowances for the replacement MACRS property in the hands 
of the acquiring taxpayer. For example, a taxpayer exchanging, in a 
like-kind exchange, MACRS property for property that was depreciated

[[Page 534]]

under section 168 of the Internal Revenue Code of 1954 (ACRS) by the 
previous owner must use this section because the replacement property 
will become MACRS property in the hands of the acquiring taxpayer. In 
addition, elections made by previous owners in determining depreciation 
allowances for the replacement MACRS property have no effect on the 
acquiring taxpayer. For example, a taxpayer exchanging, in a like-kind 
exchange, MACRS property that the taxpayer depreciates under the general 
depreciation system of section 168(a) for other MACRS property that the 
previous owner elected to depreciate under the alternative depreciation 
system pursuant to section 168(g)(7) does not have to continue using the 
alternative depreciation system for the replacement MACRS property.
    (3) Recovery period and/or depreciation method of the properties are 
the same, or both are not the same--(i) In general. For purposes of 
paragraphs (c)(3) and (c)(4) of this section in determining whether the 
recovery period and the depreciation method prescribed under section 168 
for the replacement MACRS property are the same as the recovery period 
and the depreciation method prescribed under section 168 for the 
relinquished MACRS property, the recovery period and the depreciation 
method for the replacement MACRS property are considered to be the 
recovery period and the depreciation method that would have applied 
under section 168, taking into account any elections made by the 
acquiring taxpayer under section 168(b)(5) or 168(g)(7), had the 
replacement MACRS property been placed in service by the acquiring 
taxpayer at the same time as the relinquished MACRS property.
    (ii) Both the recovery period and the depreciation method are the 
same. If both the recovery period and the depreciation method prescribed 
under section 168 for the replacement MACRS property are the same as the 
recovery period and the depreciation method prescribed under section 168 
for the relinquished MACRS property, the depreciation allowances for the 
replacement MACRS property beginning in the year of replacement are 
determined by using the same recovery period and depreciation method 
that were used for the relinquished MACRS property. Thus, the 
replacement MACRS property is depreciated over the remaining recovery 
period (taking into account the applicable convention), and by using the 
depreciation method, of the relinquished MACRS property. Except as 
provided in paragraph (c)(5) of this section, the depreciation 
allowances for the depreciable exchanged basis for any 12-month taxable 
year beginning with the year of replacement are determined by 
multiplying the depreciable exchanged basis by the applicable 
depreciation rate for each taxable year (for further guidance, for 
example, see section 6 of Rev. Proc. 87-57 (1987-2 CB 687, 692) and 
Sec.  601.601(d)(2)(ii)(b) of this chapter).
    (iii) Either the recovery period or the depreciation method is the 
same, or both are not the same. If either the recovery period or the 
depreciation method prescribed under section 168 for the replacement 
MACRS property is the same as the recovery period or the depreciation 
method prescribed under section 168 for the relinquished MACRS property, 
the depreciation allowances for the depreciable exchanged basis 
beginning in the year of replacement are determined using the recovery 
period or the depreciation method that is the same as the relinquished 
MACRS property. See paragraph (c)(4) of this section to determine the 
depreciation allowances when the recovery period or the depreciation 
method of the replacement MACRS property is not the same as that of the 
relinquished MACRS property.
    (4) Recovery period or depreciation method of the properties is not 
the same. If the recovery period prescribed under section 168 for the 
replacement MACRS property (as determined under paragraph (c)(3)(i) of 
this section) is not the same as the recovery period prescribed under 
section 168 for the relinquished MACRS property, the depreciation 
allowances for the depreciable exchanged basis beginning in the year of 
replacement are determined under this paragraph (c)(4). Similarly, if 
the depreciation method prescribed under section 168 for the replacement 
MACRS property (as determined under paragraph (c)(3)(i) of this section) 
is not the same

[[Page 535]]

as the depreciation method prescribed under section 168 for the 
relinquished MACRS property, the depreciation method used to determine 
the depreciation allowances for the depreciable exchanged basis 
beginning in the year of replacement is determined under this paragraph 
(c)(4).
    (i) Longer recovery period. If the recovery period prescribed under 
section 168 for the replacement MACRS property (as determined under 
paragraph (c)(3)(i) of this section) is longer than that prescribed for 
the relinquished MACRS property, the depreciation allowances for the 
depreciable exchanged basis beginning in the year of replacement are 
determined as though the replacement MACRS property had originally been 
placed in service by the acquiring taxpayer in the same taxable year the 
relinquished MACRS property was placed in service by the acquiring 
taxpayer, but using the longer recovery period of the replacement MACRS 
property (as determined under paragraph (c)(3)(i) of this section) and 
the convention determined under paragraph (c)(4)(v) of this section. 
Thus, the depreciable exchanged basis is depreciated over the remaining 
recovery period (taking into account the applicable convention) of the 
replacement MACRS property.
    (ii) Shorter recovery period. If the recovery period prescribed 
under section 168 for the replacement MACRS property (as determined 
under paragraph (c)(3)(i) of this section) is shorter than that of the 
relinquished MACRS property, the depreciation allowances for the 
depreciable exchanged basis beginning in the year of replacement are 
determined using the same recovery period as that of the relinquished 
MACRS property. Thus, the depreciable exchanged basis is depreciated 
over the remaining recovery period (taking into account the applicable 
convention) of the relinquished MACRS property.
    (iii) Less accelerated depreciation method--(A) If the depreciation 
method prescribed under section 168 for the replacement MACRS property 
(as determined under paragraph (c)(3)(i) of this section) is less 
accelerated than that of the relinquished MACRS property at the time of 
disposition, the depreciation allowances for the depreciable exchanged 
basis beginning in the year of replacement are determined as though the 
replacement MACRS property had originally been placed in service by the 
acquiring taxpayer at the same time the relinquished MACRS property was 
placed in service by the acquiring taxpayer, but using the less 
accelerated depreciation method. Thus, the depreciable exchanged basis 
is depreciated using the less accelerated depreciation method.
    (B) Except as provided in paragraph (c)(5) of this section, the 
depreciation allowances for the depreciable exchanged basis for any 12-
month taxable year beginning in the year of replacement are determined 
by multiplying the adjusted depreciable basis by the applicable 
depreciation rate for each taxable year. If, for example, the 
depreciation method of the replacement MACRS property in the year of 
replacement is the 150-percent declining balance method and the 
depreciation method of the relinquished MACRS property in the year of 
replacement is the 200-percent declining balance method, and neither 
method had been switched to the straight line method in the year of 
replacement or any prior taxable year, the applicable depreciation rate 
for the year of replacement and subsequent taxable years is determined 
by using the depreciation rate of the replacement MACRS property as if 
the replacement MACRS property was placed in service by the acquiring 
taxpayer at the same time the relinquished MACRS property was placed in 
service by the acquiring taxpayer, until the 150-percent declining 
balance method has been switched to the straight line method. If, for 
example, the depreciation method of the replacement MACRS property is 
the straight line method, the applicable depreciation rate for the year 
of replacement is determined by using the remaining recovery period at 
the beginning of the year of disposition (as determined under this 
paragraph (c)(4) and taking into account the applicable convention).
    (iv) More accelerated depreciation method--(A) If the depreciation 
method prescribed under section 168 for the replacement MACRS property 
(as determined under paragraph (c)(3)(i) of this

[[Page 536]]

section) is more accelerated than that of the relinquished MACRS 
property at the time of disposition, the depreciation allowances for the 
replacement MACRS property beginning in the year of replacement are 
determined using the same depreciation method as the relinquished MACRS 
property.
    (B) Except as provided in paragraph (c)(5) of this section, the 
depreciation allowances for the depreciable exchanged basis for any 12-
month taxable year beginning in the year of replacement are determined 
by multiplying the adjusted depreciable basis by the applicable 
depreciation rate for each taxable year. If, for example, the 
depreciation method of the relinquished MACRS property in the year of 
replacement is the 150-percent declining balance method and the 
depreciation method of the replacement MACRS property in the year of 
replacement is the 200-percent declining balance method, and neither 
method had been switched to the straight line method in the year of 
replacement or any prior taxable year, the applicable depreciation rate 
for the year of replacement and subsequent taxable years is the same 
depreciation rate that applied to the relinquished MACRS property in the 
year of replacement, until the 150-percent declining balance method has 
been switched to the straight line method. If, for example, the 
depreciation method is the straight line method, the applicable 
depreciation rate for the year of replacement is determined by using the 
remaining recovery period at the beginning of the year of disposition 
(as determined under this paragraph (c)(4) and taking into account the 
applicable convention).
    (v) Convention. The applicable convention for the exchanged basis is 
determined under this paragraph (c)(4)(v).
    (A) Either the relinquished MACRS property or the replacement MACRS 
property is mid-month property. If either the relinquished MACRS 
property or the replacement MACRS property is property for which the 
applicable convention (as determined under section 168(d)) is the mid-
month convention, the exchanged basis must be depreciated using the mid-
month convention.
    (B) Neither the relinquished MACRS property nor the replacement 
MACRS property is mid-month property. If neither the relinquished MACRS 
property nor the replacement MACRS property is property for which the 
applicable convention (as determined under section 168(d)) is the mid-
month convention, the applicable convention for the exchanged basis is 
the same convention that applied to the relinquished MACRS property. If 
the relinquished MACRS property is placed in service in the year of 
disposition, and the time of replacement is also in the year of 
disposition, the convention that applies to the relinquished MACRS 
property is determined under paragraph (f)(1)(i) of this section. If, 
however, relinquished MACRS property was placed in service in the year 
of disposition and the time of replacement is in a taxable year 
subsequent to the year of disposition, the convention that applies to 
the exchanged basis is the convention that applies in that subsequent 
taxable year (see paragraph (f)(1)(ii) of this section).
    (5) Year of disposition and year of replacement. No depreciation 
deduction is allowable for MACRS property disposed of by a taxpayer in a 
like-kind exchange or involuntary conversion in the same taxable year 
that such property was placed in service by the taxpayer. If replacement 
MACRS property is disposed of by a taxpayer during the same taxable year 
that the relinquished MACRS property is placed in service by the 
taxpayer, no depreciation deduction is allowable for either MACRS 
property. Otherwise, the depreciation allowances for the year of 
disposition and for the year of replacement are determined as follows:
    (i) Relinquished MACRS property--(A) General rule. Except as 
provided in paragraphs (c)(5)(i)(B), (c)(5)(iii), (e), and (i) of this 
section, the depreciation allowance in the year of disposition for the 
relinquished MACRS property is computed by multiplying the allowable 
depreciation deduction for the property for that year by a fraction, the 
numerator of which is the number of months (including fractions of 
months) the property is deemed to be placed in service during the year 
of disposition (taking into account the applicable convention of the 
relinquished MACRS

[[Page 537]]

property), and the denominator of which is 12. In the case of 
termination under Sec.  1.168(i)-1(e)(3)(v) of general asset account 
treatment of an asset, or of all the assets remaining, in a general 
asset account, the allowable depreciation deduction in the year of 
disposition for the asset or assets for which general asset account 
treatment is terminated is determined using the depreciation method, 
recovery period, and convention of the general asset account. This 
allowable depreciation deduction is adjusted to account for the period 
the asset or assets is deemed to be in service in accordance with this 
paragraph (c)(5)(i).
    (B) Special rule. If, at the beginning of the year of disposition, 
the remaining recovery period of the relinquished MACRS property, taking 
into account the applicable convention of such property, is less than 
the period between the beginning of the year of disposition and the time 
of disposition, the depreciation deduction for the relinquished MACRS 
property for the year of disposition is equal to the adjusted 
depreciable basis of the relinquished MACRS property at the beginning of 
the year of disposition. If this paragraph applies, the exchanged basis 
is zero and no depreciation is allowable for the exchanged basis in the 
replacement MACRS property.
    (ii) Replacement MACRS property--(A) Remaining recovery period of 
the replacement MACRS property. The replacement MACRS property is 
treated as placed in service at the time of replacement under the 
convention that applies to the replacement MACRS property as determined 
under this paragraph (c)(5)(ii). The remaining recovery period of the 
replacement MACRS property at the time of replacement is the excess of 
the recovery period for the replacement MACRS property, as determined 
under paragraph (c) of this section, over the period of time that the 
replacement MACRS property would have been in service if it had been 
placed in service when the relinquished MACRS property was placed in 
service and removed from service at the time of disposition of the 
relinquished MACRS property. This period is determined by using the 
convention that applied to the relinquished MACRS property to determine 
the date that the relinquished MACRS property is deemed to have been 
placed in service and the date that it is deemed to have been disposed 
of. The length of time the replacement MACRS property would have been in 
service is determined by using these dates and the convention that 
applies to the replacement MACRS property.
    (B) Year of replacement is 12 months. Except as provided in 
paragraphs (c)(5)(iii), (e), and (i) of this section, the depreciation 
allowance in the year of replacement for the depreciable exchanged basis 
is determined by--
    (1) Calculating the applicable depreciation rate for the replacement 
MACRS property as of the beginning of the year of replacement taking 
into account the depreciation method prescribed for the replacement 
MACRS property under paragraph (c)(3) of this section and the remaining 
recovery period of the replacement MACRS property as of the beginning of 
the year of disposition as determined under this paragraph (c)(5)(ii);
    (2) Calculating the depreciable exchanged basis of the replacement 
MACRS property, and adding to that amount the amount determined under 
paragraph (c)(5)(i) of this section for the year of disposition; and
    (3) Multiplying the product of the amounts determined under 
paragraphs (c)(5)(ii)(B)(1) and (B)(2) of this section by a fraction, 
the numerator of which is the number of months (including fractions of 
months) the property is deemed to be in service during the year of 
replacement (in the year of replacement the replacement MACRS property 
is deemed to be placed in service by the acquiring taxpayer at the time 
of replacement under the convention determined under paragraph (c)(4)(v) 
of this section), and the denominator of which is 12.
    (iii) Year of disposition or year of replacement is less than 12 
months. If the year of disposition or the year of replacement is less 
than 12 months, the depreciation allowance determined under paragraph 
(c)(5)(ii)(A) of this section must be adjusted for a short taxable year 
(for further guidance, for example, see Rev. Proc. 89-15 (1989-1 CB

[[Page 538]]

816) and Sec.  601.601(d)(2)(ii)(b) of this chapter).
    (iv) Deferred transactions--(A) In general. If the replacement MACRS 
property is not acquired until after the disposition of the relinquished 
MACRS property, taking into account the applicable convention of the 
relinquished MACRS property and replacement MACRS property, depreciation 
is not allowable during the period between the disposition of the 
relinquished MACRS property and the acquisition of the replacement MACRS 
property. The recovery period for the replacement MACRS property is 
suspended during this period. For purposes of paragraph (c)(5)(ii) of 
this section, only the depreciable exchanged basis of the replacement 
MACRS property is taken into account for calculating the amount in 
paragraph (c)(5)(ii)(B)(2) of this section if the year of replacement is 
a taxable year subsequent to the year of disposition.
    (B) Allowable depreciation for a qualified intermediary. [Reserved]
    (v) Remaining recovery period. The remaining recovery period of the 
replacement MACRS property is determined as of the beginning of the year 
of disposition of the relinquished MACRS property. For purposes of 
determining the remaining recovery period of the replacement MACRS 
property, the replacement MACRS property is deemed to have been 
originally placed in service under the convention determined under 
paragraph (c)(4)(v) of this section, but at the time the relinquished 
MACRS property was deemed to be placed in service under the convention 
that applied to it when it was placed in service.
    (6) Examples. The application of this paragraph (c) is illustrated 
by the following examples:

    Example 1. A1, a calendar-year taxpayer, exchanges Building M, an 
office building, for Building N, a warehouse in a like-kind exchange. 
Building M is relinquished in July 2004 and Building N is acquired and 
placed in service in October 2004. A1 did not make any elections under 
section 168 for either Building M or Building N. The unadjusted 
depreciable basis of Building M was $4,680,000 when placed in service in 
July 1997. Since the recovery period and depreciation method prescribed 
under section 168 for Building N (39 years, straight line method) are 
the same as the recovery period and depreciation method prescribed under 
section 168 for Building M (39 years, straight line method), Building N 
is depreciated over the remaining recovery period of, and using the same 
depreciation method and convention as that of, Building M. Applying the 
applicable convention, Building M is deemed disposed of on July 15, 
2004, and Building N is placed in service on October 15, 2004. Thus, 
Building N will be depreciated using the straight line method over a 
remaining recovery period of 32 years beginning in October 2004 (the 
remaining recovery period of 32 years and 6.5 months at the beginning of 
2004, less the 6.5 months of depreciation taken prior to the disposition 
of the exchanged MACRS property (Building M) in 2004). For 2004, the 
year in which the transaction takes place, the depreciation allowance 
for Building M is ($120,000)(6.5/12) which equals $65,000. The 
depreciation allowance for Building N for 2004 is ($120,000)(2.5/12) 
which equals $25,000. For 2005 and subsequent years, Building N is 
depreciated over the remaining recovery period of, and using the same 
depreciation method and convention as that of, Building M. Thus, the 
depreciation allowance for Building N is the same as Building M, namely 
$10,000 per month.
    Example 2. B, a calendar-year taxpayer, placed in service Bridge P 
in January 1998. Bridge P is depreciated using the half-year convention. 
In January 2004, B exchanges Bridge P for Building Q, an apartment 
building, in a like-kind exchange. Pursuant to paragraph (k)(2)(i) of 
this section, B decided to apply Sec.  1.168(i)-6 to the exchange of 
Bridge P for Building Q, the replacement MACRS property. B did not make 
any elections under section 168 for either Bridge P or Building Q. Since 
the recovery period prescribed under section 168 for Building Q (27.5 
years) is longer than that of Bridge P (15 years), Building Q is 
depreciated as if it had originally been placed in service in July 1998 
and disposed of in July 2004 using a 27.5 year recovery period. 
Additionally, since the depreciation method prescribed under section 168 
for Building Q (straight line method) is less accelerated than that of 
Bridge P (150-percent declining balance method), then the depreciation 
allowance for Building Q is computed using the straight line method. 
Thus, when Building Q is acquired and placed in service in 2004, its 
basis is depreciated over the remaining 21.5 year recovery period using 
the straight line method of depreciation and the mid-month convention 
beginning in July 2004.
    Example 3. C, a calendar-year taxpayer, placed in service Building 
R, a restaurant, in January 1996. In January 2004, C exchanges Building 
R for Tower S, a radio transmitting tower, in a like-kind exchange. 
Pursuant to paragraph (k)(2)(i) of this section, C decided to apply 
Sec.  1.168(i)-6 to the exchange of Building R for Tower S, the 
replacement MACRS

[[Page 539]]

property. C did not make any elections under section 168 for either 
Building R or Tower S. Since the recovery period prescribed under 
section 168 for Tower S (15 years) is shorter than that of Building R 
(39 years), Tower S is depreciated over the remaining recovery period of 
Building R. Additionally, since the depreciation method prescribed under 
section 168 for Tower S (150% declining balance method) is more 
accelerated than that of Building R (straight line method), then the 
depreciation allowance for Tower S is also computed using the same 
depreciation method as Building R. Thus, Tower S is depreciated over the 
remaining 31 year recovery period of Building R using the straight line 
method of depreciation and the mid-month convention. Alternatively, C 
may elect under paragraph (i) of this section to treat Tower S as though 
it is placed in service in January 2004. In such case, C uses the 
applicable recovery period, depreciation method, and convention 
prescribed under section 168 for Tower S.
    Example 4. (i) In February 2002, D, a calendar-year taxpayer and 
manufacturer of rubber products, acquired for $60,000 and placed in 
service Asset T (a special tool) and depreciated Asset T using the 
straight line method election under section 168(b)(5) and the mid-
quarter convention over its 3-year recovery period. D elected not to 
deduct the additional first year depreciation for 3-year property placed 
in service in 2002. In June 2004, D exchanges Asset T for Asset U (not a 
special tool) in a like-kind exchange. D elected not to deduct the 
additional first year depreciation for 7-year property placed in service 
in 2004. Since the recovery period prescribed under section 168 for 
Asset U (7 years) is longer than that of Asset T (3 years), Asset U is 
depreciated as if it had originally been placed in service in February 
2002 using a 7-year recovery period. Additionally, since the 
depreciation method prescribed under section 168 for Asset U (200-
percent declining balance method) is more accelerated than that of Asset 
T (straight line method) at the time of disposition, the depreciation 
allowance for Asset U is computed using the straight line method. Asset 
U is depreciated over its remaining recovery period of 4.75 years using 
the straight line method of depreciation and the mid-quarter convention.
    (ii) The 2004 depreciation allowance for Asset T is $7,500 ($20,000 
allowable depreciation deduction for 2004) x 4.5 months / 12).
    (iii) The depreciation rate in 2004 for Asset U is 0.1951 (1 / 5.125 
years (the length of the applicable recovery period remaining as of the 
beginning of 2004)). Therefore, the depreciation allowance for Asset U 
in 2004 is $2,744 (0.1951 x $22,500 (the sum of the $15,000 depreciable 
exchanged basis of Asset U ($22,500 adjusted depreciable basis at the 
beginning of 2004 for Asset T, less the $7,500 depreciation allowable 
for Asset T for 2004) and the $7,500 depreciation allowable for Asset T 
for 2004) x 7.5 months / 12).
    Example 5. The facts are the same as in Example 4 except that D 
exchanges Asset T for Asset U in June 2005, in a like-kind exchange. 
Under these facts, the remaining recovery period of Asset T at the 
beginning of 2005 is 1.5 months and, as a result, is less than the 5-
month period between the beginning of 2005 (year of disposition) and 
June 2005 (time of disposition). Accordingly, pursuant to paragraph 
(c)(5)(i)(B) of this section, the 2005 depreciation allowance for Asset 
T is $2,500 ($2,500 adjusted depreciable basis at the beginning of 2005 
($60,000 original basis minus $17,500 depreciation deduction for 2002 
minus $20,000 depreciation deduction for 2003 minus $20,000 depreciation 
deduction for 2004)). Because the exchanged basis of asset U is $0.00, 
no depreciation is allowable for asset U.
    Example 6. On January 1, 2004, E, a calendar-year taxpayer, acquired 
and placed in service Canopy V, a gas station canopy. The purchase price 
of Canopy V was $60,000. On August 1, 2004, Canopy V was destroyed in a 
hurricane and was therefore no longer usable in E's business. On October 
1, 2004, as part of the involuntary conversion, E acquired and placed in 
service new Canopy W with the insurance proceeds E received due to the 
loss of Canopy V. E elected not to deduct the additional first year 
depreciation for 5-year property placed in service in 2004. E 
depreciates both canopies under the general depreciation system of 
section 168(a) by using the 200-percent declining balance method of 
depreciation, a 5-year recovery period, and the half-year convention. No 
depreciation deduction is allowable for Canopy V. The depreciation 
deduction allowable for Canopy W for 2004 is $12,000 ($60,000 x the 
annual depreciation rate of .40 x \1/2\ year). For 2005, the 
depreciation deduction for Canopy W is $19,200 ($48,000 adjusted basis x 
the annual depreciation rate of .40).
    Example 7. The facts are the same as in Example 6, except that E did 
not make the election out of the additional first year depreciation for 
5-year property placed in service in 2004. E depreciates both canopies 
under the general depreciation system of section 168(a) by using the 
200-percent declining balance method of depreciation, a 5-year recovery 
period, and the half-year convention. No depreciation deduction is 
allowable for Canopy V. For 2004, E is allowed a 50-percent additional 
first year depreciation deduction of $30,000 for Canopy W (the 
unadjusted depreciable basis of $60,000 multiplied by .50), and a 
regular MACRS depreciation deduction of $6,000 for Canopy W (the 
depreciable exchanged basis of $30,000 multiplied by the annual 
depreciation rate of .40 x \1/2\ year). For 2005, E is allowed a regular 
MACRS depreciation deduction of $9,600 for Canopy W (the depreciable 
exchanged basis of $24,000 ($30,000

[[Page 540]]

minus regular 2003 depreciation of $6,000) multiplied by the annual 
depreciation rate of .40).
    Example 8. In January 2001, F, a calendar-year taxpayer, places in 
service a paved parking lot, Lot W, and begins depreciating Lot W over 
its 15-year recovery period. F's unadjusted depreciable basis in Lot W 
is $1,000x. On April 1, 2004, F disposes of Lot W in a like-kind 
exchange for Building X, which is nonresidential real property. Lot W is 
depreciated using the 150 percent declining balance method and the half-
year convention. Building X is depreciated using the straight-line 
method with a 39-year recovery period and using the mid-month 
convention. Both Lot W and Building X were in service at the time of the 
exchange. Because Lot W was depreciated using the half-year convention, 
it is deemed to have been placed in service on July 1, 2001, the first 
day of the second half of 2001, and to have been disposed of on July 1, 
2004, the first day of the second half of 2004. To determine the 
remaining recovery period of Building X at the time of replacement, 
Building X is deemed to have been placed in service on July 1, 2001, and 
removed from service on July 1, 2004. Thus, Building X is deemed to have 
been in service, at the time of replacement, for 3 years (36 months = 
5.5 months in 2001 + 12 months in 2002 + 12 months in 2003 + 6.5 months 
in 2004) and its remaining recovery period is 36 years (39 - 3). Because 
Building X is deemed to be placed in service at the time of replacement, 
July 1, 2004, the first day of the second half of 2004, Building X is 
depreciated for 5.5 months in 2004. However, at the beginning of the 
year of replacement the remaining recovery period for Building X is 36 
years and 6.5 months (39 years - 2 years and 5.5 months (5.5 months in 
2001 + 12 months in 2002 + 12 months in 2003)). The depreciation rate 
for building X for 2004 is 0.02737 (= 1/(39-2-5.5/12)). For 2005, the 
depreciation rate for Building X is 0.02814 (= 1/(39-3-5.5/12)).
    Example 9. The facts are the same as in Example 8. F did not make 
the election under paragraph (i) of this section for Building Y in the 
initial exchange. In January 2006, F exchanges Building Y for Building 
Z, an office building, in a like-kind exchange. F did not make any 
elections under section 168 for either Building Y or Building Z. Since 
the recovery period prescribed for Building Y as a result of the initial 
exchange (39 years) is longer than that of Building Z (27.5 years), 
Building Z is depreciated over the remaining 33 years of the recovery 
period of Building Y. The depreciation methods are the same for both 
Building Y and Building Z so F's exchanged basis in Building Z is 
depreciated over 33 years, using the straight-line method and the mid-
month convention, beginning in January 2006. Alternatively, F could have 
made the election under paragraph (i) of this section. If F makes such 
election, Building Z is treated as placed in service by F when acquired 
in January 2006 and F would recover its exchanged basis in Building Z 
over 27.5 years, using the straight line method and the mid-month 
convention, beginning in January 2006.

    (d) Special rules for determining depreciation allowances--(1) 
Excess basis--(i) In general. Any excess basis in the replacement MACRS 
property is treated as property that is placed in service by the 
acquiring taxpayer in the year of replacement. Thus, the depreciation 
allowances for the depreciable excess basis are determined by using the 
applicable recovery period, depreciation method, and convention 
prescribed under section 168 for the property at the time of 
replacement. However, if replacement MACRS property is disposed of 
during the same taxable year the relinquished MACRS property is placed 
in service by the acquiring taxpayer, no depreciation deduction is 
allowable for either MACRS property. See paragraph (g) of this section 
regarding the application of section 179. See paragraph (h) of this 
section regarding the application of section 168(k) or 1400L(b).
    (ii) Example. The application of this paragraph (d)(1) is 
illustrated by the following example:

    Example. In 1989, G placed in service a hospital. On January 16, 
2004, G exchanges this hospital plus $2,000,000 cash for an office 
building in a like-kind exchange. On January 16, 2004, the hospital has 
an adjusted depreciable basis of $1,500,000. After the exchange, the 
basis of the office building is $3,500,000. Pursuant to paragraph 
(k)(2)(i) of this section, G decided to apply Sec.  1.168(i)-6 to the 
exchange of the hospital for the office building, the replacement MACRS 
property. The depreciable exchanged basis of the office building is 
depreciated in accordance with paragraph (c) of this section. The 
depreciable excess basis of $2,000,000 is treated as being placed in 
service by G in 2004 and, as a result, is depreciated using the 
applicable depreciation method, recovery period, and convention 
prescribed for the office building under section 168 at the time of 
replacement.

    (2) Depreciable and nondepreciable property--(i) If land or other 
nondepreciable property is acquired in a like-kind exchange for, or as a 
result of an involuntary conversion of, depreciable property, the land 
or other nondepreciable property is not depreciated. If

[[Page 541]]

both MACRS and nondepreciable property are acquired in a like-kind 
exchange for, or as part of an involuntary conversion of, MACRS 
property, the basis allocated to the nondepreciable property (as 
determined under section 1031(d) and the regulations under section 
1031(d) or section 1033(b) and the regulations under section 1033(b)) is 
not depreciated and the basis allocated to the replacement MACRS 
property (as determined under section 1031(d) and the regulations under 
section 1031(d) or section 1033(b) and the regulations under section 
1033(b)) is depreciated in accordance with this section.
    (ii) If MACRS property is acquired, or if both MACRS and 
nondepreciable property are acquired, in a like-kind exchange for, or as 
part of an involuntary conversion of, land or other nondepreciable 
property, the basis in the replacement MACRS property that is 
attributable to the relinquished nondepreciable property is treated as 
though the replacement MACRS property is placed in service by the 
acquiring taxpayer in the year of replacement. Thus, the depreciation 
allowances for the replacement MACRS property are determined by using 
the applicable recovery period, depreciation method, and convention 
prescribed under section 168 for the replacement MACRS property at the 
time of replacement. See paragraph (g) of this section regarding the 
application of section 179. See paragraph (h) of this section regarding 
the application of section 168(k) or 1400L(b).
    (3) Depreciation limitations for automobiles--(i) In general. 
Depreciation allowances under section 179 and section 167 (including 
allowances under sections 168 and 1400L(b)) for a passenger automobile, 
as defined in section 280F(d)(5), are subject to the limitations of 
section 280F(a). The depreciation allowances for a passenger automobile 
that is replacement MACRS property (replacement MACRS passenger 
automobile) generally are limited in any taxable year to the replacement 
automobile section 280F limit for the taxable year. The taxpayer's basis 
in the replacement MACRS passenger automobile is treated as being 
comprised of two separate components. The first component is the 
exchanged basis and the second component is the excess basis, if any. 
The depreciation allowances for a passenger automobile that is 
relinquished MACRS property (relinquished MACRS passenger automobile) 
for the taxable year generally are limited to the relinquished 
automobile section 280F limit for that taxable year. In the year of 
disposition the sum of the depreciation deductions for the relinquished 
MACRS passenger automobile and the replacement MACRS passenger 
automobile may not exceed the replacement automobile section 280F limit 
unless the taxpayer makes the election under Sec.  1.168(i)-6(i). For 
purposes of this paragraph (d)(3), the following definitions apply:
    (A) Replacement automobile section 280F limit is the limit on 
depreciation deductions under section 280F(a) for the taxable year based 
on the time of replacement of the replacement MACRS passenger automobile 
(including the effect of any elections under section 168(k) or section 
1400L(b), as applicable).
    (B) Relinquished automobile section 280F limit is the limit on 
depreciation deductions under section 280F(a) for the taxable year based 
on when the relinquished MACRS passenger automobile was placed in 
service by the taxpayer.
    (ii) Order in which limitations on depreciation under section 
280F(a) are applied. Generally, depreciation deductions allowable under 
section 280F(a) reduce the basis in the relinquished MACRS passenger 
automobile and the exchanged basis of the replacement MACRS passenger 
automobile, before the excess basis of the replacement MACRS passenger 
automobile is reduced. The depreciation deductions for the relinquished 
MACRS passenger automobile in the year of disposition and the 
replacement MACRS passenger automobile in the year of replacement and 
each subsequent taxable year are allowable in the following order:
    (A) The depreciation deduction allowable for the relinquished MACRS 
passenger automobile as determined under paragraph (c)(5)(i) of this 
section for the year of disposition to the extent of the smaller of the 
replacement automobile section 280F limit and the relinquished 
automobile section 280F limit,

[[Page 542]]

if the year of disposition is the year of replacement. If the year of 
replacement is a taxable year subsequent to the year of disposition, the 
depreciation deduction allowable for the relinquished MACRS passenger 
automobile for the year of disposition is limited to the relinquished 
automobile section 280F limit.
    (B) The additional first year depreciation allowable on the 
remaining exchanged basis (remaining carryover basis as determined under 
Sec.  1.168(k)-1(f)(5) or Sec.  1.1400L(b)-1(f)(5), as applicable) of 
the replacement MACRS passenger automobile, as determined under Sec.  
1.168(k)-1(f)(5) or Sec.  1.1400L(b)-1(f)(5), as applicable, to the 
extent of the excess of the replacement automobile section 280F limit 
over the amount allowable under paragraph (d)(3)(ii)(A) of this section.
    (C) The depreciation deduction allowable for the taxable year on the 
depreciable exchanged basis of the replacement MACRS passenger 
automobile determined under paragraph (c) of this section to the extent 
of any excess over the sum of the amounts allowable under paragraphs 
(d)(3)(ii)(A) and (B) of this section of the smaller of the replacement 
automobile section 280F limit and the relinquished automobile section 
280F limit.
    (D) Any section 179 deduction allowable in the year of replacement 
on the excess basis of the replacement MACRS passenger automobile to the 
extent of the excess of the replacement automobile section 280F limit 
over the sum of the amounts allowable under paragraphs (d)(3)(ii)(A), 
(B), and (C) of this section.
    (E) The additional first year depreciation allowable on the 
remaining excess basis of the replacement MACRS passenger automobile, as 
determined under Sec.  1.168(k)-1(f)(5) or Sec.  1.1400L(b)-1(f)(5), as 
applicable, to the extent of the excess of the replacement automobile 
section 280F limit over the sum of the amounts allowable under 
paragraphs (d)(3)(ii)(A), (B), (C), and (D) of this section.
    (F) The depreciation deduction allowable under paragraph (d) of this 
section for the depreciable excess basis of the replacement MACRS 
passenger automobile to the extent of the excess of the replacement 
automobile section 280F limit over the sum of the amounts allowable 
under paragraphs (d)(3)(ii)(A), (B), (C), (D), and (E) of this section.
    (iii) Examples. The application of this paragraph (d)(3) is 
illustrated by the following examples:

    Example 1. H, a calendar-year taxpayer, acquired and placed in 
service Automobile X in January 2000 for $30,000 to be used solely for 
H's business. In December 2003, H exchanges, in a like-kind exchange, 
Automobile X plus $15,000 cash for new Automobile Y that will also be 
used solely in H's business. Automobile Y is 50-percent bonus 
depreciation property for purposes of section 168(k)(4). Both 
automobiles are depreciated using the double declining balance method, 
the half-year convention, and a 5-year recovery period. Pursuant to 
Sec.  1.168(k)-1(g)(3)(ii) and paragraph (k)(2)(i) of this section, H 
decided to apply Sec.  1.168(i)-6 to the exchange of Automobile X for 
Automobile Y, the replacement MACRS property. The relinquished 
automobile section 280F limit for 2003 for Automobile X is $1,775. The 
replacement automobile section 280F limit for Automobile Y is $10,710. 
The exchanged basis for Automobile Y is $17,315 ($30,000 less total 
depreciation allowable of $12,685 (($3,060 for 2000, $4,900 for 2001, 
$2,950 for 2002, and $1,775 for 2003)). Without taking section 280F into 
account, the additional first year depreciation deduction for the 
remaining exchanged basis is $8,658 ($17,315 x 0.5). Because this amount 
is less than $8,935 ($10,710 (the replacement automobile section 280F 
limit for 2003 for Automobile Y) - $1,775 (the depreciation allowable 
for Automobile X for 2003)), the additional first year depreciation 
deduction for the exchanged basis is $8,658. No depreciation deduction 
is allowable in 2003 for the depreciable exchanged basis because the 
depreciation deductions taken for Automobile X and the remaining 
exchanged basis exceed the exchanged automobile section 280F limit. An 
additional first year depreciation deduction of $277 is allowable for 
the excess basis of $15,000 in Automobile Y. Thus, at the end of 2003 
the adjusted depreciable basis in Automobile Y is $23,379 comprised of 
adjusted depreciable exchanged basis of $8,657 ($17,315 (exchanged 
basis) - $8,658 (additional first year depreciation for exchanged 
basis)) and of an adjusted depreciable excess basis of $14,723 ($15,000 
(excess basis) - $277 (additional first year depreciation for 2003)).
    Example 2. The facts are the same as in Example 1, except that H 
used Automobile X only 75 percent for business use. As such, the total 
allowable depreciation for Automobile X is reduced to reflect that the 
automobile is only used 75 percent for business. The total allowable 
depreciation of Automobile X is

[[Page 543]]

$9,513.75 ($2,295 for 2000 ($3,060 limit x .75), $3,675 for 2001 ($4,900 
limit x .75), $2,212.50 for 2002 ($2,950 limit x .75), and $1,331.25 for 
2003 ($1,775 limit x .75). However, under Sec.  1.280F-2T(g)(2)(ii)(A), 
the exchanged basis is reduced by the excess (if any) of the 
depreciation that would have been allowable if the exchanged automobile 
had been used solely for business over the depreciation that was 
allowable in those years. Thus, the exchanged basis, for purposes of 
computing depreciation, for Automobile Y is $17,315.
    Example 3. The facts are the same as in Example 1, except that H 
placed in service Automobile X in January 2002, and H elected not to 
claim the additional first year depreciation deduction for 5-year 
property placed in service in 2002 and 2003. The relinquished automobile 
section 280F limit for Automobile X for 2003 is $4,900. Because the 
replacement automobile section 280F limit for 2003 for Automobile Y 
($3,060) is less than the relinquished automobile section 280F limit for 
Automobile X for 2003 and is less than $5,388 (($30,000 (cost) - $3,060 
(depreciation allowable for 2002)) x 0.4 x 6/12), the depreciation that 
would be allowable for Automobile X (determined without regard to 
section 280F) in the year of disposition, the depreciation for 
Automobile X in the year of disposition is limited to $3,060. For 2003 
no depreciation is allowable for the excess basis and the exchanged 
basis in Automobile Y.
    Example 4. AB, a calendar-year taxpayer, purchased and placed in 
service Automobile X1 in February 2000 for $10,000. X1 is a passenger 
automobile subject to section 280F(a) and is used solely for AB's 
business. AB depreciated X1 using a 5-year recovery period, the double 
declining balance method, and the half-year convention. As of January 1, 
2003, the adjusted depreciable basis of X1 was $2,880 ($10,000 original 
cost minus $2,000 depreciation deduction for 2000, minus $3,200 
depreciation deduction for 2001, and $1,920 depreciation deduction for 
2002). In November 2003, AB exchanges, in a like-kind exchange, 
Automobile X1 plus $14,000 cash for new Automobile Y1 that will be used 
solely in AB's business. Automobile Y1 is 50-percent bonus depreciation 
property for purposes of section 168(k)(4) and qualifies for the 
expensing election under section 179. Pursuant to paragraph Sec.  
1.168(k)-1(g)(3)(ii) and paragraph (k)(2)(i) of this section, AB decided 
to apply Sec.  1.168(i)-6 to the exchange of Automobile X1 for 
Automobile Y1, the replacement MACRS property. AB also makes the 
election under section 179 for the excess basis of Automobile Y1. AB 
depreciates Y1 using a five-year recovery period, the double declining 
balance method and the half-year convention. For 2003, the relinquished 
automobile section 280F limit for Automobile X1 is $1,775 and the 
replacement automobile section 280F limit for 2003 for Automobile Y1 is 
$10,710.
    (i) The 2003 depreciation deduction for Automobile X1 is $576. The 
depreciation deduction calculated for X1 is $576 (the adjusted 
depreciable basis of Automobile X1 at the beginning of 2003 of $2,880 x 
40% x \1/2\ year), which is less than the relinquished automobile 
section 280F limit and the replacement automobile section 280F limit.
    (ii) The additional first year depreciation deduction for the 
exchanged basis is $1,152. The additional first year depreciation 
deduction of $1,152 (remaining exchanged basis of $2,304 ($2,880 
adjusted basis of Automobile X1 at the beginning of 2003 minus $576) - 
0.5)) is less than the replacement automobile section 280F limit minus 
$576.
    (iii) AB's MACRS depreciation deduction allowable in 2003 for the 
remaining exchanged basis of $1,152 is $47 (the relinquished automobile 
section 280F limit of $1,775 less the depreciation deduction of $576 
taken for Automobile X1 less the additional first year depreciation 
deduction of $1,152 taken for the exchanged basis) which is less than 
the depreciation deduction calculated for the depreciable exchanged 
basis.
    (iv) For 2003, AB takes a $1,400 section 179 deduction for the 
excess basis of Automobile Y1. AB must reduce the excess basis of 
$14,000 by the section 179 deduction of $1,400 to determine the 
remaining excess basis of $12,600.
    (v) For 2003, AB is allowed a 50-percent additional first year 
depreciation deduction of $6,300 (the remaining excess basis of $12,600 
multiplied by .50).
    (vi) For 2003, AB's depreciation deduction for the depreciable 
excess basis is limited to $1,235. The depreciation deduction computed 
without regard to the replacement automobile section 280F limit is 
$1,260 ($6,300 depreciable excess basis x 0.4 x 6/12). However the 
depreciation deduction for the depreciable excess basis is limited to 
$1,235 ($10,710 (replacement automobile section 280F limit) - $576 
(depreciation deduction for Automobile X1) - $1,152 (additional first 
year depreciation deduction for the exchanged basis) - $47 (depreciation 
deduction for exchanged basis) - 1,400 (section 179 deduction) - $6,300 
(additional first year depreciation deduction for remaining excess 
basis)).

    (4) Involuntary conversion for which the replacement MACRS property 
is acquired and placed in service before disposition of relinquished 
MACRS property. If, in an involuntary conversion, a taxpayer acquires 
and places in service the replacement MACRS property before the date of 
disposition of the relinquished MACRS property, the taxpayer depreciates 
the unadjusted depreciable basis of the replacement MACRS property under 
section 168 beginning in the taxable year when the replacement

[[Page 544]]

MACRS property is placed in service by the taxpayer and by using the 
applicable depreciation method, recovery period, and convention 
prescribed under section 168 for the replacement MACRS property at the 
placed-in-service date. However, at the time of disposition of the 
relinquished MACRS property, the taxpayer determines the exchanged basis 
and the excess basis of the replacement MACRS property and begins to 
depreciate the depreciable exchanged basis of the replacement MACRS 
property in accordance with paragraph (c) of this section. The 
depreciable excess basis of the replacement MACRS property continues to 
be depreciated by the taxpayer in accordance with the first sentence of 
this paragraph (d)(4). Further, in the year of disposition of the 
relinquished MACRS property, the taxpayer must include in taxable income 
the excess of the depreciation deductions allowable on the unadjusted 
depreciable basis of the replacement MACRS property over the 
depreciation deductions that would have been allowable to the taxpayer 
on the depreciable excess basis of the replacement MACRS property from 
the date the replacement MACRS property was placed in service by the 
taxpayer (taking into account the applicable convention) to the time of 
disposition of the relinquished MACRS property. However, see Sec.  
1.168(k)-1(f)(5)(v) for replacement MACRS property that is qualified 
property or 50-percent bonus depreciation property and Sec.  1.1400L(b)-
1(f)(5) for replacement MACRS property that is qualified New York 
Liberty Zone property.
    (e) Use of optional depreciation tables--(1) Taxpayer not bound by 
prior use of table. If a taxpayer used an optional depreciation table 
for the relinquished MACRS property, the taxpayer is not required to use 
an optional table for the depreciable exchanged basis of the replacement 
MACRS property. Conversely, if a taxpayer did not use an optional 
depreciation table for the relinquished MACRS property, the taxpayer may 
use the appropriate table for the depreciable exchanged basis of the 
replacement MACRS property. If a taxpayer decides not to use the table 
for the depreciable exchanged basis of the replacement MACRS property, 
the depreciation allowance for this property for the year of replacement 
and subsequent taxable years is determined under paragraph (c) of this 
section. If a taxpayer decides to use the optional depreciation tables, 
no depreciation deduction is allowable for MACRS property placed in 
service by the acquiring taxpayer and subsequently exchanged or 
involuntarily converted by such taxpayer in the same taxable year, and, 
if, during the same taxable year, MACRS property is placed in service by 
the acquiring taxpayer, exchanged or involuntarily converted by such 
taxpayer, and the replacement MACRS property is disposed of by such 
taxpayer, no depreciation deduction is allowable for either MACRS 
property.
    (2) Determination of the depreciation deduction--(i) Relinquished 
MACRS property. In the year of disposition, the depreciation allowance 
for the relinquished MACRS property is computed by multiplying the 
unadjusted depreciable basis (less the amount of the additional first 
year depreciation deduction allowed or allowable, whichever is greater, 
under section 168(k) or section 1400L(b), as applicable) of the 
relinquished MACRS property by the annual depreciation rate (expressed 
as a decimal equivalent) specified in the appropriate table for the 
recovery year corresponding to the year of disposition. This product is 
then multiplied by a fraction, the numerator of which is the number of 
months (including fractions of months) the property is deemed to be 
placed in service during the year of the exchange or involuntary 
conversion (taking into account the applicable convention) and the 
denominator of which is 12. However, if the year of disposition is less 
than 12 months, the depreciation allowance determined under this 
paragraph (e)(2)(i) must be adjusted for a short taxable year (for 
further guidance, for example, see Rev. Proc. 89-15 (1989-1 CB 816) and 
Sec.  601.601(d)(2)(ii)(b) of this chapter).
    (ii) Replacement MACRS property--(A) Determination of the 
appropriate optional depreciation table. If a taxpayer chooses to use 
the appropriate optional depreciation table for the depreciable 
exchanged basis, the depreciation allowances for the depreciable 
exchanged

[[Page 545]]

basis beginning in the year of replacement are determined by choosing 
the optional depreciation table that corresponds to the recovery period, 
depreciation method, and convention of the replacement MACRS property 
determined under paragraph (c) of this section.
    (B) Calculating the depreciation deduction for the replacement MACRS 
property. (1) The depreciation deduction for the taxable year is 
computed by first determining the appropriate recovery year in the table 
identified under paragraph (e)(2)(ii)(A) of this section. The 
appropriate recovery year for the year of replacement is the same as the 
recovery year for the year of disposition, regardless of the taxable 
year in which the replacement property is acquired. For example, if the 
recovery year for the year of disposition would have been year 4 in the 
table that applied before the disposition of the relinquished MACRS 
property, then the recovery year for the year of replacement is Year 4 
in the table identified under paragraph (e)(2)(ii)(A) of this section.
    (2) Next, the annual depreciation rate (expressed as a decimal 
equivalent) for each recovery year is multiplied by a transaction 
coefficient. The transaction coefficient is the formula (1 / (1 - x)) 
where x equals the sum of the annual depreciation rates from the table 
identified under paragraph (e)(2)(ii)(A) of this section (expressed as a 
decimal equivalent) corresponding to the replacement MACRS property (as 
determined under paragraph (e)(2)(ii)(A) of this section) for the 
taxable years beginning with the placed-in-service year of the 
relinquished MACRS property through the taxable year immediately prior 
to the year of disposition. The product of the annual depreciation rate 
and the transaction coefficient is multiplied by the depreciable 
exchanged basis (taking into account paragraph (e)(2)(i) of this 
section). In the year of replacement, this product is then multiplied by 
a fraction, the numerator of which is the number of months (including 
fractions of months) the property is deemed to be placed in service by 
the acquiring taxpayer during the year of replacement (taking into 
account the applicable convention) and the denominator of which is 12. 
However, if the year of replacement is the year the relinquished MACRS 
property is placed in service by the acquiring taxpayer, the preceding 
sentence does not apply. In addition, if the year of replacement is less 
than 12 months, the depreciation allowance determined under paragraph 
(e)(2)(ii) of this section must be adjusted for a short taxable year 
(for further guidance, for example, see Rev. Proc. 89-15 (1989-1 CB 816) 
and Sec.  601.601(d)(2)(ii)(b) of this chapter).
    (iii) Unrecovered basis. If the replacement MACRS property would 
have unrecovered depreciable basis after the final recovery year (for 
example, due to a deferred exchange), the unrecovered basis is an 
allowable depreciation deduction in the taxable year that corresponds to 
the final recovery year unless the unrecovered basis is subject to a 
depreciation limitation such as section 280F.
    (3) Excess basis. As provided in paragraph (d)(1) of this section, 
any excess basis in the replacement MACRS property is treated as 
property that is placed in service by the acquiring taxpayer at the time 
of replacement. Thus, if the taxpayer chooses to use the appropriate 
optional depreciation table for the depreciable excess basis in the 
replacement MACRS property, the depreciation allowances for the 
depreciable excess basis are determined by multiplying the depreciable 
excess basis by the annual depreciation rate (expressed as a decimal 
equivalent) specified in the appropriate table for each taxable year. 
The appropriate table for the depreciable excess basis is based on the 
depreciation method, recovery period, and convention applicable to the 
depreciable excess basis under section 168 at the time of replacement. 
However, If the year of replacement is less than 12 months, the 
depreciation allowance determined under this paragraph (e)(3) must be 
adjusted for a short taxable year (for further guidance, for example, 
see Rev. Proc. 89-15 (1989-1 CB 816) and Sec.  601.601(d)(2)(ii)(b) of 
this chapter).
    (4) Examples. The application of this paragraph (e) is illustrated 
by the following examples:

    Example 1. J, a calendar-year taxpayer, acquired 5-year property for 
$10,000 and placed

[[Page 546]]

it in service in January 2001. J uses the optional tables to depreciate 
the property. J uses the half-year convention and did not make any 
elections for the property. In December 2003, J exchanges the 5-year 
property for used 7-year property in a like-kind exchange. Pursuant to 
paragraph (k)(2)(i) of this section, J decided to apply Sec.  1.168(i)-6 
to the exchange of the 5-year property for the 7-year property, the 
replacement MACRS property. The depreciable exchanged basis of the 7-
year property equals the adjusted depreciable basis of the 5-year 
property at the time of disposition of the relinquished MACRS property, 
namely $3,840 ($10,000 less $2,000 depreciation in 2001, $3,200 
depreciation in 2002, and $960 depreciation in 2003). J must first 
determine the appropriate optional depreciation table pursuant to 
paragraph (c) of this section. Since the replacement MACRS property has 
a longer recovery period and the same depreciation method as the 
relinquished MACRS property, J uses the optional depreciation table 
corresponding to a 7-year recovery period, the 200% declining balance 
method, and the half-year convention (because the 5-year property was 
depreciated using a half-year convention). Had the replacement MACRS 
property been placed in service in the same taxable year as the placed-
in-service year of the relinquished MACRS property, the depreciation 
allowance for the replacement MACRS property for the year of replacement 
would be determined using recovery year 3 of the optional table. The 
depreciation allowance equals the depreciable exchanged basis ($3,840) 
multiplied by the annual depreciation rate for the current taxable year 
(.1749 for recovery year 3) as modified by the transaction coefficient 
[1 / (1 - (.1429 + .2449))] which equals 1.6335. Thus, J multiplies 
$3,840, its depreciable exchanged basis in the replacement MACRS 
property, by the product of .1749 and 1.6335, and then by one-half, to 
determine the depreciation allowance for 2003, $549. For 2004, J 
multiples its depreciable exchanged basis in the replacement MACRS 
property determined at the time of replacement of $3,840 by the product 
of the modified annual depreciation rate for the current taxable year 
(.1249 for recovery year 4) and the transaction coefficient (1.6335) to 
determine its depreciation allowance of $783.
    Example 2. K, a calendar-year taxpayer, acquired used Asset V for 
$100,000 and placed it in service in January 1999. K depreciated Asset V 
under the general depreciation system of section 168(a) by using a 5-
year recovery period, the 200-percent declining balance method of 
depreciation, and the half-year convention. In December 2003, as part of 
the involuntary conversion, Asset V is involuntarily converted due to an 
earthquake. In October 2005, K purchases used Asset W with the insurance 
proceeds from the destruction of Asset V and places Asset W in service 
to replace Asset V. Pursuant to paragraph (k)(2)(i) of this section, K 
decided to apply Sec.  1.168(i)-6 to the involuntary conversion of Asset 
V with the replacement of Asset W, the replacement MACRS property. If 
Asset W had been placed in service when Asset V was placed in service, 
it would have been depreciated using a 7-year recovery period, the 200-
percent declining balance method, and the half-year convention. K uses 
the optional depreciation tables to depreciate Asset V and Asset W. For 
2003 (recovery year 5 on the optional table), the depreciation deduction 
for Asset V is $5,760 ((0.1152)($100,000)(1/2)). Thus, the adjusted 
depreciable basis of Asset V at the time of replacement is $11,520 
($100,000 less $20,000 depreciation in 1999, $32,000 depreciation in 
2000, $19,200 depreciation in 2001, $11,520 depreciation in 2002, and 
$5,760 depreciation in 2003). Under the table that applied to Asset V, 
the year of disposition was recovery year 5 and the depreciation 
deduction was determined under the straight line method. The table that 
applies for Asset W is the table that applies the straight line 
depreciation method, the half-year convention, and a 7-year recovery 
period. The appropriate recovery year under this table is recovery year 
5. The depreciation deduction for Asset W for 2005 is $1,646 
(($11,520)(0.1429)(1/(1-0.5))(1/2)). Thus, the depreciation deduction 
for Asset W in 2006 (recovery year 6) is $3,290 ($11,520)(0.1428)(1/(1-
0.5)). The depreciation deduction for 2007 (recovery year 7) is $3,292 
(($11,520)(.1429)(1/(1-.5))). The depreciation deduction for 2008 
(recovery year 8) is $3292 ($11,520 less allowable depreciation for 
Asset W for 2005 through 2007 ($1,646 + $3,290 + $3,292)).
    Example 3. L, a calendar-year taxpayer, placed in service used 
Computer X in January 2002 for $5,000. L depreciated Computer X under 
the general depreciation system of section 168(a) by using the 200-
percent declining balance method of depreciation, a 5-year recovery 
period, and the half-year convention. Computer X is destroyed in a fire 
in March 2004. For 2004, the depreciation deduction allowable for 
Computer X equals $480 ([($5,000)(.1920)] x (1/2)). Thus, the adjusted 
depreciable basis of Computer X was $1,920 when it was destroyed ($5,000 
unadjusted depreciable basis less $1,000 depreciation for 2002, $1,600 
depreciation for 2003, and $480 depreciation for 2004). In April 2004, 
as part of the involuntary conversion, L acquired and placed in service 
used Computer Y with insurance proceeds received due to the loss of 
Computer X. Computer Y will be depreciated using the same depreciation 
method, recovery period, and convention as Computer X. L elected to use 
the optional depreciation tables to compute the depreciation allowance 
for Computer X and Computer Y. The depreciation deduction allowable for 
2004 for Computer Y equals $384 ([$1,920 x (.1920)(1/(1-.52))] x (1/2)).


[[Page 547]]


    (f) Mid-quarter convention. For purposes of applying the 40-percent 
test under section 168(d) and the regulations under section 168(d), the 
following rules apply:
    (1) Exchanged basis. If, in a taxable year, MACRS property is placed 
in service by the acquiring taxpayer (but not as a result of a like-kind 
exchange or involuntary conversion) and--
    (i) In the same taxable year, is disposed of by the acquiring 
taxpayer in a like-kind exchange or an involuntary conversion and 
replaced by the acquiring taxpayer with replacement MACRS property, the 
exchanged basis (determined without any adjustments for depreciation 
deductions during the taxable year) of the replacement MACRS property is 
taken into account in the year of replacement in the quarter the 
relinquished MACRS property was placed in service by the acquiring 
taxpayer; or
    (ii) In the same taxable year, is disposed of by the acquiring 
taxpayer in a like-kind exchange or an involuntary conversion, and in a 
subsequent taxable year is replaced by the acquiring taxpayer with 
replacement MACRS property, the exchanged basis (determined without any 
adjustments for depreciation deductions during the taxable year) of the 
replacement MACRS property is taken into account in the year of 
replacement in the quarter the replacement MACRS property was placed in 
service by the acquiring taxpayer; or
    (iii) In a subsequent taxable year, disposed of by the acquiring 
taxpayer in a like-kind exchange or involuntary conversion, the 
exchanged basis of the replacement MACRS property is not taken into 
account in the year of replacement.
    (2) Excess basis. Any excess basis is taken into account in the 
quarter the replacement MACRS property is placed in service by the 
acquiring taxpayer.
    (3) Depreciable property acquired for nondepreciable property. Both 
the exchanged basis and excess basis of the replacement MACRS property 
described in paragraph (d)(2)(ii) of this section (depreciable property 
acquired for nondepreciable property), are taken into account for 
determining whether the mid-quarter convention applies in the year of 
replacement.
    (g) Section 179 election. In applying the section 179 election, only 
the excess basis, if any, in the replacement MACRS property is taken 
into account. If the replacement MACRS property is described in 
paragraph (d)(2)(ii) of this section (depreciable property acquired for 
nondepreciable property), only the excess basis in the replacement MACRS 
property is taken into account.
    (h) Additional first year depreciation deduction. See Sec.  
1.168(k)-1(f)(5) (for qualified property or 50-percent bonus 
depreciation property) and Sec.  1.1400L(b)-1(f)(5) (for qualified New 
York Liberty Zone property).
    (i) Elections--(1) Election not to apply this section. A taxpayer 
may elect not to apply this section for any MACRS property involved in a 
like-kind exchange or involuntary conversion. An election under this 
paragraph (i)(1) applies only to the taxpayer making the election and 
the election applies to both the relinquished MACRS property and the 
replacement MACRS property. If an election is made under this paragraph 
(i)(1), the depreciation allowances for the replacement MACRS property 
beginning in the year of replacement and for the relinquished MACRS 
property in the year of disposition are not determined under this 
section (except as otherwise provided in this paragraph). Instead, for 
depreciation purposes only, the sum of the exchanged basis and excess 
basis, if any, in the replacement MACRS property is treated as property 
placed in service by the taxpayer at the time of replacement and the 
adjusted depreciable basis of the relinquished MACRS property is treated 
as being disposed of by the taxpayer at the time of disposition. While 
the relinquished MACRS property is treated as being disposed of at the 
time of disposition for depreciation purposes, the election not to apply 
this section does not affect the application of sections 1031 and 1033 
(for example, if a taxpayer does not make the election under this 
paragraph (i)(1) and does not recognize gain or loss under section 1031, 
this result would not change if the taxpayer chose to make the election

[[Page 548]]

under this paragraph (i)(1)). In addition, the election not to apply 
this section does not affect the application of sections 1245 and 1250 
to the relinquished MACRS property. Paragraphs (c)(5)(i) (determination 
of depreciation for relinquished MACRS property in the year of 
disposition), (c)(5)(iii) (rules for deferred transactions), (g) 
(section 179 election), and (h) (additional first year depreciation 
deduction) of this section apply to property to which this paragraph 
(i)(1) applies. See paragraph (j) of this section for the time and 
manner of making the election under this paragraph (i)(1).
    (2) Election to treat certain replacement property as MACRS 
property. If the tangible depreciable property acquired by a taxpayer in 
a like-kind exchange or involuntary conversion (the replacement 
property) replaces tangible depreciable property for which the taxpayer 
made a valid election under section 168(f)(1) to exclude it from the 
application of MACRS (the relinquished property), the taxpayer may elect 
to treat, for depreciation purposes only, the sum of the exchanged basis 
and excess basis, if any, of the replacement property as MACRS property 
that is placed in service by the taxpayer at the time of replacement. An 
election under this paragraph (i)(2) applies only to the taxpayer making 
the election and the election applies to both the relinquished property 
and the replacement property. If an election is made under this 
paragraph (i)(2), the adjusted depreciable basis of the relinquished 
property is treated as being disposed of by the taxpayer at the time of 
disposition. Rules similar to those provided in Sec. Sec.  1.168(i)-
6(b)(3) and (4) apply for purposes of determining the time of 
disposition and time of replacement under this paragraph (i)(2). While 
the relinquished property is treated as being disposed of at the time of 
disposition for depreciation purposes, the election under this paragraph 
(i)(2) does not affect the application of sections 1031 and 1033, and 
the application of sections 1245 and 1250 to the relinquished property. 
If an election is made under this paragraph (i)(2), rules similar to 
those provided in paragraphs (c)(5)(iii) (rules for deferred 
transactions), (g) (section 179 election), and (h) (additional first 
year depreciation deduction) of this section apply to property. Except 
as provided in paragraph (k)(3)(ii) of this section, a taxpayer makes 
the election under this paragraph (i)(2) by claiming the depreciation 
allowance as determined under MACRS for the replacement property on the 
taxpayer's timely filed (including extensions) original Federal tax 
return for the placed-in-service year of the replacement property as 
determined under this paragraph (i)(2).
    (j) Time and manner of making election under paragraph (i)(1) of 
this section--(1) In general. The election provided in paragraph (i)(1) 
of this section is made separately by each person acquiring replacement 
MACRS property. The election is made for each member of a consolidated 
group by the common parent of the group, by the partnership (and not by 
the partners separately) in the case of a partnership, or by the S 
corporation (and not by the shareholders separately) in the case of an S 
corporation. A separate election under paragraph (i)(1) of this section 
is required for each like-kind exchange or involuntary conversion. The 
election provided in paragraph (i)(1) of this section must be made 
within the time and manner provided in paragraph (j)(2) and (3) of this 
section and may not be made by the taxpayer in any other manner (for 
example, the election cannot be made through a request under section 
446(e) to change the taxpayer's method of accounting), except as 
provided in paragraph (k)(2) of this section.
    (2) Time for making election. The election provided in paragraph 
(i)(1) of this section must be made by the due date (including 
extensions) of the taxpayer's Federal tax return for the year of 
replacement.
    (3) Manner of making election. The election provided in paragraph 
(i)(1) of this section is made in the manner provided for on Form 4562, 
Depreciation and Amortization, and its instructions. If Form 4562 is 
revised or renumbered, any reference in this section to that form is 
treated as a reference to the revised or renumbered form.
    (4) Revocation. The election provided in paragraph (i)(1) of this 
section, once made, may be revoked only with the

[[Page 549]]

consent of the Commissioner of Internal Revenue. Such consent will be 
granted only in extraordinary circumstances. Requests for consent are 
requests for a letter ruling and must be filed with the Commissioner of 
Internal Revenue, Washington, DC 20224. Requests for consent may not be 
made in any other manner (for example, through a request under section 
446(e) to change the taxpayer's method of accounting).
    (k) Effective date--(1) In general. Except as provided in paragraph 
(k)(3) of this section, this section applies to a like-kind exchange or 
an involuntary conversion of MACRS property for which the time of 
disposition and the time of replacement both occur after February 27, 
2004.
    (2) Application to pre-effective date like-kind exchanges and 
involuntary conversions. For a like-kind exchange or an involuntary 
conversion of MACRS property for which the time of disposition, the time 
of replacement, or both occur on or before February 27, 2004, a taxpayer 
may--
    (i) Apply the provisions of this section. If a taxpayer's applicable 
Federal tax return has been filed on or before February 27, 2004, and 
the taxpayer has treated the replacement MACRS property as acquired, and 
the relinquished MACRS property as disposed of, in a like-kind exchange 
or an involuntary conversion, the taxpayer changes its method of 
accounting for depreciation of the replacement MACRS property and 
relinquished MACRS property in accordance with this paragraph (k)(2)(i) 
by following the applicable administrative procedures issued under Sec.  
1.446-1(e)(3)(ii) for obtaining the Commissioner's automatic consent to 
a change in method of accounting (for further guidance, see Rev. Proc. 
2002-9 (2002-1 CB 327) and Sec.  601.601(d)(2)(ii)(b) of this chapter); 
or
    (ii) Rely on prior guidance issued by the Internal Revenue Service 
for determining the depreciation deductions of replacement MACRS 
property and relinquished MACRS property (for further guidance, for 
example, see Notice 2000-4 (2001-1 CB 313) and Sec.  
601.601(d)(2)(ii)(b) of this chapter). In relying on such guidance, a 
taxpayer may use any reasonable, consistent method of determining 
depreciation in the year of disposition and the year of replacement. If 
a taxpayer's applicable Federal tax return has been filed on or before 
February 27, 2004, and the taxpayer has treated the replacement MACRS 
property as acquired, and the relinquished MACRS property as disposed 
of, in a like-kind exchange or an involuntary conversion, the taxpayer 
changes its method of accounting for depreciation of the replacement 
MACRS property and relinquished MACRS property in accordance with this 
paragraph (k)(2)(ii) by following the applicable administrative 
procedures issued under Sec.  1.446-1(e)(3)(ii) for obtaining the 
Commissioner's automatic consent to a change in method of accounting 
(for further guidance, see Rev. Proc. 2002-9 (2002-1 CB 327) and Sec.  
601.601(d)(2)(ii)(b) of this chapter).
    (3) Like-kind exchanges and involuntary conversions where the 
taxpayer made the election under section 168(f)(1) for the relinquished 
property--(i) In general. If the tangible depreciable property acquired 
by a taxpayer in a like-kind exchange or involuntary conversion (the 
replacement property) replaces tangible depreciable property for which 
the taxpayer made a valid election under section 168(f)(1) to exclude it 
from the application of MACRS (the relinquished property), paragraph 
(i)(2) of this section applies to such relinquished property and 
replacement property for which the time of disposition and the time of 
replacement (both as determined under paragraph (i)(2) of this section) 
both occur after February 26, 2007.
    (ii) Application of paragraph (i)(2) of this section to pre-February 
26, 2007 like-kind exchanges and involuntary conversions. If the 
tangible depreciable property acquired by a taxpayer in a like-kind 
exchange or involuntary conversion (the replacement property) replaces 
tangible depreciable property for which the taxpayer made a valid 
election under section 168(f)(1) to exclude it from the application of 
MACRS (the relinquished property), the taxpayer may apply paragraph 
(i)(2) of this section to the relinquished property and the replacement 
property for which the time of disposition, the

[[Page 550]]

time of replacement (both as determined under paragraph (i)(2) of this 
section), or both occur on or before February 26, 2007. If the taxpayer 
wants to apply paragraph (i)(2) of this section and the taxpayer's 
applicable Federal tax return has been filed on or before February 26, 
2007, the taxpayer must change its method of accounting for depreciation 
of the replacement property and relinquished property in accordance with 
this paragraph (k)(3)(ii) by following the applicable administrative 
procedures issued under Sec.  1.446-1(e)(3)(ii) for obtaining the 
Commissioner's automatic consent to a change in method of accounting 
(for further guidance, see Rev. Proc. 2002-9 (2002-1 CB 327) and Sec.  
601.601(d)(2)(ii)(b) of this chapter).

[T.D. 9314, 72 FR 9251, Mar. 1, 2007]



Sec.  1.168(i)-7  Accounting for MACRS property.

    (a) In general. A taxpayer may account for MACRS property (as 
defined in Sec.  1.168(b)-1(a)(2)) by treating each individual asset as 
an account (a ``single asset account'' or an ``item account'') or by 
combining two or more assets in a single account (a ``multiple asset 
account'' or a ``pool''). A taxpayer may establish as many accounts for 
MACRS property as the taxpayer wants. This section does not apply to 
assets included in general asset accounts. For rules applicable to 
general asset accounts, see Sec.  1.168(i)-1.
    (b) Required use of single asset accounts. A taxpayer must account 
for an asset in a single asset account if the taxpayer uses the asset 
both in a trade or business or for the production of income and in a 
personal activity, or if the taxpayer places in service and disposes of 
the asset during the same taxable year. Also, if general asset account 
treatment for an asset terminates under Sec.  1.168(i)-1(c)(1)(ii)(A), 
(e)(3)(iii), (e)(3)(v), (e)(3)(vii), (g), or (h)(1), as applicable, the 
taxpayer must account for the asset in a single asset account beginning 
in the taxable year in which the general asset account treatment for the 
asset terminates. If a taxpayer accounts for an asset in a multiple 
asset account or a pool and the taxpayer disposes of the asset, the 
taxpayer must account for the asset in a single asset account beginning 
in the taxable year in which the disposition occurs. See Sec.  1.168(i)-
8(h)(2)(i). If a taxpayer disposes of a portion of an asset and Sec.  
1.168(i)-8(d)(1) applies to that disposition, the taxpayer must account 
for the disposed portion in a single asset account beginning in the 
taxable year in which the disposition occurs. See Sec.  1.168(i)-
8(h)(3)(i).
    (c) Establishment of multiple asset accounts or pools--(1) Assets 
eligible for multiple asset accounts or pools. Except as provided in 
paragraph (b) of this section, assets that are subject to either the 
general depreciation system of section 168(a) or the alternative 
depreciation system of section 168(g) may be accounted for in one or 
more multiple asset accounts or pools.
    (2) Grouping assets in multiple asset accounts or pools--(i) General 
rules. Assets that are eligible to be grouped into a single multiple 
asset account or pool may be divided into more than one multiple asset 
account or pool. Each multiple asset account or pool must include only 
assets that--
    (A) Have the same applicable depreciation method;
    (B) Have the same applicable recovery period;
    (C) Have the same applicable convention; and
    (D) Are placed in service by the taxpayer in the same taxable year.
    (ii) Special rules. In addition to the general rules in paragraph 
(c)(2)(i) of this section, the following rules apply when establishing 
multiple asset accounts or pools--
    (A) Assets subject to the mid-quarter convention may only be grouped 
into a multiple asset account or pool with assets that are placed in 
service in the same quarter of the taxable year;
    (B) Assets subject to the mid-month convention may only be grouped 
into a multiple asset account or pool with assets that are placed in 
service in the same month of the taxable year;
    (C) Passenger automobiles for which the depreciation allowance is 
limited under section 280F(a) must be grouped into a separate multiple 
asset account or pool;
    (D) Assets not eligible for any additional first year depreciation 
deduction

[[Page 551]]

(including assets for which the taxpayer elected not to deduct the 
additional first year depreciation) provided by, for example, section 
168(k) through (n), 1400L(b), or 1400N(d), must be grouped into a 
separate multiple asset account or pool;
    (E) Assets eligible for the additional first year depreciation 
deduction may only be grouped into a multiple asset account or pool with 
assets for which the taxpayer claimed the same percentage of the 
additional first year depreciation (for example, 30 percent, 50 percent, 
or 100 percent);
    (F) Except for passenger automobiles described in paragraph 
(c)(2)(ii)(C) of this section, listed property (as defined in section 
280F(d)(4)) must be grouped into a separate multiple asset account or 
pool;
    (G) Assets for which the depreciation allowance for the placed-in-
service year is not determined by using an optional depreciation table 
(for further guidance, see section 8 of Rev. Proc. 87-57, 1987-2 CB 687, 
693 (see Sec.  601.601(d)(2) of this chapter)) must be grouped into a 
separate multiple asset account or pool; and
    (H) Mass assets (as defined in Sec.  1.168(i)-8(b)(3)) that are or 
will be subject to Sec.  1.168(i)-8(g)(2)(iii) (disposed of or converted 
mass asset is identified by a mortality dispersion table) must be 
grouped into a separate multiple asset account or pool.
    (d) Cross references. See Sec.  1.167(a)-7(c) for the records to be 
maintained by a taxpayer for each account. In addition, see Sec.  
1.168(i)-1(l)(3) for the records to be maintained by a taxpayer for each 
general asset account.
    (e) Effective/applicability dates--(1) In general. This section 
applies to taxable years beginning on or after January 1, 2014.
    (2) Early application of this section. A taxpayer may choose to 
apply the provisions of this section to taxable years beginning on or 
after January 1, 2012.
    (3) Early application of regulation project REG-110732-13. A 
taxpayer may rely on the provisions of this section in regulation 
project REG-110732-13 (2013-43 IRB 404) (see Sec.  601.601(d)(2) of this 
chapter) for taxable years beginning on or after January 1, 2012. 
However, a taxpayer may not rely on the provisions of this section in 
regulation project REG-110732-13 for taxable years beginning on or after 
January 1, 2014.
    (4) Optional application of TD 9564. A taxpayer may choose to apply 
Sec.  1.168(i)-7T as contained in 26 CFR part 1 edition revised as of 
April 1, 2013, to taxable years beginning on or after January 1, 2012. 
However, a taxpayer may not apply Sec.  1.168(i)-7T as contained in 26 
CFR part 1 edition revised as of April 1, 2013, to taxable years 
beginning on or after January 1, 2014.
    (5) Change in method of accounting. A change to comply with this 
section for depreciable assets placed in service in a taxable year 
ending on or after December 30, 2003, is a change in method of 
accounting to which the provisions of section 446(e) and the regulations 
under section 446(e) apply. A taxpayer also may treat a change to comply 
with this section for depreciable assets placed in service in a taxable 
year ending before December 30, 2003, as a change in method of 
accounting to which the provisions of section 446(e) and the regulations 
under section 446(e) apply.

[T.D. 9636, 78 FR 57707, Sept. 19, 2013, as amended by T.D. 9689, 79 FR 
48678, Aug. 18, 2014; 79 FR 78697, Dec. 31, 2014]



Sec.  1.168(i)-8  Dispositions of MACRS property.

    (a) Scope. This section provides rules applicable to dispositions of 
MACRS property (as defined in Sec.  1.168(b)-1(a)(2)) or to depreciable 
property (as defined in Sec.  1.168(b)-1(a)(1)) that would be MACRS 
property but for an election made by the taxpayer either to expense all 
or some of the property's cost under section 179, section 179A, section 
179B, section 179C, section 179D, or section 1400I(a)(1), or any similar 
provision, or to amortize all or some of the property's cost under 
section 1400I(a)(2) or any similar provision. This section also applies 
to dispositions described in paragraph (d)(1) of this section of a 
portion of such property. Except as provided in Sec.  1.168(i)-1(e)(3), 
this section does not apply to dispositions of assets included in a 
general asset account. For rules applicable to dispositions of assets 
included in a general asset account, see Sec.  1.168(i)-1(e).

[[Page 552]]

    (b) Definitions. For purposes of this section--
    (1) Building has the same meaning as that term is defined in Sec.  
1.48-1(e)(1).
    (2) Disposition occurs when ownership of the asset is transferred or 
when the asset is permanently withdrawn from use either in the 
taxpayer's trade or business or in the production of income. A 
disposition includes the sale, exchange, retirement, physical 
abandonment, or destruction of an asset. A disposition also occurs when 
an asset is transferred to a supplies, scrap, or similar account, or 
when a portion of an asset is disposed of as described in paragraph 
(d)(1) of this section. If a structural component, or a portion thereof, 
of a building is disposed of in a disposition described in paragraph 
(d)(1) of this section, a disposition also includes the disposition of 
such structural component or such portion thereof.
    (3) Mass assets is a mass or group of individual items of 
depreciable assets--
    (i) That are not necessarily homogenous;
    (ii) Each of which is minor in value relative to the total value of 
the mass or group;
    (iii) Numerous in quantity;
    (iv) Usually accounted for only on a total dollar or quantity basis;
    (v) With respect to which separate identification is impracticable; 
and
    (vi) Placed in service in the same taxable year.
    (4) Portion of an asset is any part of an asset that is less than 
the entire asset as determined under paragraph (c)(4) of this section.
    (5) Structural component has the same meaning as that term is 
defined in Sec.  1.48-1(e)(2).
    (6) Unadjusted depreciable basis of the multiple asset account or 
pool is the sum of the unadjusted depreciable bases (as defined in Sec.  
1.168(b)-1(a)(3)) of all assets included in the multiple asset account 
or pool.
    (c) Special rules--(1) Manner of disposition. The manner of 
disposition (for example, normal retirement, abnormal retirement, 
ordinary retirement, or extraordinary retirement) is not taken into 
account in determining whether a disposition occurs or gain or loss is 
recognized.
    (2) Disposition by transfer to a supplies account. If a taxpayer 
made an election under Sec.  1.162-3(d) to treat the cost of any rotable 
spare part, temporary spare part, or standby emergency spare part (as 
defined in Sec.  1.162-3(c)) as a capital expenditure subject to the 
allowance for depreciation, the taxpayer can dispose of the rotable, 
temporary, or standby emergency spare part by transferring it to a 
supplies account only if the taxpayer has obtained the consent of the 
Commissioner to revoke the Sec.  1.162-3(d) election. If a taxpayer made 
an election under Sec.  1.162-3T(d) to treat the cost of any material 
and supply (as defined in Sec.  1.162-3T(c)(1)) as a capital expenditure 
subject to the allowance for depreciation, the taxpayer can dispose of 
the material and supply by transferring it to a supplies account only if 
the taxpayer has obtained the consent of the Commissioner to revoke the 
Sec.  1.162-3T(d) election. See Sec.  1.162-3(d)(3) for the procedures 
for revoking a Sec.  1.162-3(d) or a Sec.  1.162-3T(d) election.
    (3) Leasehold improvements. This section also applies to--
    (i) A lessor of leased property that made an improvement to that 
property for the lessee of the property, has a depreciable basis in the 
improvement, and disposes of the improvement, or disposes of a portion 
of the improvement under paragraph (d)(1) of this section, before or 
upon the termination of the lease with the lessee. See section 
168(i)(8)(B); and
    (ii) A lessee of leased property that made an improvement to that 
property, has a depreciable basis in the improvement, and disposes of 
the improvement, or disposes of a portion of the improvement under 
paragraph (d)(1) of this section, before or upon the termination of the 
lease.
    (4) Determination of asset disposed of--(i) General rules. For 
purposes of applying this section, the facts and circumstances of each 
disposition are considered in determining what is the appropriate asset 
disposed of. The asset for disposition purposes may not consist of items 
placed in service by the taxpayer on different dates, without taking 
into account the applicable convention. For purposes of determining what 
is the appropriate asset disposed of, the unit of property determination

[[Page 553]]

under Sec.  1.263(a)-3(e) or in published guidance in the Internal 
Revenue Bulletin (see Sec.  601.601(d)(2) of this chapter) under section 
263(a) does not apply.
    (ii) Special rules. In addition to the general rules in paragraph 
(c)(4)(i) of this section, the following rules apply for purposes of 
applying this section:
    (A) Each building, including its structural components, is the 
asset, except as provided in Sec.  1.1250-1(a)(2)(ii) or in paragraph 
(c)(4)(ii)(B) or (D) of this section.
    (B) If a building has two or more condominium or cooperative units, 
each condominium or cooperative unit, including its structural 
components, is the asset, except as provided in Sec.  1.1250-1(a)(2)(ii) 
or in paragraph (c)(4)(ii)(D) of this section.
    (C) If a taxpayer properly includes an item in one of the asset 
classes 00.11 through 00.4 of Rev. Proc. 87-56 (1987-2 CB 674) (see 
Sec.  601.601(d)(2) of this chapter) or properly classifies an item in 
one of the categories under section 168(e)(3), except for a category 
that includes buildings or structural components (for example, retail 
motor fuels outlet, qualified leasehold improvement property, qualified 
restaurant property, and qualified retail improvement property), each 
item is the asset provided paragraph (c)(4)(ii)(D) of this section does 
not apply to the item. For example, each desk is the asset, each 
computer is the asset, and each qualified smart electric meter is the 
asset.
    (D) If the taxpayer places in service an improvement or addition to 
an asset after the taxpayer placed the asset in service, the improvement 
or addition and, if applicable, its structural components are a separate 
asset.
    (d) Disposition of a portion of an asset--(1) In general. For 
purposes of applying this section, a disposition includes a disposition 
of a portion of an asset as a result of a casualty event described in 
section 165, a disposition of a portion of an asset for which gain, 
determined without regard to section 1245 or section 1250, is not 
recognized in whole or in part under section 1031 or section 1033, a 
transfer of a portion of an asset in a transaction described in section 
168(i)(7)(B), or a sale of a portion of an asset, even if the taxpayer 
does not make the election under paragraph (d)(2)(i) of this section for 
that disposed portion. For other transactions, a disposition includes a 
disposition of a portion of an asset only if the taxpayer makes the 
election under paragraph (d)(2)(i) of this section for that disposed 
portion.
    (2) Partial disposition election--(i) In general. A taxpayer may 
make an election under this paragraph (d)(2) to apply this section to a 
disposition of a portion of an asset. If the asset is properly included 
in one of the asset classes 00.11 through 00.4 of Rev. Proc. 87-56, a 
taxpayer may make an election under this paragraph (d)(2) to apply this 
section to a disposition of a portion of such asset only if the taxpayer 
classifies the replacement portion of the asset under the same asset 
class as the disposed portion of the asset.
    (ii) Time and manner for making election--(A) Time for making 
election. Except as provided in paragraph (d)(2)(iii) or (iv) of this 
section, a taxpayer must make the election specified in paragraph 
(d)(2)(i) of this section by the due date, including extensions, of the 
original Federal tax return for the taxable year in which the portion of 
an asset is disposed of by the taxpayer.
    (B) Manner of making election. Except as provided in paragraph 
(d)(2)(iii) or (iv) of this section, a taxpayer must make the election 
specified in paragraph (d)(2)(i) of this section by applying the 
provisions of this section for the taxable year in which the portion of 
an asset is disposed of by the taxpayer, by reporting the gain, loss, or 
other deduction on the taxpayer's timely filed, including extensions, 
original Federal tax return for that taxable year, and, if the asset is 
properly included in one of the asset classes 00.11 through 00.4 of Rev. 
Proc. 87-56, by classifying the replacement portion of such asset under 
the same asset class as the disposed portion of the asset in the taxable 
year in which the replacement portion is placed in service by the 
taxpayer. Except as provided in paragraph (d)(2)(iii) or (iv)(B) of this 
section or except as otherwise expressly provided by other guidance 
published in the Internal Revenue Bulletin (see Sec.  601.601(d)(2) of 
this chapter), the election specified in paragraph (d)(2)(i) of this 
section may not be made through

[[Page 554]]

the filing of an application for change in accounting method.
    (iii) Special rule for subsequent Internal Revenue Service 
adjustment. This paragraph (d)(2)(iii) applies when a taxpayer deducted 
the amount paid or incurred for the replacement of a portion of an asset 
as a repair under Sec.  1.162-4, the taxpayer did not make the election 
specified in paragraph (d)(2)(i) of this section for the disposed 
portion of that asset within the time and in the manner under paragraph 
(d)(2)(ii) or (iv) of this section, and as a result of an examination of 
the taxpayer's Federal tax return, the Internal Revenue Service 
disallows the taxpayer's repair deduction for the amount paid or 
incurred for the replacement of the portion of that asset and instead 
capitalizes such amount under Sec.  1.263(a)-2 or Sec.  1.263(a)-3. If 
this paragraph (d)(2)(iii) applies, the taxpayer may make the election 
specified in paragraph (d)(2)(i) of this section for the disposition of 
the portion of the asset to which the Internal Revenue Service's 
adjustment pertains by filing an application for change in accounting 
method, provided the asset of which the disposed portion was a part is 
owned by the taxpayer at the beginning of the year of change (as defined 
for purposes of section 446(e)).
    (iv) Special rules for 2012 or 2013 returns. If, under paragraph 
(j)(2) of this section, a taxpayer chooses to apply the provisions of 
this section to a taxable year beginning on or after January 1, 2012, 
and ending on or before September 19, 2013 (applicable taxable year), 
and the taxpayer did not make the election specified in paragraph 
(d)(2)(i) of this section on its timely filed original Federal tax 
return for the applicable taxable year, including extensions, the 
taxpayer must make the election specified in paragraph (d)(2)(i) of this 
section for the applicable taxable year by filing either--
    (A) An amended Federal tax return for the applicable taxable year on 
or before 180 days from the due date including extensions of the 
taxpayer's Federal tax return for the applicable taxable year, 
notwithstanding that the taxpayer may not have extended the due date; or
    (B) An application for change in accounting method with the 
taxpayer's timely filed original Federal tax return for the first or 
second taxable year succeeding the applicable taxable year.
    (v) Revocation. A taxpayer may revoke the election specified in 
paragraph (d)(2)(i) of this section only by filing a request for a 
private letter ruling and obtaining the Commissioner's consent to revoke 
the election. The Commissioner may grant a request to revoke this 
election if the taxpayer acted reasonably and in good faith, and the 
revocation will not prejudice the interests of the Government. See 
generally Sec.  301.9100-3 of this chapter. The election specified in 
paragraph (d)(2)(i) of this section may not be revoked through the 
filing of an application for change in accounting method.
    (e) Gain or loss on dispositions. Solely for purposes of this 
paragraph (e), the term asset is an asset within the scope of this 
section or the portion of such asset that is disposed of in a 
disposition described in paragraph (d)(1) of this section. Except as 
provided by section 280B and Sec.  1.280B-1, the following rules apply 
when an asset is disposed of during a taxable year:
    (1) If an asset is disposed of by sale, exchange, or involuntary 
conversion, gain or loss must be recognized under the applicable 
provisions of the Internal Revenue Code.
    (2) If an asset is disposed of by physical abandonment, loss must be 
recognized in the amount of the adjusted depreciable basis (as defined 
in Sec.  1.168(b)-1(a)(4)) of the asset at the time of the abandonment, 
taking into account the applicable convention. However, if the abandoned 
asset is subject to nonrecourse indebtedness, paragraph (e)(1) of this 
section applies to the asset instead of this paragraph (e)(2). For a 
loss from physical abandonment to qualify for recognition under this 
paragraph (e)(2), the taxpayer must intend to discard the asset 
irrevocably so that the taxpayer will neither use the asset again nor 
retrieve it for sale, exchange, or other disposition.
    (3) If an asset is disposed of other than by sale, exchange, 
involuntary conversion, physical abandonment, or conversion to personal 
use (as, for example, when the asset is transferred to a supplies or 
scrap account), gain is not recognized. Loss must be recognized in

[[Page 555]]

the amount of the excess of the adjusted depreciable basis of the asset 
at the time of the disposition, taking into account the applicable 
convention, over the asset's fair market value at the time of the 
disposition, taking into account the applicable convention.
    (f) Basis of asset disposed of--(1) In general. The adjusted basis 
of an asset disposed of for computing gain or loss is its adjusted 
depreciable basis at the time of the asset's disposition, as determined 
under the applicable convention for the asset.
    (2) Assets disposed of are in multiple asset accounts. (i) If the 
taxpayer accounts for the asset disposed of in a multiple asset account 
or pool and it is impracticable from the taxpayer's records to determine 
the unadjusted depreciable basis (as defined in Sec.  1.168(b)-1(a)(3)) 
of the asset disposed of, the taxpayer may use any reasonable method 
that is consistently applied to all assets in the same multiple asset 
account or pool for purposes of determining the unadjusted depreciable 
basis of assets disposed of. Examples of a reasonable method include, 
but are not limited to, the following:
    (A) If the replacement asset is a restoration (as defined in Sec.  
1.263(a)-3(k)), and is not a betterment (as defined in Sec.  1.263(a)-
3(j)) or an adaptation to a new or different use (as defined in Sec.  
1.263(a)-3(l)), discounting the cost of the replacement asset to its 
placed-in-service year cost using the Producer Price Index for Finished 
Goods or its successor, the Producer Price Index for Final Demand, or 
any other index designated by guidance in the Internal Revenue Bulletin 
(see Sec.  601.601(d)(2) of this chapter) for purposes of this paragraph 
(f)(2);
    (B) A pro rata allocation of the unadjusted depreciable basis of the 
multiple asset account or pool based on the replacement cost of the 
disposed asset and the replacement cost of all of the assets in the 
multiple asset account or pool; and
    (C) A study allocating the cost of the asset to its individual 
components.
    (ii) To determine the adjusted depreciable basis of an asset 
disposed of in a multiple asset account or pool, the depreciation 
allowable for the asset disposed of is computed by using the 
depreciation method, recovery period, and convention applicable to the 
multiple asset account or pool in which the asset disposed of was 
included and by including the additional first year depreciation 
deduction claimed for the asset disposed of.
    (3) Disposition of a portion of an asset. (i) This paragraph (f)(3) 
applies only when a taxpayer disposes of a portion of an asset and 
paragraph (d)(1) of this section applies to that disposition. For 
computing gain or loss, the adjusted basis of the disposed portion of 
the asset is the adjusted depreciable basis of that disposed portion at 
the time of its disposition, as determined under the applicable 
convention for the asset. If it is impracticable from the taxpayer's 
records to determine the unadjusted depreciable basis (as defined in 
Sec.  1.168(b)-1(a)(3)) of the disposed portion of the asset, the 
taxpayer may use any reasonable method for purposes of determining the 
unadjusted depreciable basis (as defined in Sec.  1.168(b)-1(a)(3)) of 
the disposed portion of the asset. If a taxpayer disposes of more than 
one portion of the same asset and it is impracticable from the 
taxpayer's records to determine the unadjusted depreciable basis (as 
defined in Sec.  1.168(b)-1(a)(3)) of the first disposed portion of the 
asset, the reasonable method used by the taxpayer must be consistently 
applied to all portions of the same asset for purposes of determining 
the unadjusted depreciable basis of each disposed portion of the asset. 
If the asset, a portion of which is disposed of, is in a multiple asset 
account or pool and it is impracticable from the taxpayer's records to 
determine the unadjusted depreciable basis (as defined in Sec.  
1.168(b)-1(a)(3)) of the disposed portion of the asset, the reasonable 
method used by the taxpayer must be consistently applied to all assets 
in the same multiple asset account or pool for purposes of determining 
the unadjusted depreciable basis of assets disposed of or any disposed 
portion of the assets. Examples of a reasonable method include, but are 
not limited to, the following:
    (A) If the replacement portion is a restoration (as defined in Sec.  
1.263(a)-3(k)), and is not a betterment (as defined in Sec.  1.263(a)-
3(j)) or an adaptation

[[Page 556]]

to a new or different use (as defined in Sec.  1.263(a)-3(l)), 
discounting the cost of the replacement portion of the asset to its 
placed-in-service year cost using the Producer Price Index for Finished 
Goods or its successor, the Producer Price Index for Final Demand, or 
any other index designated by guidance in the Internal Revenue Bulletin 
(see Sec.  601.601(d)(2) of this chapter) for purposes of this paragraph 
(f)(3);
    (B) A pro rata allocation of the unadjusted depreciable basis of the 
asset based on the replacement cost of the disposed portion of the asset 
and the replacement cost of the asset; and
    (C) A study allocating the cost of the asset to its individual 
components.
    (ii) To determine the adjusted depreciable basis of the disposed 
portion of the asset, the depreciation allowable for the disposed 
portion is computed by using the depreciation method, recovery period, 
and convention applicable to the asset in which the disposed portion was 
included and by including the portion of the additional first year 
depreciation deduction claimed for the asset that is attributable to the 
disposed portion.
    (g) Identification of asset disposed of--(1) In general. Except as 
provided in paragraph (g)(2) or (3) of this section, a taxpayer must use 
the specific identification method of accounting to identify which asset 
is disposed of by the taxpayer. Under this method of accounting, the 
taxpayer can determine the particular taxable year in which the asset 
disposed of was placed in service by the taxpayer.
    (2) Asset disposed of is in a multiple asset account. If a taxpayer 
accounts for the asset disposed of in a multiple asset account or pool 
and the total dispositions of assets with the same recovery period 
during the taxable year are readily determined from the taxpayer's 
records, but it is impracticable from the taxpayer's records to 
determine the particular taxable year in which the asset disposed of was 
placed in service by the taxpayer, the taxpayer must identify the asset 
disposed of by using--
    (i) A first-in, first-out method of accounting if the unadjusted 
depreciable basis of the asset disposed of cannot be readily determined 
from the taxpayer's records. Under this method of accounting, the 
taxpayer identifies the multiple asset account or pool with the earliest 
placed-in-service year that has the same recovery period as the asset 
disposed of and that has assets at the beginning of the taxable year of 
the disposition, and the taxpayer treats the asset disposed of as being 
from that multiple asset account or pool;
    (ii) A modified first-in, first-out method of accounting if the 
unadjusted depreciable basis of the asset disposed of can be readily 
determined from the taxpayer's records. Under this method of accounting, 
the taxpayer identifies the multiple asset account or pool with the 
earliest placed-in-service year that has the same recovery period as the 
asset disposed of and that has assets at the beginning of the taxable 
year of the disposition with the same unadjusted depreciable basis as 
the asset disposed of, and the taxpayer treats the asset disposed of as 
being from that multiple asset account or pool;
    (iii) A mortality dispersion table if the asset disposed of is a 
mass asset. The mortality dispersion table must be based upon an 
acceptable sampling of the taxpayer's actual disposition experience for 
mass assets or other acceptable statistical or engineering techniques. 
To use a mortality dispersion table, the taxpayer must adopt 
recordkeeping practices consistent with the taxpayer's prior practices 
and consonant with good accounting and engineering practices; or
    (iv) Any other method as the Secretary may designate by publication 
in the Federal Register or in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2) of this chapter) on or after September 19, 2013. See 
paragraph (g)(4) of this section regarding the last-in, first-out method 
of accounting.
    (3) Disposition of a portion of an asset. If a taxpayer disposes of 
a portion of an asset and paragraph (d)(1) of this section applies to 
that disposition, but it is impracticable from the taxpayer's records to 
determine the particular taxable year in which the asset was placed in 
service, the taxpayer must identify the asset by using any applicable 
method provided in paragraph (g)(2) of this section, after taking into 
account paragraph (g)(4) of this section.

[[Page 557]]

    (4) Last-in, first-out method of accounting. For purposes of this 
paragraph (g), a last-in, first-out method of accounting may not be 
used. Examples of a last-in, first-out method of accounting include the 
taxpayer identifying the multiple asset account or pool with the most 
recent placed-in-service year that has the same recovery period as the 
asset disposed of and that has assets at the beginning of the taxable 
year of the disposition, and the taxpayer treating the asset disposed of 
as being from that multiple asset account or pool, or the taxpayer 
treating the disposed portion of an asset as being from an asset with 
the most recent placed-in-service year that is the same as the asset of 
which the disposed portion is a part.
    (h) Accounting for asset disposed of--(1) Depreciation ends. 
Depreciation ends for an asset at the time of the asset's disposition, 
as determined under the applicable convention for the asset. See Sec.  
1.167(a)-10(b). If the asset disposed of is in a single asset account 
initially or as a result of Sec.  1.168(i)-8(h)(2)(i), Sec.  1.168(i)-
8(h)(3)(i), or general asset account treatment for the asset terminated 
under Sec.  1.168(i)-1(c)(1)(ii)(A), (e)(3)(iii), (e)(3)(v), 
(e)(3)(vii), (g), or (h)(1), as applicable, the single asset account 
terminates at the time of the asset's disposition, as determined under 
the applicable convention for the asset. If a taxpayer disposes of a 
portion of an asset and paragraph (d)(1) of this section applies to that 
disposition, depreciation ends for that disposed portion of the asset at 
the time of the disposition of the disposed portion, as determined under 
the applicable convention for the asset.
    (2) Asset disposed of in a multiple asset account or pool. If the 
taxpayer accounts for the asset disposed of in a multiple asset account 
or pool, then--
    (i) As of the first day of the taxable year in which the disposition 
occurs, the asset disposed of is removed from the multiple asset account 
or pool and is placed into a single asset account. See Sec.  1.168(i)-
7(b);
    (ii) The unadjusted depreciable basis of the multiple asset account 
or pool must be reduced by the unadjusted depreciable basis of the asset 
disposed of as of the first day of the taxable year in which the 
disposition occurs. See paragraph (f)(2)(i) of this section for 
determining the unadjusted depreciable basis of the asset disposed of;
    (iii) The depreciation reserve of the multiple asset account or pool 
must be reduced by the greater of the depreciation allowed or allowable 
for the asset disposed of as of the end of the taxable year immediately 
preceding the year of disposition. The allowable depreciation is 
computed by using the depreciation method, recovery period, and 
convention applicable to the multiple asset account or pool in which the 
asset disposed of was included and by including the additional first 
year depreciation deduction claimed for the asset disposed of; and
    (iv) In determining the adjusted depreciable basis of the asset 
disposed of at the time of disposition, taking into account the 
applicable convention, the depreciation allowable for the asset disposed 
of is computed by using the depreciation method, recovery period, and 
convention applicable to the multiple asset account or pool in which the 
asset disposed of was included and by including the additional first 
year depreciation deduction claimed for the asset disposed of.
    (3) Disposition of a portion of an asset. This paragraph (h)(3) 
applies only when a taxpayer disposes of a portion of an asset and 
paragraph (d)(1) of this section applies to that disposition. In this 
case--
    (i) As of the first day of the taxable year in which the disposition 
occurs, the disposed portion is placed into a single asset account. See 
Sec.  1.168(i)-7(b);
    (ii) The unadjusted depreciable basis of the asset must be reduced 
by the unadjusted depreciable basis of the disposed portion as of the 
first day of the taxable year in which the disposition occurs. See 
paragraph (f)(3)(i) of this section for determining the unadjusted 
depreciable basis of the disposed portion;
    (iii) The depreciation reserve of the asset must be reduced by the 
greater of the depreciation allowed or allowable for the disposed 
portion as of the end of the taxable year immediately preceding the year 
of disposition. The allowable depreciation is computed by using the 
depreciation method, recovery period, and convention applicable

[[Page 558]]

to the asset in which the disposed portion was included and by including 
the portion of the additional first year depreciation deduction claimed 
for the asset that is attributable to the disposed portion; and
    (iv) In determining the adjusted depreciable basis of the disposed 
portion at the time of disposition, taking into account the applicable 
convention, the depreciation allowable for the disposed portion is 
computed by using the depreciation method, recovery period, and 
convention applicable to the asset in which the disposed portion was 
included and by including the portion of the additional first year 
depreciation deduction claimed for the asset that is attributable to the 
disposed portion.
    (i) Examples. The application of this section is illustrated by the 
following examples:

    Example 1. A owns an office building with four elevators. A replaces 
one of the elevators. The elevator is a structural component of the 
office building. In accordance with paragraph (c)(4)(ii)(A) of this 
section, the office building, including its structural components, is 
the asset for disposition purposes. A does not make the partial 
disposition election provided under paragraph (d)(2) of this section for 
the elevator. Thus, the retirement of the replaced elevator is not a 
disposition. As a result, depreciation continues for the cost of the 
building, including the cost of the retired elevator and the building's 
other structural components, and A does not recognize a loss for this 
retired elevator. If A must capitalize the amount paid for the 
replacement elevator pursuant to Sec.  1.263(a)-3, the replacement 
elevator is a separate asset for disposition purposes pursuant to 
paragraph (c)(4)(ii)(D) of this section and for depreciation purposes 
pursuant to section 168(i)(6).
    Example 2. The facts are the same as in Example 1, except A accounts 
for each structural component of the office building as a separate asset 
in its fixed asset system. Although A treats each structural component 
as a separate asset in its records, the office building, including its 
structural components, is the asset for disposition purposes in 
accordance with paragraph (c)(4)(ii)(A) of this section. Accordingly, 
the result is the same as in Example 1.
    Example 3. The facts are the same as in Example 1, except A makes 
the partial disposition election provided under paragraph (d)(2) of this 
section for the elevator. Although the office building, including its 
structural components, is the asset for disposition purposes, the result 
of A making the partial disposition election for the elevator is that 
the retirement of the replaced elevator is a disposition. Thus, 
depreciation for the retired elevator ceases at the time of its 
retirement, taking into account the applicable convention, and A 
recognizes a loss upon this retirement. Further, A must capitalize the 
amount paid for the replacement elevator pursuant to Sec.  1.263(a)-
3(k)(1)(i), and the replacement elevator is a separate asset for 
disposition purposes pursuant to paragraph (c)(4)(ii)(D) of this section 
and for depreciation purposes pursuant to section 168(i)(6).
    Example 4. B, a calendar-year commercial airline company, owns 
several aircraft that are used in the commercial carrying of passengers 
and described in asset class 45.0 of Rev. Proc. 87-56. B replaces the 
existing engines on one of the aircraft with new engines. Assume each 
aircraft is a unit of property as determined under Sec.  1.263(a)-
3(e)(3) and each engine of an aircraft is a major component or 
substantial structural part of the aircraft as determined under Sec.  
1.263(a)-3(k)(6). Assume also that B treats each aircraft as the asset 
for disposition purposes in accordance with paragraph (c)(4) of this 
section. B makes the partial disposition election provided under 
paragraph (d)(2) of this section for the engines in the aircraft. 
Although the aircraft is the asset for disposition purposes, the result 
of B making the partial disposition election for the engines is that the 
retirement of the replaced engines is a disposition. Thus, depreciation 
for the retired engines ceases at the time of their retirement, taking 
into account the applicable convention, and B recognizes a loss upon 
this retirement. Further, B must capitalize the amount paid for the 
replacement engines pursuant to Sec.  1.263(a)-3(k)(1)(i), and the 
replacement engines are a separate asset for disposition purposes 
pursuant to paragraph (c)(4)(ii)(D) of this section and for depreciation 
purposes pursuant to section 168(i)(6).
    Example 5. The facts are the same as in Example 4, except B does not 
make the partial disposition election provided under paragraph (d)(2) of 
this section for the engines. Thus, the retirement of the replaced 
engines on one of the aircraft is not a disposition. As a result, 
depreciation continues for the cost of the aircraft, including the cost 
of the retired engines, and B does not recognize a loss for these 
retired engines. If B must capitalize the amount paid for the 
replacement engines pursuant to Sec.  1.263(a)-3, the replacement 
engines are a separate asset for disposition purposes pursuant to 
paragraph (c)(4)(ii)(D) of this section and for depreciation purposes 
pursuant to section 168(i)(6).
    Example 6. C, a corporation, owns several trucks that are used in 
its trade or business and described in asset class 00.241 of Rev. Proc. 
87-56. C replaces the engine on one of the trucks with a new engine. 
Assume each truck is a unit of property as determined

[[Page 559]]

under Sec.  1.263(a)-3(e)(3) and each engine is a major component or 
substantial structural part of the truck as determined under Sec.  
1.263(a)-3(k)(6). Because the trucks are described in asset class 00.241 
of Rev. Proc. 87-56, C must treat each truck as the asset for 
disposition purposes. C does not make the partial disposition election 
provided under paragraph (d)(2) of this section for the engine. Thus, 
the retirement of the replaced engine on the truck is not a disposition. 
As a result, depreciation continues for the cost of the truck, including 
the cost of the retired engine, and C does not recognize a loss for this 
retired engine. If C must capitalize the amount paid for the replacement 
engine pursuant to Sec.  1.263(a)-3, the replacement engine is a 
separate asset for disposition purposes pursuant to paragraph 
(c)(4)(ii)(D) of this section and for depreciation purposes pursuant to 
section 168(i)(6).
    Example 7. D owns a retail building. D replaces 60% of the roof of 
this building. In accordance with paragraph (c)(4)(ii)(A) of this 
section, the retail building, including its structural components, is 
the asset for disposition purposes. Assume D must capitalize the costs 
incurred for replacing 60% of the roof pursuant to Sec.  1.263(a)-
3(k)(1)(vi). D makes the partial disposition election provided under 
paragraph (d)(2) of this section for the 60% of the replaced roof. Thus, 
the retirement of 60% of the roof is a disposition. As a result, 
depreciation for 60% of the roof ceases at the time of its retirement, 
taking into account the applicable convention, and D recognizes a loss 
upon this retirement. Further, D must capitalize the amount paid for the 
60% of the roof pursuant to Sec.  1.263(a)-3(k)(1)(i) and (vi) and the 
replacement 60% of the roof is a separate asset for disposition purposes 
pursuant to paragraph (c)(4)(ii)(D) of this section and for depreciation 
purposes pursuant to section 168(i)(6).
    Example 8. (i) The facts are the same as in Example 7. Ten years 
after replacing 60% of the roof, D replaces 55% of the roof of the 
building. In accordance with paragraph (c)(4)(ii)(A) and (D) of this 
section, for disposition purposes, the retail building, including its 
structural components, except the replacement 60% of the roof, is an 
asset and the replacement 60% of the roof is a separate asset. Assume D 
must capitalize the costs incurred for replacing 55% of the roof 
pursuant to Sec.  1.263(a)-3(k)(1)(vi). D makes the partial disposition 
election provided under paragraph (d)(2) of this section for the 55% of 
the replaced roof. Thus, the retirement of 55% of the roof is a 
disposition.
    (ii) However, D cannot determine from its records whether the 
replaced 55% is part of the 60% of the roof replaced ten years ago or 
whether the replaced 55% includes part or all of the remaining 40% of 
the original roof. Pursuant to paragraph (g)(3) of this section, D 
identifies which asset it disposed of by using the first-in, first-out 
method of accounting. As a result, D disposed of the remaining 40% of 
the original roof and 25% of the 60% of the roof replaced ten years ago.
    (iii) Thus, depreciation for the remaining 40% of the original roof 
ceases at the time of its retirement, taking into account the applicable 
convention, and D recognizes a loss upon this retirement. Further, 
depreciation for 25% of the 60% of the roof replaced ten years ago 
ceases at the time of its retirement, taking into account the applicable 
convention, and D recognizes a loss upon this retirement. Also, D must 
capitalize the amount paid for the 55% of the roof pursuant to Sec.  
1.263(a)-3(k)(1)(i) and (vi), and the replacement 55% of the roof is a 
separate asset for disposition purposes pursuant to paragraph 
(c)(4)(ii)(D) of this section and for depreciation purposes pursuant to 
section 168(i)(6).
    Example 9. (i) On July 1, 2011, E, a calendar-year taxpayer, 
purchased and placed in service an existing multi-story office building 
that costs $20,000,000. The cost of each structural component of the 
building was not separately stated. E accounts for the building and its 
structural components in its tax and financial accounting records as a 
single asset with a cost of $20,000,000. E depreciates the building as 
nonresidential real property and uses the optional depreciation table 
that corresponds with the general depreciation system, the straight-line 
method, a 39-year recovery period, and the mid-month convention. As of 
January 1, 2014, the depreciation reserve for the building is 
$1,261,000.
    (ii) On June 30, 2014, E replaces one of the two elevators in the 
office building. E did not dispose of any other structural components of 
this building in 2014 and prior years. E makes the partial disposition 
election provided under paragraph (d)(2) of this section for this 
elevator. Although the office building, including its structural 
components, is the asset for disposition purposes, the result of E 
making the partial disposition election for the elevator is that the 
retirement of the replaced elevator is a disposition. Assume the 
replacement elevator is a restoration under Sec.  1.263(a)-3(k), and not 
a betterment under Sec.  1.263(a)-3(j) or an adaptation to a new or 
different use under Sec.  1.263(a)-3(l). Because E cannot identify the 
cost of the elevator from its records and the replacement elevator is a 
restoration under Sec.  1.263(a)-3(k), E determines the cost of the 
disposed elevator by discounting the cost of the replacement elevator to 
its placed-in-service year cost using the Producer Price Index for Final 
Demand. Using this reasonable method, E determines the cost of the 
retired elevator by discounting the cost of the replacement elevator to 
its cost in 2011 (the placed-in-service year) using the Producer Price 
Index for Final Demand, resulting in $150,000 of the $20,000,000 
purchase price for the building to

[[Page 560]]

be the cost of the retired elevator. Using the optional depreciation 
table that corresponds with the general depreciation system, the 
straight-line method, a 39-year recovery period, and the mid-month 
convention, the depreciation allowed or allowable for the retired 
elevator as of December 31, 2013, is $9,458.
    (iii) For E's 2014 Federal tax return, the loss for the retired 
elevator is determined as follows. The depreciation allowed or allowable 
for 2014 for the retired elevator is $1,763 ((unadjusted depreciable 
basis of $150,000 x depreciation rate of 2.564% for 2014) x 5.5/12 
months). Thus, the adjusted depreciable basis of the retired elevator is 
$138,779 (the adjusted depreciable basis of $140,542 removed from the 
building cost less the depreciation allowed or allowable of $1,763 for 
2014). As a result, E recognizes a loss of $138,779 for the retired 
elevator in 2014.
    (iv) For E's 2014 Federal tax return, the depreciation allowance for 
the building is computed as follows. As of January 1, 2014, the 
unadjusted depreciable basis of the building is reduced from $20,000,000 
to $19,850,000 ($20,000,000 less the unadjusted depreciable basis of 
$150,000 for the retired elevator), and the depreciation reserve of the 
building is reduced from $1,261,000 to $1,251,542 ($1,261,000 less the 
depreciation allowed or allowable of $9,458 for the retired elevator as 
of December 31, 2013). Consequently, the depreciation allowance for the 
building for 2014 is $508,954 ($19,850,000 x depreciation rate of 2.564% 
for 2014).
    (v) E also must capitalize the amount paid for the replacement 
elevator pursuant to Sec.  1.263(a)-3(k)(1). The replacement elevator is 
a separate asset for disposition purposes pursuant to paragraph 
(c)(4)(ii)(D) of this section and for depreciation purposes pursuant to 
section 168(i)(6).
    Example 10. (i) Since 2005, F, a calendar year taxpayer, has 
accounted for items of MACRS property that are mass assets in pools. 
Each pool includes only the mass assets that have the same depreciation 
method, recovery period, and convention, and are placed in service by F 
in the same taxable year. None of the pools are general asset accounts 
under section 168(i)(4) and the regulations under section 168(i)(4). F 
identifies any dispositions of these mass assets by specific 
identification.
    (ii) During 2014, F sells 10 items of mass assets with a 5-year 
recovery period each for $100. Under the specific identification method, 
F identifies these mass assets as being from the pool established by F 
in 2012 for mass assets with a 5-year recovery period. Assume F 
depreciates this pool using the optional depreciation table that 
corresponds with the general depreciation system, the 200-percent 
declining balance method, a 5-year recovery period, and the half-year 
convention. F elected not to deduct the additional first year 
depreciation provided by section 168(k) for 5-year property placed in 
service during 2012. As of January 1, 2014, this pool contains 100 
similar items of mass assets with a total cost of $25,000 and a total 
depreciation reserve of $13,000. Because all the items of mass assets in 
the pool are similar, F allocates the cost and depreciation allowed or 
allowable for the pool ratably among each item in the pool. This 
allocation is a reasonable method because all the items of mass assets 
in the pool are similar. Using this reasonable method, F allocates a 
cost of $250 ($25,000 x (1/100)) to each disposed of mass asset and 
depreciation allowed or allowable of $130 ($13,000 x (1/100)) to each 
disposed of mass asset. The depreciation allowed or allowable in 2014 
for each disposed of mass asset is $24 (($250 x 19.2%)/2). As a result, 
the adjusted depreciable basis of each disposed of mass asset under 
section 1011 is $96 ($250 - $130 - $24). Thus, F recognizes a gain of $4 
for each disposed of mass asset in 2014, which is subject to section 
1245.
    (iii) Further, as of January 1, 2014, the unadjusted depreciable 
basis of the 2012 pool of mass assets with a 5-year recovery period is 
reduced from $25,000 to $22,500 ($25,000 less the unadjusted depreciable 
basis of $2,500 for the 10 disposed of items), and the depreciation 
reserve of this 2012 pool is reduced from $13,000 to $11,700 ($13,000 
less the depreciation allowed or allowable of $1,300 for the 10 disposed 
of items as of December 31, 2013). Consequently, as of January 1, 2014, 
the 2012 pool of mass assets with a 5-year recovery period has 90 items 
with a total cost of $22,500 and a depreciation reserve of $11,700. 
Thus, the depreciation allowance for this pool for 2014 is $4,320 
($22,500 x 19.2%).
    Example 11. (i) The facts are the same as in Example 10. Because of 
changes in F's recordkeeping in 2015, it is impracticable for F to 
continue to identify disposed of mass assets using specific 
identification and to determine the unadjusted depreciable basis of the 
disposed of mass assets. As a result, F files a Form 3115, Application 
for Change in Accounting Method, to change to a first-in, first-out 
method beginning with the taxable year beginning on January 1, 2015, on 
a modified cut-off basis. See Sec.  1.446-1(e)(2)(ii)(d)(2)(vii). Under 
the first-in, first-out method, the mass assets disposed of in a taxable 
year are deemed to be from the pool with the earliest placed-in-service 
year that has assets as of the beginning of the taxable year of the 
disposition with the same recovery period as the asset disposed of. The 
Commissioner of Internal Revenue consents to this change in method of 
accounting.
    (ii) During 2015, F sells 20 items of mass assets with a 5-year 
recovery period each for $50. As of January 1, 2015, the 2008 pool is 
the pool with the earliest placed-in-service year for mass assets with a 
5-year recovery period, and this pool contains 25 items of mass

[[Page 561]]

assets with a total cost of $10,000 and a total depreciation reserve of 
$10,000. Thus, F allocates a cost of $400 ($10,000 x (1/25)) to each 
disposed of mass asset and depreciation allowed or allowable of $400 to 
each disposed of mass asset. As a result, the adjusted depreciable basis 
of each disposed of mass asset is $0. Thus, F recognizes a gain of $50 
for each disposed of mass asset in 2015, which is subject to section 
1245.
    (iii) Further, as of January 1, 2015, the unadjusted depreciable 
basis of the 2008 pool of mass assets with a 5-year recovery period is 
reduced from $10,000 to $2,000 ($10,000 less the unadjusted depreciable 
basis of $8,000 for the 20 disposed of items ($400 x 20)), and the 
depreciation reserve of this 2008 pool is reduced from $10,000 to $2,000 
($10,000 less the depreciation allowed or allowable of $8,000 for the 20 
disposed of items as of December 31, 2014). Consequently, as of January 
1, 2015, the 2008 pool of mass assets with a 5-year recovery period has 
5 items with a total cost of $2,000 and a depreciation reserve of 
$2,000.

    (j) Effective/applicability dates--(1) In general. This section 
applies to taxable years beginning on or after January 1, 2014.
    (2) Early application of this section. A taxpayer may choose to 
apply the provisions of this section to taxable years beginning on or 
after January 1, 2012.
    (3) Early application of regulation project REG-110732-13. A 
taxpayer may rely on the provisions of this section in regulation 
project REG-110732-13 (2013-43 IRB 404) (see Sec.  601.601(d)(2) of this 
chapter) for taxable years beginning on or after January 1, 2012. 
However, a taxpayer may not rely on the provisions of this section in 
regulation project REG-110732-13 for taxable years beginning on or after 
January 1, 2014.
    (4) Optional application of TD 9564. A taxpayer may choose to apply 
Sec.  1.168(i)-8T as contained in 26 CFR part 1 edition revised as of 
April 1, 2014, to taxable years beginning on or after January 1, 2012. 
However, a taxpayer may not apply Sec.  1.168(i)-8T as contained in 26 
CFR part 1 edition revised as of April 1, 2014, to taxable years 
beginning on or after January 1, 2014.
    (5) Change in method of accounting. A change to comply with this 
section for depreciable assets placed in service in a taxable year 
ending on or after December 30, 2003, is a change in method of 
accounting to which the provisions of section 446(e) and the regulations 
under section 446(e) apply. A taxpayer also may treat a change to comply 
with this section for depreciable assets placed in service in a taxable 
year ending before December 30, 2003, as a change in method of 
accounting to which the provisions of section 446(e) and the regulations 
under section 446(e) apply. This paragraph (j)(5) does not apply to a 
change to comply with paragraph (d)(2) of this section, except as 
provided in paragraph (d)(2)(iii) or (iv)(B) of this section or 
otherwise provided by other guidance published in the Internal Revenue 
Bulletin (see Sec.  601.601(d)(2) of this chapter).

[T.D. 9689, 79 FR 48678, Aug. 18, 2014, as amended at 79 FR 78697, Dec. 
31, 2014]



Sec.  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. Sec.  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:

[[Page 562]]



                          40-Year Straight Line Method (Assuming Mid-Month Convention)
----------------------------------------------------------------------------------------------------------------
                                And the month in the first recovery year the property is placed in service is--
  If the recovery year is--  -----------------------------------------------------------------------------------
                                1      2      3      4      5      6      7      8      9      10     11     12
----------------------------------------------------------------------------------------------------------------
                                                    The applicable recovery percentage is--
                             -----------------------------------------------------------------------------------
 1..........................    2.4    2.2    2.0    1.8    1.6    1.4    1.1    0.9    0.7    0.5    0.3    0.1
 2..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
 3..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
 4..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
 5..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
 6..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
 7..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
 8..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
 9..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
10..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
11..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
12..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
13..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
14..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
15..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
16..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
17..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
18..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
19..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
20..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
21..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
22..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
23..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
24..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
25..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
26..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
27..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
28..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
29..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
30..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
31..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
32..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
33..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
34..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
35..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
36..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
37..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
38..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
39..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
40..........................    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5    2.5
41..........................    0.1    0.3    0.5    0.7    0.9    1.1    1.4    1.6    1.8    2.0    2.2    2.4
----------------------------------------------------------------------------------------------------------------

    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. Sec.  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).


[[Page 563]]


    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 x $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. Sec.  
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             $9.00
 percentage for second recovery year ($100 x .09..............
Excess allowable recovery deduction multiplied by the              -1.03
 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) (($11 x .09)/.96)..............
                                                               ---------
Difference--allowable deduction for 1984......................     $7.97
                                                               =========
Unadjusted basis multiplied by the applicable recovery             $9.00
 percentage for third recovery year ($100 x .09)..............
Excess allowable recovery deduction multiplied by the              -1.03
 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) (($11 x .09)/.96)..............
                                                               ---------
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:

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[GRAPHIC] [TIFF OMITTED] TC05OC91.040


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 lease 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

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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

[[Page 566]]

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. Sec.  301.9100-6T(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)?

[[Page 567]]

    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

[[Page 568]]

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

[[Page 569]]

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

[[Page 570]]

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 33\1/3\ 
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, 33\1/3\ percent of the building 
and 33\1/3\ 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 33\1/3\ 
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

[[Page 571]]

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

[[Page 572]]

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.

[[Page 573]]

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

[[Page 574]]

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.

[T.D. 8033, 50 FR 27224, July 2, 1985, as amended by T.D. 8435, 57 FR 
43896, Sept. 23, 1992]



Sec.  1.168(k)-0  Table of contents.

    This section lists the headings that appear in Sec.  1.168(k)-1.

     Sec.  1.168(k)-1 Additional first year depreciation deduction.

    (a) Scope and definitions.
    (1) Scope.
    (2) Definitions.
    (b) Qualified property or 50-percent bonus depreciation property.
    (1) In general.
    (2) Description of qualified property or 50-percent bonus 
depreciation property.
    (i) In general.
    (ii) Property not eligible for additional first year depreciation 
deduction.
    (A) Property that is not qualified property.
    (B) Property that is not 50-percent bonus depreciation property.
    (3) Original use.
    (i) In general.
    (ii) Conversion to business or income-producing use.
    (A) Personal use to business or income-producing use.
    (B) Inventory to business or income-producing use.
    (iii) Sale-leaseback, syndication, and certain other transactions.
    (A) Sale-leaseback transaction.
    (B) Syndication transaction and certain other transactions.
    (C) Sale-leaseback transaction followed by a syndication transaction 
and certain other transactions.
    (iv) Fractional interests in property.
    (v) Examples.
    (4) Acquisition of property.
    (i) In general.
    (A) Qualified property.
    (B) 50-percent bonus depreciation property.
    (ii) Definition of binding contract.
    (A) In general.
    (B) Conditions.
    (C) Options.
    (D) Supply agreements.
    (E) Components.
    (iii) Self-constructed property.
    (A) In general.
    (B) When does manufacture, construction, or production begin.
    (1) In general.
    (2) Safe harbor.

[[Page 575]]

    (C) Components of self-constructed property.
    (1) Acquired components.
    (2) Self-constructed components.
    (iv) Disqualified transactions.
    (A) In general.
    (B) Related party defined.
    (v) Examples.
    (5) Placed-in-service date.
    (i) In general.
    (ii) Sale-leaseback, syndication, and certain other transactions.
    (A) Sale-leaseback transaction.
    (B) Syndication transaction and certain other transactions.
    (C) Sale-leaseback transaction followed by a syndication transaction 
and certain other transactions.
    (iii) Technical termination of a partnership.
    (iv) Section 168(i)(7) transactions.
    (v) Example.
    (c) Qualified leasehold improvement property.
    (1) In general.
    (2) Certain improvements not included.
    (3) Definitions.
    (d) Computation of depreciation deduction for qualified property or 
50-percent bonus depreciation property.
    (1) Additional first year depreciation deduction.
    (i) In general.
    (ii) Property having a longer production period.
    (iii) Alternative minimum tax.
    (2) Otherwise allowable depreciation deduction.
    (i) In general.
    (ii) Alternative minimum tax.
    (3) Examples.
    (e) Election not to deduct additional first year depreciation.
    (1) In general.
    (i) Qualified property.
    (ii) 50-percent bonus depreciation property.
    (2) Definition of class of property.
    (3) Time and manner for making election.
    (i) Time for making election.
    (ii) Manner of making election.
    (4) Special rules for 2000 or 2001 returns.
    (5) Failure to make election.
    (6) Alternative minimum tax.
    (7) Revocation.
    (i) In general.
    (ii) Automatic 6-month extension.
    (f) Special rules.
    (1) Property placed in service and disposed of in the same taxable 
year.
    (i) In general.
    (ii) Technical termination of a partnership.
    (iii) Section 168(i)(7) transactions.
    (iv) Examples.
    (2) Redetermination of basis.
    (i) Increase in basis.
    (ii) Decrease in basis.
    (iii) Definition.
    (iv) Examples.
    (3) Section 1245 and 1250 depreciation recapture.
    (4) Coordination with section 169.
    (5) Like-kind exchanges and involuntary conversions.
    (i) Scope.
    (ii) Definitions.
    (iii) Computation.
    (A) In general.
    (B) Year of disposition and year of replacement.
    (C) Property having a longer production period.
    (D) Alternative minimum tax.
    (iv) Sale-leasebacks.
    (v) Acquired MACRS property or acquired computer software that is 
acquired and placed in service before disposition of involuntarily 
converted MACRS property or involuntarily converted computer software.
    (A) Time of replacement.
    (B) Depreciation of acquired MACRS property or acquired computer 
software.
    (vi) Examples.
    (6) Change in use.
    (i) Change in use of depreciable property.
    (ii) Conversion to personal use.
    (iii) Conversion to business or income-producing use.
    (A) During the same taxable year.
    (B) Subsequent to the acquisition year.
    (iv) Depreciable property changes use subsequent to the placed-in-
service year.
    (v) Examples.
    (7) Earnings and profits.
    (8) Limitation of amount of depreciation for certain passenger 
automobiles.
    (9) Section 754 election.
    (10) Coordination with section 47.
    (11) Coordination with section 514(a)(3).
    (g) Effective date.
    (1) In general.
    (2) Technical termination of a partnership or section 168(i)(7) 
transactions.
    (3) Like-kind exchanges and involuntary conversions.
    (4) Change in method of accounting.
    (i) Special rules for 2000 or 2001 returns.
    (ii) Like-kind exchanges and involuntary conversions.
    (5) Revisions to paragraphs (b)(3)(ii)(B) and (b)(5)(ii)(B).
    (6) Rehabilitation credit.

[T.D. 9091, 68 FR 52991, Sept. 8, 2003. Redesignated and amended by T.D. 
9283, 71 FR 51738, Aug. 31, 2006]



Sec.  1.168(k)-1  Additional first year depreciation deduction.

    (a) Scope and definitions--(1) Scope. This section provides the 
rules for determining the 30-percent additional first year depreciation 
deduction allowable under section 168(k)(1) for

[[Page 576]]

qualified property and the 50-percent additional first year depreciation 
deduction allowable under section 168(k)(4) for 50-percent bonus 
depreciation property.
    (2) Definitions. For purposes of section 168(k) and this section, 
the following definitions apply:
    (i) Depreciable property is property that is of a character subject 
to the allowance for depreciation as determined under section 167 and 
the regulations thereunder.
    (ii) MACRS property is tangible, depreciable property that is placed 
in service after December 31, 1986 (or after July 31, 1986, if the 
taxpayer made an election under section 203(a)(1)(B) of the Tax Reform 
Act of 1986; 100 Stat. 2143) and subject to section 168, except for 
property excluded from the application of section 168 as a result of 
section 168(f) or as a result of a transitional rule.
    (iii) Unadjusted depreciable basis is the basis of property for 
purposes of section 1011 without regard to any adjustments described in 
section 1016(a)(2) and (3). This basis reflects the reduction in basis 
for the percentage of the taxpayer's use of property for the taxable 
year other than in the taxpayer's trade or business (or for the 
production of income), for any portion of the basis the taxpayer 
properly elects to treat as an expense under section 179 or section 
179C, and for any adjustments to basis provided by other provisions of 
the Internal Revenue Code and the regulations thereunder (other than 
section 1016(a)(2) and (3)) (for example, a reduction in basis by the 
amount of the disabled access credit pursuant to section 44(d)(7)). For 
property subject to a lease, see section 167(c)(2).
    (iv) Adjusted depreciable basis is the unadjusted depreciable basis 
of the property, as defined in Sec.  1.168(k)-1(a)(2)(iii), less the 
adjustments described in section 1016(a)(2) and (3).
    (b) Qualified property or 50-percent bonus depreciation property--
(1) In general. Qualified property or 50-percent bonus depreciation 
property is depreciable property that meets all the following 
requirements in the first taxable year in which the property is subject 
to depreciation by the taxpayer whether or not depreciation deductions 
for the property are allowable:
    (i) The requirements in Sec.  1.168(k)-1(b)(2) (description of 
property);
    (ii) The requirements in Sec.  1.168(k)-1(b)(3) (original use);
    (iii) The requirements in Sec.  1.168(k)-1(b)(4) (acquisition of 
property); and
    (iv) The requirements in Sec.  1.168(k)-1(b)(5) (placed-in-service 
date).
    (2) Description of qualified property or 50-percent bonus 
depreciation property--(i) In general. Depreciable property will meet 
the requirements of this paragraph (b)(2) if the property is--
    (A) MACRS property (as defined in Sec.  1.168(k)-1(a)(2)(ii)) that 
has a recovery period of 20 years or less. For purposes of this 
paragraph (b)(2)(i)(A) and section 168(k)(2)(B)(i)(II) and 168(k)(4)(C), 
the recovery period is determined in accordance with section 168(c) 
regardless of any election made by the taxpayer under section 168(g)(7);
    (B) Computer software as defined in, and depreciated under, section 
167(f)(1) and the regulations thereunder;
    (C) Water utility property as defined in section 168(e)(5) and 
depreciated under section 168; or
    (D) Qualified leasehold improvement property as defined in paragraph 
(c) of this section and depreciated under section 168.
    (ii) Property not eligible for additional first year depreciation 
deduction--(A) Property that is not qualified property. For purposes of 
the 30-percent additional first year depreciation deduction, depreciable 
property will not meet the requirements of this paragraph (b)(2) if the 
property is--
    (1) Described in section 168(f);
    (2) Required to be depreciated under the alternative depreciation 
system of section 168(g) pursuant to section 168(g)(1)(A) through (D) or 
other provisions of the Internal Revenue Code (for example, property 
described in section 263A(e)(2)(A) if the taxpayer (or any related 
person as defined in section 263A(e)(2)(B)) has made an election under 
section 263A(d)(3), or property described in section 280F(b)(1)).
    (3) Included in any class of property for which the taxpayer elects 
not to deduct the 30-percent additional first

[[Page 577]]

year depreciation (for further guidance, see paragraph (e) of this 
section); or
    (4) Qualified New York Liberty Zone leasehold improvement property 
as defined in section 1400L(c)(2).
    (B) Property that is not 50-percent bonus depreciation property. For 
purposes of the 50-percent additional first year depreciation deduction, 
depreciable property will not meet the requirements of this paragraph 
(b)(2) if the property is--
    (1) Described in paragraph (b)(2)(ii)(A)(1), (2), or (4) of this 
section; or
    (2) Included in any class of property for which the taxpayer elects 
the 30-percent, instead of the 50-percent, additional first year 
depreciation deduction or elects not to deduct any additional first year 
depreciation (for further guidance, see paragraph (e) of this section).
    (3) Original use--(i) In general. For purposes of the 30-percent 
additional first year depreciation deduction, depreciable property will 
meet the requirements of this paragraph (b)(3) if the original use of 
the property commences with the taxpayer after September 10, 2001. For 
purposes of the 50-percent additional first year depreciation deduction, 
depreciable property will meet the requirements of this paragraph (b)(3) 
if the original use of the property commences with the taxpayer after 
May 5, 2003. Except as provided in paragraphs (b)(3)(iii) and (iv) of 
this section, original use means the first use to which the property is 
put, whether or not that use corresponds to the use of the property by 
the taxpayer. Thus, additional capital expenditures incurred by a 
taxpayer to recondition or rebuild property acquired or owned by the 
taxpayer satisfies the original use requirement. However, the cost of 
reconditioned or rebuilt property does not satisfy the original use 
requirement. The question of whether property is reconditioned or 
rebuilt property is a question of fact. For purposes of this paragraph 
(b)(3)(i), property that contains used parts will not be treated as 
reconditioned or rebuilt if the cost of the used parts is not more than 
20 percent of the total cost of the property, whether acquired or self-
constructed.
    (ii) Conversion to business or income-producing use--(A) Personal 
use to business or income-producing use. If a taxpayer initially 
acquires new property for personal use and subsequently uses the 
property in the taxpayer's trade or business or for the taxpayer's 
production of income, the taxpayer is considered the original user of 
the property. If a person initially acquires new property for personal 
use and a taxpayer subsequently acquires the property from the person 
for use in the taxpayer's trade or business or for the taxpayer's 
production of income, the taxpayer is not considered the original user 
of the property.
    (B) Inventory to business or income-producing use. If a taxpayer 
initially acquires new property and holds the property primarily for 
sale to customers in the ordinary course of the taxpayer's business and 
subsequently withdraws the property from inventory and uses the property 
primarily in the taxpayer's trade or business or primarily for the 
taxpayer's production of income, the taxpayer is considered the original 
user of the property. If a person initially acquires new property and 
holds the property primarily for sale to customers in the ordinary 
course of the person's business and a taxpayer subsequently acquires the 
property from the person for use primarily in the taxpayer's trade or 
business or primarily for the taxpayer's production of income, the 
taxpayer is considered the original user of the property. For purposes 
of this paragraph (b)(3)(ii)(B), the original use of the property by the 
taxpayer commences on the date on which the taxpayer uses the property 
primarily in the taxpayer's trade or business or primarily for the 
taxpayer's production of income.
    (iii) Sale-leaseback, syndication, and certain other transactions--
(A) Sale-leaseback transaction. If new property is originally placed in 
service by a person after September 10, 2001 (for qualified property), 
or after May 5, 2003 (for 50-percent bonus depreciation property), and 
is sold to a taxpayer and leased back to the person by the taxpayer 
within three months after the date the

[[Page 578]]

property was originally placed in service by the person, the taxpayer-
lessor is considered the original user of the property.
    (B) Syndication transaction and certain other transactions. If new 
property is originally placed in service by a lessor (including by 
operation of paragraph (b)(5)(ii)(A) of this section) after September 
10, 2001 (for qualified property), or after May 5, 2003 (for 50-percent 
bonus depreciation property), and is sold by the lessor or any 
subsequent purchaser within three months after the date the property was 
originally placed in service by the lessor (or, in the case of multiple 
units of property subject to the same lease, within three months after 
the date the final unit is placed in service, so long as the period 
between the time the first unit is placed in service and the time the 
last unit is placed in service does not exceed 12 months), and the user 
of the property after the last sale during the three-month period 
remains the same as when the property was originally placed in service 
by the lessor, the purchaser of the property in the last sale during the 
three-month period is considered the original user of the property.
    (C) Sale-leaseback transaction followed by a syndication transaction 
and certain other transactions. If a sale-leaseback transaction that 
satisfies the requirements in paragraph (b)(3)(iii)(A) of this section 
is followed by a transaction that satisfies the requirements in 
paragraph (b)(3)(iii)(B) of this section, the original user of the 
property is determined in accordance with paragraph (b)(3)(iii)(B) of 
this section.
    (iv) Fractional interests in property. If, in the ordinary course of 
its business, a taxpayer sells fractional interests in property to third 
parties unrelated to the taxpayer, each first fractional owner of the 
property is considered as the original user of its proportionate share 
of the property. Furthermore, if the taxpayer uses the property before 
all of the fractional interests of the property are sold but the 
property continues to be held primarily for sale by the taxpayer, the 
original use of any fractional interest sold to a third party unrelated 
to the taxpayer subsequent to the taxpayer's use of the property begins 
with the first purchaser of that fractional interest. For purposes of 
this paragraph (b)(3)(iv), persons are not related if they do not have a 
relationship described in section 267(b) or 707(b) and the regulations 
thereunder.
    (v) Examples. The application of this paragraph (b)(3) is 
illustrated by the following examples:

    Example 1. On August 1, 2002, A buys from B for $20,000 a machine 
that has been previously used by B in B's trade or business. On March 1, 
2003, A makes a $5,000 capital expenditure to recondition the machine. 
The $20,000 purchase price does not qualify for the additional first 
year depreciation deduction because the original use requirement of this 
paragraph (b)(3) is not met. However, the $5,000 expenditure satisfies 
the original use requirement of this paragraph (b)(3) and, assuming all 
other requirements are met, qualifies for the 30-percent additional 
first year depreciation deduction, regardless of whether the $5,000 is 
added to the basis of the machine or is capitalized as a separate asset.
    Example 2. C, an automobile dealer, uses some of its automobiles as 
demonstrators in order to show them to prospective customers. The 
automobiles that are used as demonstrators by C are held by C primarily 
for sale to customers in the ordinary course of its business. On 
September 1, 2002, D buys from C an automobile that was previously used 
as a demonstrator by C. D will use the automobile solely for business 
purposes. The use of the automobile by C as a demonstrator does not 
constitute a ``use'' for purposes of the original use requirement and, 
therefore, D will be considered the original user of the automobile for 
purposes of this paragraph (b)(3). Assuming all other requirements are 
met, D's purchase price of the automobile qualifies for the 30-percent 
additional first year depreciation deduction for D, subject to any 
limitation under section 280F.
    Example 3. On April 1, 2000, E acquires a horse to be used in E's 
thoroughbred racing business. On October 1, 2003, F buys the horse from 
E and will use the horse in F's horse breeding business. The use of the 
horse by E in its racing business prevents the original use of the horse 
from commencing with F. Thus, F's purchase price of the horse does not 
qualify for the additional first year depreciation deduction.
    Example 4. In the ordinary course of its business, G sells 
fractional interests in its aircraft to unrelated parties. G holds out 
for sale eight equal fractional interests in an aircraft. On January 1, 
2003, G sells five of the eight fractional interests in the aircraft to 
H, an unrelated party, and H begins to use its proportionate share of 
the aircraft immediately upon purchase. On June 1, 2003, G

[[Page 579]]

sells to I, an unrelated party to G, the remaining unsold \3/8\ 
fractional interests in the aircraft. H is considered the original user 
as to its \5/8\ fractional interest in the aircraft and I is considered 
the original user as to its \3/8\ fractional interest in the aircraft. 
Thus, assuming all other requirements are met, H's purchase price for 
its \5/8\ fractional interest in the aircraft qualifies for the 30-
percent additional first year depreciation deduction and I's purchase 
price for its \3/8\ fractional interest in the aircraft qualifies for 
the 50-percent additional first year depreciation deduction.
    Example 5. On September 1, 2001, JJ, an equipment dealer, buys new 
tractors that are held by JJ primarily for sale to customers in the 
ordinary course of its business. On October 15, 2001, JJ withdraws the 
tractors from inventory and begins to use the tractors primarily for 
producing rental income. The holding of the tractors by JJ as inventory 
does not constitute a ``use'' for purposes of the original use 
requirement and, therefore, the original use of the tractors commences 
with JJ on October 15, 2001, for purposes of paragraph (b)(3) of this 
section. However, the tractors are not eligible for the additional first 
year depreciation deduction because JJ acquired the tractors before 
September 11, 2001.

    (4) Acquisition of property--(i) In general--(A) Qualified property. 
For purposes of the 30-percent additional first year depreciation 
deduction, depreciable property will meet the requirements of this 
paragraph (b)(4) if the property is--
    (1) Acquired by the taxpayer after September 10, 2001, and before 
January 1, 2005, but only if no written binding contract for the 
acquisition of the property was in effect before September 11, 2001; or
    (2) Acquired by the taxpayer pursuant to a written binding contract 
that was entered into after September 10, 2001, and before January 1, 
2005.
    (B) 50-percent bonus depreciation property. For purposes of the 50-
percent additional first year depreciation deduction, depreciable 
property will meet the requirements of this paragraph (b)(4) if the 
property is--
    (1) Acquired by the taxpayer after May 5, 2003, and before January 
1, 2005, but only if no written binding contract for the acquisition of 
the property was in effect before May 6, 2003; or
    (2) Acquired by the taxpayer pursuant to a written binding contract 
that was entered into after May 5, 2003, and before January 1, 2005.
    (ii) Definition of binding contract--(A) In general. 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 (for 
example, by use of a liquidated damages provision). For this purpose, a 
contractual provision that limits damages to an amount equal to at least 
5 percent of the total contract price will not be treated as limiting 
damages to a specified amount. 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 written 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 asset 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 full 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.
    (B) Conditions. A contract is binding even if subject to a 
condition, as long as the condition is not within the control of either 
party or a predecessor. A contract will continue to be binding if the 
parties make insubstantial changes in its terms and conditions or 
because any term is to be determined by a standard beyond the control of 
either party. A contract that imposes significant obligations on the 
taxpayer or a predecessor will be treated as binding notwithstanding the 
fact that certain terms remain to be negotiated by the parties to the 
contract.
    (C) Options. An option to either acquire or sell property is not a 
binding contract.
    (D) Supply agreements. A binding contract does not include a supply 
or similar agreement if the amount and design specifications of the 
property to be purchased have not been specified. The contract will not 
be a binding contract for the property to be purchased until

[[Page 580]]

both the amount and the design specifications are specified. For 
example, if the provisions of a supply or similar agreement state the 
design specifications of the property to be purchased, a purchase order 
under the agreement for a specific number of assets is treated as a 
binding contract.
    (E) Components. A binding contract to acquire one or more components 
of a larger property will not be treated as a binding contract to 
acquire the larger property. If a binding contract to acquire the 
component does not satisfy the requirements of this paragraph (b)(4), 
the component does not qualify for the 30-percent or 50-percent 
additional first year depreciation deduction, as applicable.
    (iii) Self-constructed property--(A) In general. If a taxpayer 
manufactures, constructs, or produces property for use by the taxpayer 
in its trade or business (or for its production of income), the 
acquisition rules in paragraph (b)(4)(i) of this section are treated as 
met for qualified property if the taxpayer begins manufacturing, 
constructing, or producing the property after September 10, 2001, and 
before January 1, 2005, and for 50-percent bonus depreciation property 
if the taxpayer begins manufacturing, constructing, or producing the 
property after May 5, 2003, and before January 1, 2005. Property that is 
manufactured, constructed, or produced for the taxpayer by another 
person under a written binding contract (as defined in paragraph 
(b)(4)(ii) of this section) that is entered into prior to the 
manufacture, construction, or production of the property for use by the 
taxpayer in its trade or business (or for its production of income) is 
considered to be manufactured, constructed, or produced by the taxpayer. 
If a taxpayer enters into a written binding contract (as defined in 
paragraph (b)(4)(ii) of this section) after September 10, 2001, and 
before January 1, 2005, with another person to manufacture, construct, 
or produce property described in section 168(k)(2)(B) (longer production 
period property) or section 168(k)(2)(C) (certain aircraft) and the 
manufacture, construction, or production of this property begins after 
December 31, 2004, the acquisition rule in paragraph (b)(4)(i)(A)(2) or 
(b)(4)(i)(B)(2) of this section is met.
    (B) When does manufacture, construction, or production begin--(1) In 
general. For purposes of paragraph (b)(4)(iii) of this section, 
manufacture, construction, or production of property begins when 
physical work of a significant nature begins. Physical work does not 
include preliminary activities such as planning or designing, securing 
financing, exploring, or researching. The determination of when physical 
work of a significant nature begins depends on the facts and 
circumstances. For example, if a retail motor fuels outlet or other 
facility is to be constructed on-site, construction begins when physical 
work of a significant nature commences at the site; that is, when work 
begins on the excavation for footings, pouring the pads for the outlet, 
or the driving of foundation pilings into the ground. Preliminary work, 
such as clearing a site, test drilling to determine soil condition, or 
excavation to change the contour of the land (as distinguished from 
excavation for footings) does not constitute the beginning of 
construction. However, if a retail motor fuels outlet or other facility 
is to be assembled on-site from modular units manufactured off-site and 
delivered to the site where the outlet will be used, manufacturing 
begins when physical work of a significant nature commences at the off-
site location.
    (2) Safe harbor. For purposes of paragraph (b)(4)(iii)(B)(1) of this 
section, a taxpayer may choose to determine when physical work of a 
significant nature begins in accordance with this paragraph 
(b)(4)(iii)(B)(2). Physical work of a significant nature will not be 
considered to begin before the taxpayer incurs (in the case of an 
accrual basis taxpayer) or pays (in the case of a cash basis taxpayer) 
more than 10 percent of the total cost of the property (excluding the 
cost of any land and preliminary activities such as planning or 
designing, securing financing, exploring, or researching). When property 
is manufactured, constructed, or produced for the taxpayer by another 
person, this safe harbor test must be satisfied by the taxpayer. For 
example, if a retail motor fuels outlet or other facility is to be 
constructed for an accrual basis

[[Page 581]]

taxpayer by another person for the total cost of $200,000 (excluding the 
cost of any land and preliminary activities such as planning or 
designing, securing financing, exploring, or researching), construction 
is deemed to begin for purposes of this paragraph (b)(4)(iii)(B)(2) when 
the taxpayer has incurred more than 10 percent (more than $20,000) of 
the total cost of the property. A taxpayer chooses to apply this 
paragraph (b)(4)(iii)(B)(2) by filing an income tax return for the 
placed-in-service year of the property that determines when physical 
work of a significant nature begins consistent with this paragraph 
(b)(4)(iii)(B)(2).
    (C) Components of self-constructed property--(1) Acquired 
components. If a binding contract (as defined in paragraph (b)(4)(ii) of 
this section) to acquire a component does not satisfy the requirements 
of paragraph (b)(4)(i) of this section, the component does not qualify 
for the 30-percent or 50-percent additional first year depreciation 
deduction, as applicable. A binding contract (as defined in paragraph 
(b)(4)(ii) of this section) to acquire one or more components of a 
larger self-constructed property will not preclude the larger self-
constructed property from satisfying the acquisition rules in paragraph 
(b)(4)(iii)(A) of this section. Accordingly, the unadjusted depreciable 
basis of the larger self-constructed property that is eligible for the 
30-percent or 50-percent additional first year depreciation deduction, 
as applicable (assuming all other requirements are met), must not 
include the unadjusted depreciable basis of any component that does not 
satisfy the requirements of paragraph (b)(4)(i) of this section. If the 
manufacture, construction, or production of the larger self-constructed 
property begins before September 11, 2001, for qualified property, or 
before May 6, 2003, for 50-percent bonus depreciation property, the 
larger self-constructed property and any acquired components related to 
the larger self-constructed property do not qualify for the 30-percent 
or 50-percent additional first year depreciation deduction, as 
applicable. If a binding contract to acquire the component is entered 
into after September 10, 2001, for qualified property, or after May 5, 
2003, for 50-percent bonus depreciation property, and before January 1, 
2005, but the manufacture, construction, or production of the larger 
self-constructed property does not begin before January 1, 2005, the 
component qualifies for the additional first year depreciation deduction 
(assuming all other requirements are met) but the larger self-
constructed property does not.
    (2) Self-constructed components. If the manufacture, construction, 
or production of a component does not satisfy the requirements of 
paragraph (b)(4)(iii)(A) of this section, the component does not qualify 
for the 30-percent or 50-percent additional first year depreciation 
deduction, as applicable. However, if the manufacture, construction, or 
production of a component does not satisfy the requirements of paragraph 
(b)(4)(iii)(A) of this section, but the manufacture, construction, or 
production of the larger self-constructed property satisfies the 
requirements of paragraph (b)(4)(iii)(A) of this section, the larger 
self-constructed property qualifies for the 30-percent or 50-percent 
additional first year depreciation deduction, as applicable (assuming 
all other requirements are met) even though the component does not 
qualify for the 30-percent or 50-percent additional first year 
depreciation deduction. Accordingly, the unadjusted depreciable basis of 
the larger self-constructed property that is eligible for the 30-percent 
or 50-percent additional first year depreciation deduction, as 
applicable (assuming all other requirements are met), must not include 
the unadjusted depreciable basis of any component that does not qualify 
for the 30-percent or 50-percent additional first year depreciation 
deduction. If the manufacture, construction, or production of the larger 
self-constructed property began before September 11, 2001, for qualified 
property, or before May 6, 2003, for 50-percent bonus depreciation 
property, the larger self-constructed property and any self-constructed 
components related to the larger self-constructed property do not 
qualify for the 30-percent or 50-percent additional first

[[Page 582]]

year depreciation deduction, as applicable. If the manufacture, 
construction, or production of a component begins after September 10, 
2001, for qualified property, or after May 5, 2003, for 50-percent bonus 
depreciation property, and before January 1, 2005, but the manufacture, 
construction, or production of the larger self-constructed property does 
not begin before January 1, 2005, the component qualifies for the 
additional first year depreciation deduction (assuming all other 
requirements are met) but the larger self-constructed property does not.
    (iv) Disqualified transactions--(A) In general. Property does not 
satisfy the requirements of this paragraph (b)(4) if the user of the 
property as of the date on which the property was originally placed in 
service (including by operation of paragraphs (b)(5)(ii), (iii), and 
(iv) of this section), or a related party to the user or to the 
taxpayer, acquired, or had a written binding contract (as defined in 
paragraph (b)(4)(ii) of this section) in effect for the acquisition of 
the property at any time before September 11, 2001 (for qualified 
property), or before May 6, 2003 (for 50-percent bonus depreciation 
property). In addition, property manufactured, constructed, or produced 
for the use by the user of the property or by a related party to the 
user or to the taxpayer does not satisfy the requirements of this 
paragraph (b)(4) if the manufacture, construction, or production of the 
property for the user or the related party began at any time before 
September 11, 2001 (for qualified property), or before May 6, 2003 (for 
50-percent bonus depreciation property).
    (B) Related party defined. For purposes of this paragraph 
(b)(4)(iv), persons are related if they have a relationship specified in 
section 267(b) or 707(b) and the regulations thereunder.
    (v) Examples. The application of this paragraph (b)(4) is 
illustrated by the following examples:

    Example 1. On September 1, 2001, J, a corporation, entered into a 
written agreement with K, a manufacturer, to purchase 20 new lamps for 
$100 each within the next two years. Although the agreement specifies 
the number of lamps to be purchased, the agreement does not specify the 
design of the lamps to be purchased. Accordingly, the agreement is not a 
binding contract pursuant to paragraph (b)(4)(ii)(D) of this section.
    Example 2. Same facts as Example 1. On December 1, 2001, J placed a 
purchase order with K to purchase 20 new model XPC5 lamps for $100 each 
for a total amount of $2,000. Because the agreement specifies the number 
of lamps to be purchased and the purchase order specifies the design of 
the lamps to be purchased, the purchase order placed by J with K on 
December 1, 2001, is a binding contract pursuant to paragraph 
(b)(4)(ii)(D) of this section. Accordingly, the cost of the 20 lamps 
qualifies for the 30-percent additional first year depreciation 
deduction.
    Example 3. Same facts as Example 1 except that the written agreement 
between J and K is to purchase 100 model XPC5 lamps for $100 each within 
the next two years. Because this agreement specifies the amount and 
design of the lamps to be purchased, the agreement is a binding contract 
pursuant to paragraph (b)(4)(ii)(D) of this section. Accordingly, 
because the agreement was entered into before September 11, 2001, any 
lamp acquired by J under this contract does not qualify for the 
additional first year depreciation deduction.
    Example 4. On September 1, 2001, L began constructing an electric 
generation power plant for its own use. On November 1, 2002, L ceases 
construction of the power plant prior to its completion. Between 
September 1, 2001, and November 1, 2002, L incurred $3,000,000 for the 
construction of the power plant. On May 6, 2003, L resumed construction 
of the power plant and completed its construction on August 31, 2003. 
Between May 6, 2003, and August 31, 2003, L incurred another $1,600,000 
to complete the construction of the power plant and, on September 1, 
2003, L placed the power plant in service. None of L's total 
expenditures of $4,600,000 qualify for the additional first year 
depreciation deduction because, pursuant to paragraph (b)(4)(iii)(A) of 
this section, L began constructing the power plant before September 11, 
2001.
    Example 5. Same facts as Example 4 except that L began constructing 
the electric generation power plant for its own use on October 1, 2001. 
L's total expenditures of $4,600,000 qualify for the additional first 
year depreciation deduction because, pursuant to paragraph 
(b)(4)(iii)(A) of this section, L began constructing the power plant 
after September 10, 2001, and placed the power plant in service before 
January 1, 2005. Accordingly, the additional first year depreciation 
deduction for the power plant will be $1,380,000, computed as $4,600,000 
multiplied by 30 percent.
    Example 6. On August 1, 2001, M entered into a written binding 
contract to acquire a new turbine. The new turbine is a component part 
of a new electric generation power plant that is being constructed on 
M's behalf. The construction of the new electric generation

[[Page 583]]

power plant commenced in November 2001, and the new electric generation 
power plant was completed in November 2002. Because M entered into a 
written binding contract to acquire a component part (the new turbine) 
prior to September 11, 2001, pursuant to paragraph (b)(4)(iii)(C) of 
this section, the component part does not qualify for the additional 
first year depreciation deduction. However, pursuant to paragraphs 
(b)(4)(iii)(A) and (C) of this section, the new plant constructed for M 
will qualify for the 30-percent additional first year depreciation 
deduction because construction of the new plant began after September 
10, 2001, and before May 6, 2003. Accordingly, the unadjusted 
depreciable basis of the new plant that is eligible for the 30-percent 
additional first year depreciation deduction must not include the 
unadjusted depreciable basis of the new turbine.
    Example 7. Same facts as Example 6 except that M entered into the 
written binding contract to acquire the new turbine on September 30, 
2002, and construction of the new plant commenced on August 1, 2001. 
Because M began construction of the new plant prior to September 11, 
2001, pursuant to paragraphs (b)(4)(iii)(A) and (C) of this section, 
neither the new plant constructed for M nor the turbine will qualify for 
the additional first year depreciation deduction because self-
construction of the new plant began prior to September 11, 2001.
    Example 8. On September 1, 2001, N began constructing property for 
its own use. On October 1, 2001, N sold its rights to the property to O, 
a related party under section 267(b). Pursuant to paragraph (b)(4)(iv) 
of this section, the property is not eligible for the additional first 
year depreciation deduction because N and O are related parties and 
construction of the property by N began prior to September 11, 2001.
    Example 9. On September 1, 2001, P entered into a written binding 
contract to acquire property. On October 1, 2001, P sold its rights to 
the property to Q, a related party under section 267(b). Pursuant to 
paragraph (b)(4)(iv) of this section, the property is not eligible for 
the additional first year depreciation deduction because P and Q are 
related parties and a written binding contract for the acquisition of 
the property was in effect prior to September 11, 2001.
    Example 10. Prior to September 11, 2001, R began constructing an 
electric generation power plant for its own use. On May 1, 2003, prior 
to the completion of the power plant, R transferred the rights to own 
and use this power plant to S, an unrelated party, for $6,000,000. 
Between May 6, 2003, and June 30, 2003, S, a calendar-year taxpayer, 
began construction, and incurred another $1,200,000 to complete the 
construction, of the power plant and, on August 1, 2003, S placed the 
power plant in service. Because R and S are not related parties, the 
transaction between R and S will not be a disqualified transaction 
pursuant to paragraph (b)(4)(iv) of this section. Accordingly, S's total 
expenditures of $7,200,000 for the power plant qualify for the 
additional first year depreciation deduction. S's additional first year 
depreciation deduction for the power plant will be $2,400,000, computed 
as $6,000,000 multiplied by 30 percent, plus $1,200,000 multiplied by 50 
percent. The $6,000,000 portion of the total $7,200,000 unadjusted 
depreciable basis qualifies for the 30-percent additional first year 
depreciation deduction because that portion of the total unadjusted 
depreciable basis was acquired by S after September 10, 2001, and before 
May 6, 2003. However, because S began construction to complete the power 
plant after May 5, 2003, the $1,200,000 portion of the total $7,200,000 
unadjusted depreciable basis qualifies for the 50-percent additional 
first year depreciation deduction.
    Example 11. On September 1, 2001, T acquired and placed in service 
equipment. On October 15, 2001, T sells the equipment to U, an unrelated 
party, and leases the property back from U in a sale-leaseback 
transaction. Pursuant to paragraph (b)(4)(iv) of this section, the 
equipment does not qualify for the additional first year depreciation 
deduction because T, the user of the equipment, acquired the equipment 
prior to September 11, 2001. In addition, the sale-leaseback rules in 
paragraphs (b)(3)(iii)(A) and (b)(5)(ii)(A) of this section do not apply 
because the equipment was originally placed in service by T before 
September 11, 2001.
    Example 12. On July 1, 2001, KK began constructing property for its 
own use. KK placed this property in service on September 15, 2001. On 
October 15, 2001, KK sells the property to LL, an unrelated party, and 
leases the property back from LL in a sale-leaseback transaction. 
Pursuant to paragraph (b)(4)(iv) of this section, the property does not 
qualify for the additional first year depreciation deduction because the 
property was constructed for KK, the user of the property, and that 
construction began prior to September 11, 2001.
    Example 13. On June 1, 2004, MM decided to construct property 
described in section 168(k)(2)(B) for its own use. However, one of the 
component parts of the property had to be manufactured by another person 
for MM. On August 15, 2004, MM entered into a written binding contract 
with NN to acquire this component part of the property for $100,000. The 
manufacture of the component part commenced on September 1, 2004, and MM 
received the completed component part on February 1, 2005. The cost of 
this component part is 9 percent of the total cost of the property to be 
constructed by MM. MM began constructing the property described in 
section 168(k)(2)(B) on January 15, 2005, and placed this property 
(including all component parts) in service on November 1, 2005.

[[Page 584]]

Pursuant to paragraph (b)(4)(iii)(C)(2) of this section, the self-
constructed component part of $100,000 manufactured by NN for MM is 
eligible for the additional first year depreciation deduction (assuming 
all other requirements are met) because the manufacturing of the 
component part began after September 10, 2001, and before January 1, 
2005, and the property described in section 168(k)(2)(B), the larger 
self-constructed property, was placed in service by MM before January 1, 
2006. However, pursuant to paragraph (b)(4)(iii)(A) of this section, the 
cost of the property described in section 168(k)(2)(B) (excluding the 
cost of the self-constructed component part of $100,000 manufactured by 
NN for MM) is not eligible for the additional first year depreciation 
deduction because construction of the property began after December 31, 
2004.
    Example 14. On December 1, 2004, OO entered into a written binding 
contract (as defined in paragraph (b)(4)(ii) of this section) with PP to 
manufacture an aircraft described in section 168(k)(2)(C) for use in 
OO's trade or business. PP begins to manufacture the aircraft on 
February 1, 2005. OO places the aircraft in service on August 1, 2005. 
Pursuant to paragraph (b)(4)(iii)(A) of this section, the aircraft meets 
the requirements of paragraph (b)(4)(i)(B)(2) of this section because 
the aircraft was acquired by OO pursuant to a written binding contract 
entered into after May 5, 2003, and before January 1, 2005.

    (5) Placed-in-service date--(i) In general. Depreciable property 
will meet the requirements of this paragraph (b)(5) if the property is 
placed in service by the taxpayer for use in its trade or business or 
for production of income before January 1, 2005, or, in the case of 
property described in section 168(k)(2)(B) or (C), is placed in service 
by the taxpayer for use in its trade or business or for production of 
income before January 1, 2006 (or placed in service by the taxpayer for 
use in its trade or business or for production of income before January 
1, 2007, in the case of property described in section 168(k)(2)(B) or 
(C) to which section 105 of the Gulf Opportunity Zone Act of 2005 (Pub. 
L. 109-135, 119 Stat. 2577) applies (for further guidance, see 
Announcement 2006-29 (2006-19 I.R.B. 879) and Sec.  601.601(d)(2)(ii)(b) 
of this chapter)).
    (ii) Sale-leaseback, syndication, and certain other transactions--
(A) Sale-leaseback transaction. If qualified property is originally 
placed in service after September 10, 2001, or 50-percent bonus 
depreciation property is originally placed in service after May 5, 2003, 
by a person and sold to a taxpayer and leased back to the person by the 
taxpayer within three months after the date the property was originally 
placed in service by the person, the property is treated as originally 
placed in service by the taxpayer-lessor not earlier than the date on 
which the property is used by the lessee under the leaseback.
    (B) Syndication transaction and certain other transactions. If 
qualified property is originally placed in service after September 10, 
2001, or 50-percent bonus depreciation property is originally placed in 
service after May 5, 2003, by a lessor (including by operation of 
paragraph (b)(5)(ii)(A) of this section) and is sold by the lessor or 
any subsequent purchaser within three months after the date the property 
was originally placed in service by the lessor (or, in the case of 
multiple units of property subject to the same lease, within three 
months after the date the final unit is placed in service, so long as 
the period between the time the first unit is placed in service and the 
time the last unit is placed in service does not exceed 12 months), and 
the user of the property after the last sale during this three-month 
period remains the same as when the property was originally placed in 
service by the lessor, the property is treated as originally placed in 
service by the purchaser of the property in the last sale during the 
three-month period but not earlier than the date of the last sale.
    (C) Sale-leaseback transaction followed by a syndication transaction 
and certain other transactions. If a sale-leaseback transaction that 
satisfies the requirements in paragraph (b)(5)(ii)(A) of this section is 
followed by a transaction that satisfies the requirements in paragraph 
(b)(5)(ii)(B) of this section, the placed-in-service date of the 
property is determined in accordance with paragraph (b)(5)(ii)(B) of 
this section.
    (iii) Technical termination of a partnership. For purposes of this 
paragraph (b)(5), in the case of a technical termination of a 
partnership under section 708(b)(1)(B), qualified property or 50-percent 
bonus depreciation property placed in service by the terminated 
partnership during the taxable year of

[[Page 585]]

termination is treated as originally placed in service by the new 
partnership on the date the qualified property or the 50-percent bonus 
depreciation property is contributed by the terminated partnership to 
the new partnership.
    (iv) Section 168(i)(7) transactions. For purposes of this paragraph 
(b)(5), if qualified property or 50-percent bonus depreciation property 
is transferred in a transaction described in section 168(i)(7) in the 
same taxable year that the qualified property or the 50-percent bonus 
depreciation property is placed in service by the transferor, the 
transferred property is treated as originally placed in service on the 
date the transferor placed in service the qualified property or the 50-
percent bonus depreciation property, as applicable. In the case of 
multiple transfers of qualified property or 50-percent bonus 
depreciation property in multiple transactions described in section 
168(i)(7) in the same taxable year, the placed in service date of the 
transferred property is deemed to be the date on which the first 
transferor placed in service the qualified property or the 50-percent 
bonus depreciation property, as applicable.
    (v) Example. The application of this paragraph (b)(5) is illustrated 
by the following example:

    Example. On September 15, 2004, QQ acquired and placed in service 
new equipment. This equipment is not described in section 168(k)(2)(B) 
or (C). On December 1, 2004, QQ sells the equipment to RR and leases the 
equipment back from RR in a sale-leaseback transaction. On February 15, 
2005, RR sells the equipment to TT subject to the lease with QQ. As of 
February 15, 2005, QQ is still the user of the equipment. The sale-
leaseback transaction of December 1, 2004, between QQ and RR satisfies 
the requirements of paragraph (b)(5)(ii)(A) of this section. The sale 
transaction of February 15, 2005, between RR and TT satisfies the 
requirements of paragraph (b)(5)(ii)(B) of this section. Consequently, 
pursuant to paragraph (b)(5)(ii)(C) of this section, the equipment is 
treated as originally placed in service by TT on February 15, 2005. 
Further, pursuant to paragraph (b)(3)(iii)(C) of this section, TT is 
considered the original user of the equipment. Accordingly, the 
equipment is not eligible for the additional first year depreciation 
deduction.

    (c) Qualified leasehold improvement property--(1) In general. For 
purposes of section 168(k), qualified leasehold improvement property 
means any improvement, which is section 1250 property, to an interior 
portion of a building that is nonresidential real property if--
    (i) The improvement is made under or pursuant to a lease by the 
lessee (or any sublessee) of the interior portion, or by the lessor of 
that interior portion;
    (ii) The interior portion of the building is to be occupied 
exclusively by the lessee (or any sublessee) of that interior portion; 
and
    (iii) The improvement is placed in service more than 3 years after 
the date the building was first placed in service by any person.
    (2) Certain improvements not included. Qualified leasehold 
improvement property does not include any improvement for which the 
expenditure is attributable to:
    (i) The enlargement of the building;
    (ii) Any elevator or escalator;
    (iii) Any structural component benefiting a common area; or
    (iv) The internal structural framework of the building.
    (3) Definitions. For purposes of this paragraph (c), the following 
definitions apply:
    (i) Building has the same meaning as that term is defined in Sec.  
1.48-1(e)(1).
    (ii) Common area means any portion of a building that is equally 
available to all users of the building on the same basis for uses that 
are incidental to the primary use of the building. For example, 
stairways, hallways, lobbies, common seating areas, interior and 
exterior pedestrian walkways and pedestrian bridges, loading docks and 
areas, and rest rooms generally are treated as common areas if they are 
used by different lessees of a building.
    (iii) Elevator and escalator have the same meanings as those terms 
are defined in Sec.  1.48-1(m)(2).
    (iv) Enlargement has the same meaning as that term is defined in 
Sec.  1.48-12(c)(10).
    (v) Internal structural framework has the same meaning as that term 
is defined in Sec.  1.48-12(b)(3)(i)(D)(iii).

[[Page 586]]

    (vi) Lease has the same meaning as that term is defined in section 
168(h)(7). In addition, a commitment to enter into a lease is treated as 
a lease, and the parties to the commitment are treated as lessor and 
lessee. However, a lease between related persons is not considered a 
lease. For purposes of the preceding sentence, related persons are--
    (A) Members of an affiliated group (as defined in section 1504 and 
the regulations thereunder); and
    (B) Persons having a relationship described in section 267(b) and 
the regulations thereunder. For purposes of applying section 267(b), the 
language ``80 percent or more'' is used instead of ``more than 50 
percent.''
    (vii) Nonresidential real property has the same meaning as that term 
is defined in section 168(e)(2)(B).
    (viii) Structural component has the same meaning as that term is 
defined in Sec.  1.48-1(e)(2).
    (d) Computation of depreciation deduction for qualified property or 
50-percent bonus depreciation property--(1) Additional first year 
depreciation deduction--(i) In general. Except as provided in paragraph 
(f) of this section, the additional first year depreciation deduction is 
allowable in the first taxable year in which the qualified property or 
50-percent bonus depreciation property is placed in service by the 
taxpayer for use in its trade or business or for the production of 
income. Except as provided in paragraph (f)(5) of this section, the 
allowable additional first year depreciation deduction for qualified 
property is determined by multiplying the unadjusted depreciable basis 
(as defined in Sec.  1.168(k)-1(a)(2)(iii)) of the qualified property by 
30 percent. Except as provided in paragraph (f)(5) of this section, the 
allowable additional first year depreciation deduction for 50-percent 
bonus depreciation property is determined by multiplying the unadjusted 
depreciable basis (as defined in Sec.  1.168(k)-1(a)(2)(iii)) of the 50-
percent bonus depreciation property by 50 percent. Except as provided in 
paragraph (f)(1) of this section, the 30-percent or 50-percent 
additional first year depreciation deduction is not affected by a 
taxable year of less than 12 months. See paragraph (f)(1) of this 
section for qualified property or 50-percent bonus depreciation property 
placed in service and disposed of in the same taxable year. See 
paragraph (f)(5) of this section for qualified property or 50-percent 
bonus depreciation property acquired in a like-kind exchange or as a 
result of an involuntary conversion.
    (ii) Property having a longer production period. For purposes of 
paragraph (d)(1)(i) of this section, the unadjusted depreciable basis 
(as defined in Sec.  1.168(k)-1(a)(2)(iii)) of qualified property or 50-
percent bonus depreciation property described in section 168(k)(2)(B) is 
limited to the property's unadjusted depreciable basis attributable to 
the property's manufacture, construction, or production after September 
10, 2001 (for qualified property), or May 5, 2003 (for 50-percent bonus 
depreciation property), and before January 1, 2005.
    (iii) Alternative minimum tax. The 30-percent or 50-percent 
additional first year depreciation deduction is allowed for alternative 
minimum tax purposes for the taxable year in which the qualified 
property or the 50-percent bonus depreciation property is placed in 
service by the taxpayer. In general, the 30-percent or 50-percent 
additional first year depreciation deduction for alternative minimum tax 
purposes is based on the unadjusted depreciable basis of the property 
for alternative minimum tax purposes. However, see paragraph 
(f)(5)(iii)(D) of this section for qualified property or 50-percent 
bonus depreciation property acquired in a like-kind exchange or as a 
result of an involuntary conversion.
    (2) Otherwise allowable depreciation deduction. (i) In general. 
Before determining the amount otherwise allowable as a depreciation 
deduction for the qualified property or the 50-percent bonus 
depreciation property for the placed-in-service year and any subsequent 
taxable year, the taxpayer must determine the remaining adjusted 
depreciable basis of the qualified property or the 50-percent bonus 
depreciation property. This remaining adjusted depreciable basis is 
equal to the unadjusted depreciable basis of the qualified property or 
the 50-percent bonus depreciation property reduced by the amount of the 
additional first year

[[Page 587]]

depreciation allowed or allowable, whichever is greater. The remaining 
adjusted depreciable basis of the qualified property or the 50-percent 
bonus depreciation property is then depreciated using the applicable 
depreciation provisions under the Internal Revenue Code for the 
qualified property or the 50-percent bonus depreciation property. The 
remaining adjusted depreciable basis of the qualified property or the 
50-percent bonus depreciation property that is MACRS property is also 
the basis to which the annual depreciation rates in the optional 
depreciation tables apply (for further guidance, see section 8 of Rev. 
Proc. 87-57 (1987-2 C.B. 687) and Sec.  601.601(d)(2)(ii)(b) of this 
chapter). The depreciation deduction allowable for the remaining 
adjusted depreciable basis of the qualified property or the 50-percent 
bonus depreciation property is affected by a taxable year of less than 
12 months.
    (ii) Alternative minimum tax. For alternative minimum tax purposes, 
the depreciation deduction allowable for the remaining adjusted 
depreciable basis of the qualified property or the 50-percent bonus 
depreciation property is based on the remaining adjusted depreciable 
basis for alternative minimum tax purposes. The remaining adjusted 
depreciable basis of the qualified property or the 50-percent bonus 
depreciable property for alternative minimum tax purposes is depreciated 
using the same depreciation method, recovery period (or useful life in 
the case of computer software), and convention that apply to the 
qualified property or the 50-percent bonus depreciation property for 
regular tax purposes.
    (3) Examples. This paragraph (d) is illustrated by the following 
examples:

    Example 1. On March 1, 2003, V, a calendar-year taxpayer, purchased 
and placed in service qualified property that costs $1 million and is 5-
year property under section 168(e). V depreciates its 5-year property 
placed in service in 2003 using the optional depreciation table that 
corresponds with the general depreciation system, the 200-percent 
declining balance method, a 5-year recovery period, and the half-year 
convention. For 2003, V is allowed a 30-percent additional first year 
depreciation deduction of $300,000 (the unadjusted depreciable basis of 
$1 million multiplied by .30). Next, V must reduce the unadjusted 
depreciable basis of $1 million by the additional first year 
depreciation deduction of $300,000 to determine the remaining adjusted 
depreciable basis of $700,000. Then, V's depreciation deduction 
allowable in 2003 for the remaining adjusted depreciable basis of 
$700,000 is $140,000 (the remaining adjusted depreciable basis of 
$700,000 multiplied by the annual depreciation rate of .20 for recovery 
year 1).
    Example 2. On June 1, 2003, W, a calendar-year taxpayer, purchased 
and placed in service 50-percent bonus depreciation property that costs 
$126,000. The property qualifies for the expensing election under 
section 179 and is 5-year property under section 168(e). W did not 
purchase any other section 179 property in 2003. W makes the election 
under section 179 for the property and depreciates its 5-year property 
placed in service in 2003 using the optional depreciation table that 
corresponds with the general depreciation system, the 200-percent 
declining balance method, a 5-year recovery period, and the half-year 
convention. For 2003, W is first allowed a $100,000 deduction under 
section 179. Next, W must reduce the cost of $126,000 by the section 179 
deduction of $100,000 to determine the unadjusted depreciable basis of 
$26,000. Then, for 2003, W is allowed a 50-percent additional first year 
depreciation deduction of $13,000 (the unadjusted depreciable basis of 
$26,000 multiplied by .50). Next, W must reduce the unadjusted 
depreciable basis of $26,000 by the additional first year depreciation 
deduction of $13,000 to determine the remaining adjusted depreciable 
basis of $13,000. Then, W's depreciation deduction allowable in 2003 for 
the remaining adjusted depreciable basis of $13,000 is $2,600 (the 
remaining adjusted depreciable basis of $13,000 multiplied by the annual 
depreciation rate of .20 for recovery year 1).

    (e) Election not to deduct additional first year depreciation--(1) 
In general. If a taxpayer makes an election under this paragraph (e), 
the election applies to all qualified property or 50-percent bonus 
depreciation property, as applicable, that is in the same class of 
property and placed in service in the same taxable year. The rules of 
this paragraph (e) apply to the following elections provided under 
section 168(k):
    (i) Qualified property. A taxpayer may make an election not to 
deduct the 30-percent additional first year depreciation for any class 
of property that is qualified property placed in service during the 
taxable year. If this election is made, no additional first year 
depreciation deduction is allowable for the property placed in service 
during the taxable year in the class of property.

[[Page 588]]

    (ii) 50-percent bonus depreciation property. For any class of 
property that is 50-percent bonus depreciation property placed in 
service during the taxable year, a taxpayer may make an election--
    (A) To deduct the 30-percent, instead of the 50-percent, additional 
first year depreciation. If this election is made, the allowable 
additional first year depreciation deduction is determined as though the 
class of property is qualified property under section 168(k)(2); or
    (B) Not to deduct both the 30-percent and the 50-percent additional 
first year depreciation. If this election is made, no additional first 
year depreciation deduction is allowable for the class of property.
    (2) Definition of class of property. For purposes of this paragraph 
(e), the term class of property means:
    (i) Except for the property described in paragraphs (e)(2)(ii) and 
(iv) of this section, each class of property described in section 168(e) 
(for example, 5-year property);
    (ii) Water utility property as defined in section 168(e)(5) and 
depreciated under section 168;
    (iii) Computer software as defined in, and depreciated under, 
section 167(f)(1) and the regulations thereunder; or
    (iv) Qualified leasehold improvement property as defined in 
paragraph (c) of this section and depreciated under section 168.
    (3) Time and manner for making election--(i) Time for making 
election. Except as provided in paragraph (e)(4) of this section, any 
election specified in paragraph (e)(1) of this section must be made by 
the due date (including extensions) of the Federal tax return for the 
taxable year in which the qualified property or the 50-percent bonus 
depreciation property, as applicable, is placed in service by the 
taxpayer.
    (ii) Manner of making election. Except as provided in paragraph 
(e)(4) of this section, any election specified in paragraph (e)(1) of 
this section must be made in the manner prescribed on Form 4562, 
``Depreciation and Amortization,'' and its instructions. The election is 
made separately by each person owning qualified property or 50-percent 
bonus depreciation property (for example, for each member of a 
consolidated group by the common parent of the group, by the 
partnership, or by the S corporation). If Form 4562 is revised or 
renumbered, any reference in this section to that form shall be treated 
as a reference to the revised or renumbered form.
    (4) Special rules for 2000 or 2001 returns. For the election 
specified in paragraph (e)(1)(i) of this section for qualified property 
placed in service by the taxpayer during the taxable year that included 
September 11, 2001, the taxpayer should refer to the guidance provided 
by the Internal Revenue Service for the time and manner of making this 
election on the 2000 or 2001 Federal tax return for the taxable year 
that included September 11, 2001 (for further guidance, see sections 
3.03(3) and 4 of Rev. Proc. 2002-33 (2002-1 C.B. 963), Rev. Proc. 2003-
50 (2003-29 I.R.B. 119), and Sec.  601.601(d)(2)(ii)(b) of this 
chapter).
    (5) Failure to make election. If a taxpayer does not make the 
applicable election specified in paragraph (e)(1) of this section within 
the time and in the manner prescribed in paragraph (e)(3) or (4) of this 
section, the amount of depreciation allowable for that property under 
section 167(f)(1) or under section 168, as applicable, must be 
determined for the placed-in-service year and for all subsequent taxable 
years by taking into account the additional first year depreciation 
deduction. Thus, any election specified in paragraph (e)(1) of this 
section shall not be made by the taxpayer in any other manner (for 
example, the election cannot be made through a request under section 
446(e) to change the taxpayer's method of accounting).
    (6) Alternative minimum tax. If a taxpayer makes an election 
specified in paragraph (e)(1) of this section for a class of property, 
the depreciation adjustments under section 56 and the regulations under 
section 56 apply to the property to which that election applies for 
purposes of computing the taxpayer's alternative minimum taxable income.
    (7) Revocation of election--(i) In general. Except as provided in 
paragraph (e)(7)(ii) of this section, an election specified in paragraph 
(e)(1) of this section, once made, may be revoked only

[[Page 589]]

with the written consent of the Commissioner of Internal Revenue. To 
seek the Commissioner's consent, the taxpayer must submit a request for 
a letter ruling.
    (ii) Automatic 6-month extension. If a taxpayer made an election 
specified in paragraph (e)(1) of this section for a class of property, 
an automatic extension of 6 months from the due date of the taxpayer's 
Federal tax return (excluding extensions) for the placed-in-service year 
of the class of property is granted to revoke that election, provided 
the taxpayer timely filed the taxpayer's Federal tax return for the 
placed-in-service year of the class of property and, within this 6-month 
extension period, the taxpayer (and all taxpayers whose tax liability 
would be affected by the election) files an amended Federal tax return 
for the placed-in-service year of the class of property in a manner that 
is consistent with the revocation of the election.
    (f) Special rules--(1) Property placed in service and disposed of in 
the same taxable year--(i) In general. Except as provided in paragraphs 
(f)(1)(ii) and (iii) of this section, the additional first year 
depreciation deduction is not allowed for qualified property or 50-
percent bonus depreciation property placed in service and disposed of 
during the same taxable year. Also if qualified property or 50-percent 
bonus depreciation property is placed in service and disposed of during 
the same taxable year and then reacquired and again placed in service in 
a subsequent taxable year, the additional first year depreciation 
deduction is not allowable for the property in the subsequent taxable 
year.
    (ii) Technical termination of a partnership. In the case of a 
technical termination of a partnership under section 708(b)(1)(B), the 
additional first year depreciation deduction is allowable for any 
qualified property or 50-percent bonus depreciation property placed in 
service by the terminated partnership during the taxable year of 
termination and contributed by the terminated partnership to the new 
partnership. The allowable additional first year depreciation deduction 
for the qualified property or the 50-percent bonus depreciation property 
shall not be claimed by the terminated partnership but instead shall be 
claimed by the new partnership for the new partnership's taxable year in 
which the qualified property or the 50-percent bonus depreciation 
property was contributed by the terminated partnership to the new 
partnership. However, if qualified property or 50-percent bonus 
depreciation property is both placed in service and contributed to a new 
partnership in a transaction described in section 708(b)(1)(B) by the 
terminated partnership during the taxable year of termination, and if 
such property is disposed of by the new partnership in the same taxable 
year the new partnership received such property from the terminated 
partnership, then no additional first year depreciation deduction is 
allowable to either partnership.
    (iii) Section 168(i)(7) transactions. If any qualified property or 
50-percent bonus depreciation property is transferred in a transaction 
described in section 168(i)(7) in the same taxable year that the 
qualified property or the 50-percent bonus depreciation property is 
placed in service by the transferor, the additional first year 
depreciation deduction is allowable for the qualified property or the 
50-percent bonus depreciation property. The allowable additional first 
year depreciation deduction for the qualified property or the 50-percent 
bonus depreciation property for the transferor's taxable year in which 
the property is placed in service is allocated between the transferor 
and the transferee on a monthly basis. This allocation shall be made in 
accordance with the rules in Sec.  1.168(d)-1(b)(7)(ii) for allocating 
the depreciation deduction between the transferor and the transferee. 
However, if qualified property or 50-percent bonus depreciation property 
is both placed in service and transferred in a transaction described in 
section 168(i)(7) by the transferor during the same taxable year, and if 
such property is disposed of by the transferee (other than by a 
transaction described in section 168(i)(7)) during the same taxable year 
the transferee received such property from the transferor, then no 
additional first year depreciation deduction is allowable to either 
party.

[[Page 590]]

    (iv) Examples. The application of this paragraph (f)(1) is 
illustrated by the following examples:

    Example 1. X and Y are equal partners in Partnership XY, a general 
partnership. On February 1, 2002, Partnership XY purchased and placed in 
service new equipment at a cost of $30,000. On March 1, 2002, X sells 
its entire 50 percent interest to Z in a transfer that terminates the 
partnership under section 708(b)(1)(B). As a result, terminated 
Partnership XY is deemed to have contributed the equipment to new 
Partnership XY. Pursuant to paragraph (f)(1)(ii) of this section, new 
Partnership XY, not terminated Partnership XY, is eligible to claim the 
30-percent additional first year depreciation deduction allowable for 
the equipment for the taxable year 2002 (assuming all other requirements 
are met).
    Example 2. On January 5, 2002, BB purchased and placed in service 
new office desks for a total amount of $8,000. On August 20, 2002, BB 
transferred the office desks to Partnership BC in a transaction 
described in section 721. BB and Partnership BC are calendar-year 
taxpayers. Because the transaction between BB and Partnership BC is a 
transaction described in section 168(i)(7), pursuant to paragraph 
(f)(1)(iii) of this section the 30-percent additional first year 
depreciation deduction allowable for the desks is allocated between BB 
and Partnership BC in accordance with the rules in Sec.  1.168(d)-
1(b)(7)(ii) for allocating the depreciation deduction between the 
transferor and the transferee. Accordingly, the 30-percent additional 
first year depreciation deduction allowable for the desks for 2002 of 
$2,400 (the unadjusted depreciable basis of $8,000 multiplied by .30) is 
allocated between BB and Partnership BC based on the number of months 
that BB and Partnership BC held the desks in service. Thus, because the 
desks were held in service by BB for 7 of 12 months, which includes the 
month in which BB placed the desks in service but does not include the 
month in which the desks were transferred, BB is allocated $1,400 (\7/
12\ x $2,400 additional first year depreciation deduction). Partnership 
BC is allocated $1,000, the remaining \5/12\ of the $2,400 additional 
first year depreciation deduction allowable for the desks.

    (2) Redetermination of basis. If the unadjusted depreciable basis 
(as defined in Sec.  1.168(k)-1(a)(2)(iii)) of qualified property or 50-
percent bonus depreciation property is redetermined (for example, due to 
contingent purchase price or discharge of indebtedness) before January 
1, 2005, or, in the case of property described in section 168(k)(2)(B) 
or (C), is redetermined before January 1, 2006 (or redetermined before 
January 1, 2007, in the case of property described in section 
168(k)(2)(B) or (C) to which section 105 of the Gulf Opportunity Zone 
Act of 2005 (Pub. L. 109-135, 119 Stat. 2577) applies (for further 
guidance, see Announcement 2006-29 (2006-19 I.R.B. 879) and Sec.  
601.601(d)(2)(ii)(b) of this chapter)), the additional first year 
depreciation deduction allowable for the qualified property or the 50-
percent bonus depreciation property is redetermined as follows:
    (i) Increase in basis. For the taxable year in which an increase in 
basis of qualified property or 50-percent bonus depreciation property 
occurs, the taxpayer shall claim an additional first year depreciation 
deduction for qualified property by multiplying the amount of the 
increase in basis for this property by 30 percent or, for 50-percent 
bonus depreciation property, by multiplying the amount of the increase 
in basis for this property by 50 percent. For purposes of this paragraph 
(f)(2)(i), the 30-percent additional first year depreciation deduction 
applies to the increase in basis if the underlying property is qualified 
property and the 50-percent additional first year depreciation deduction 
applies to the increase in basis if the underlying property is 50-
percent bonus depreciation property. To determine the amount otherwise 
allowable as a depreciation deduction for the increase in basis of 
qualified property or 50-percent bonus depreciation property, the amount 
of the increase in basis of the qualified property or the 50-percent 
bonus depreciation property must be reduced by the additional first year 
depreciation deduction allowed or allowable, whichever is greater, for 
the increase in basis and the remaining increase in basis of--
    (A) Qualified property or 50-percent bonus depreciation property 
(except for computer software described in paragraph (b)(2)(i)(B) of 
this section) is depreciated over the recovery period of the qualified 
property or the 50-percent bonus depreciation property, as applicable, 
remaining as of the beginning of the taxable year in which the increase 
in basis occurs, and using the same depreciation method and convention 
applicable to the qualified property or 50-percent bonus depreciation 
property, as

[[Page 591]]

applicable, that applies for the taxable year in which the increase in 
basis occurs; and
    (B) Computer software (as defined in paragraph (b)(2)(i)(B) of this 
section) that is qualified property or 50-percent bonus depreciation 
property is depreciated ratably over the remainder of the 36-month 
period (the useful life under section 167(f)(1)) as of the beginning of 
the first day of the month in which the increase in basis occurs.
    (ii) Decrease in basis. For the taxable year in which a decrease in 
basis of qualified property or 50-percent bonus depreciation property 
occurs, the taxpayer shall reduce the total amount otherwise allowable 
as a depreciation deduction for all of the taxpayer's depreciable 
property by the excess additional first year depreciation deduction 
previously claimed for the qualified property or the 50-percent bonus 
depreciation property. If, for such taxable year, the excess additional 
first year depreciation deduction exceeds the total amount otherwise 
allowable as a depreciation deduction for all of the taxpayer's 
depreciable property, the taxpayer shall take into account a negative 
depreciation deduction in computing taxable income. The excess 
additional first year depreciation deduction for qualified property is 
determined by multiplying the amount of the decrease in basis for this 
property by 30 percent. The excess additional first year depreciation 
deduction for 50-percent bonus depreciation property is determined by 
multiplying the amount of the decrease in basis for this property by 50 
percent. For purposes of this paragraph (f)(2)(ii), the 30-percent 
additional first year depreciation deduction applies to the decrease in 
basis if the underlying property is qualified property and the 50-
percent additional first year depreciation deduction applies to the 
decrease in basis if the underlying property is 50-percent bonus 
depreciation property. Also, if the taxpayer establishes by adequate 
records or other sufficient evidence that the taxpayer claimed less than 
the additional first year depreciation deduction allowable for the 
qualified property or the 50-percent bonus depreciation property before 
the decrease in basis or if the taxpayer claimed more than the 
additional first year depreciation deduction allowable for the qualified 
property or the 50-percent bonus depreciation property before the 
decrease in basis, the excess additional first year depreciation 
deduction is determined by multiplying the amount of the decrease in 
basis by the additional first year depreciation deduction percentage 
actually claimed by the taxpayer for the qualified property or the 50-
percent bonus depreciation property, as applicable, before the decrease 
in basis. To determine the amount to reduce the total amount otherwise 
allowable as a depreciation deduction for all of the taxpayer's 
depreciable property for the excess depreciation previously claimed 
(other than the additional first year depreciation deduction) resulting 
from the decrease in basis of the qualified property or the 50-percent 
bonus depreciation property, the amount of the decrease in basis of the 
qualified property or the 50-percent bonus depreciation property must be 
adjusted by the excess additional first year depreciation deduction that 
reduced the total amount otherwise allowable as a depreciation deduction 
(as determined under this paragraph) and the remaining decrease in basis 
of--
    (A) Qualified property or 50-percent bonus depreciation property 
(except for computer software described in paragraph (b)(2)(i)(B) of 
this section) reduces the amount otherwise allowable as a depreciation 
deduction over the recovery period of the qualified property or the 50-
percent bonus depreciation property, as applicable, remaining as of the 
beginning of the taxable year in which the decrease in basis occurs, and 
using the same depreciation method and convention of the qualified 
property or 50-percent bonus depreciation property, as applicable, that 
applies in the taxable year in which the decrease in basis occurs. If, 
for any taxable year, the reduction to the amount otherwise allowable as 
a depreciation deduction (as determined under this paragraph 
(f)(2)(ii)(A)) exceeds the total amount otherwise allowable as a 
depreciation deduction for all of the taxpayer's depreciable property, 
the taxpayer shall take into account a negative depreciation deduction 
in computing taxable income; and

[[Page 592]]

    (B) Computer software (as defined in paragraph (b)(2)(i)(B) of this 
section) that is qualified property or 50-percent bonus depreciation 
property reduces the amount otherwise allowable as a depreciation 
deduction over the remainder of the 36-month period (the useful life 
under section 167(f)(1)) as of the beginning of the first day of the 
month in which the decrease in basis occurs. If, for any taxable year, 
the reduction to the amount otherwise allowable as a depreciation 
deduction (as determined under this paragraph (f)(2)(ii)(B)) exceeds the 
total amount otherwise allowable as a depreciation deduction for all of 
the taxpayer's depreciable property, the taxpayer shall take into 
account a negative depreciation deduction in computing taxable income.
    (iii) Definition. Except as otherwise expressly provided by the 
Internal Revenue Code (for example, section 1017(a)), the regulations 
under the Internal Revenue Code, or other guidance published in the 
Internal Revenue Bulletin (see Sec.  601.601(d)(2)(ii)(b) of this 
chapter), for purposes of this paragraph (f)(2):
    (A) An increase in basis occurs in the taxable year an amount is 
taken into account under section 461; and
    (B) A decrease in basis occurs in the taxable year an amount would 
be taken into account under section 451.
    (iv) Examples. The application of this paragraph (f)(2) is 
illustrated by the following examples:

    Example 1. (i) On May 15, 2002, CC, a cash-basis taxpayer, purchased 
and placed in service qualified property that is 5-year property at a 
cost of $200,000. In addition to the $200,000, CC agrees to pay the 
seller 25 percent of the gross profits from the operation of the 
property in 2002. On May 15, 2003, CC paid to the seller an additional 
$10,000. CC depreciates the 5-year property placed in service in 2002 
using the optional depreciation table that corresponds with the general 
depreciation system, the 200-percent declining balance method, a 5-year 
recovery period, and the half-year convention.
    (ii) For 2002, CC is allowed a 30-percent additional first year 
depreciation deduction of $60,000 (the unadjusted depreciable basis of 
$200,000 multiplied by .30). In addition, CC's depreciation deduction 
for 2002 for the remaining adjusted depreciable basis of $140,000 (the 
unadjusted depreciable basis of $200,000 reduced by the additional first 
year depreciation deduction of $60,000) is $28,000 (the remaining 
adjusted depreciable basis of $140,000 multiplied by the annual 
depreciation rate of .20 for recovery year 1).
    (iii) For 2003, CC's depreciation deduction for the remaining 
adjusted depreciable basis of $140,000 is $44,800 (the remaining 
adjusted depreciable basis of $140,000 multiplied by the annual 
depreciation rate of .32 for recovery year 2). In addition, pursuant to 
paragraph (f)(2)(i) of this section, CC is allowed an additional first 
year depreciation deduction for 2003 for the $10,000 increase in basis 
of the qualified property. Consequently, CC is allowed an additional 
first year depreciation deduction of $3,000 (the increase in basis of 
$10,000 multiplied by .30). Also, CC is allowed a depreciation deduction 
for 2003 attributable to the remaining increase in basis of $7,000 (the 
increase in basis of $10,000 reduced by the additional first year 
depreciation deduction of $3,000). The depreciation deduction allowable 
for 2003 attributable to the remaining increase in basis of $7,000 is 
$3,111 (the remaining increase in basis of $7,000 multiplied by .4444, 
which is equal to 1/remaining recovery period of 4.5 years at January 1, 
2003, multiplied by 2). Accordingly, for 2003, CC's total depreciation 
deduction allowable for the qualified property is $50,911.
    Example 2. (i) On May 15, 2002, DD, a calendar-year taxpayer, 
purchased and placed in service qualified property that is 5-year 
property at a cost of $400,000. To purchase the property, DD borrowed 
$250,000 from Bank2. On May 15, 2003, Bank2 forgives $50,000 of the 
indebtedness. DD makes the election provided in section 108(b)(5) to 
apply any portion of the reduction under section 1017 to the basis of 
the depreciable property of the taxpayer. DD depreciates the 5-year 
property placed in service in 2002 using the optional depreciation table 
that corresponds with the general depreciation system, the 200-percent 
declining balance method, a 5-year recovery period, and the half-year 
convention.
    (ii) For 2002, DD is allowed a 30-percent additional first year 
depreciation deduction of $120,000 (the unadjusted depreciable basis of 
$400,000 multiplied by .30). In addition, DD's depreciation deduction 
allowable for 2002 for the remaining adjusted depreciable basis of 
$280,000 (the unadjusted depreciable basis of $400,000 reduced by the 
additional first year depreciation deduction of $120,000) is $56,000 
(the remaining adjusted depreciable basis of $280,000 multiplied by the 
annual depreciation rate of .20 for recovery year 1).
    (iii) For 2003, DD's deduction for the remaining adjusted 
depreciable basis of $280,000 is $89,600 (the remaining adjusted 
depreciable basis of $280,000 multiplied by the annual depreciation rate 
.32 for recovery year 2). Although Bank2 forgave the indebtedness in 
2003, the basis of the property is reduced on January 1, 2004, pursuant 
to sections 108(b)(5)

[[Page 593]]

and 1017(a) under which basis is reduced at the beginning of the taxable 
year following the taxable year in which the discharge of indebtedness 
occurs.
    (iv) For 2004, DD's deduction for the remaining adjusted depreciable 
basis of $280,000 is $53,760 (the remaining adjusted depreciable basis 
of $280,000 multiplied by the annual depreciation rate .192 for recovery 
year 3). However, pursuant to paragraph (f)(2)(ii) of this section, DD 
must reduce the amount otherwise allowable as a depreciation deduction 
for 2004 by the excess depreciation previously claimed for the $50,000 
decrease in basis of the qualified property. Consequently, DD must 
reduce the amount of depreciation otherwise allowable for 2004 by the 
excess additional first year depreciation of $15,000 (the decrease in 
basis of $50,000 multiplied by .30). Also, DD must reduce the amount of 
depreciation otherwise allowable for 2004 by the excess depreciation 
attributable to the remaining decrease in basis of $35,000 (the decrease 
in basis of $50,000 reduced by the excess additional first year 
depreciation of $15,000). The reduction in the amount of depreciation 
otherwise allowable for 2004 for the remaining decrease in basis of 
$35,000 is $19,999 (the remaining decrease in basis of $35,000 
multiplied by .5714, which is equal to 1/remaining recovery period of 
3.5 years at January 1, 2004, multiplied by 2). Accordingly, assuming 
the qualified property is the only depreciable property owned by DD, for 
2004, DD's total depreciation deduction allowable for the qualified 
property is $18,761 ($53,760 minus $15,000 minus $19,999).

    (3) Section 1245 and 1250 depreciation recapture. For purposes of 
section 1245 and the regulations thereunder, the additional first year 
depreciation deduction is an amount allowed or allowable for 
depreciation. Further, for purposes of section 1250(b) and the 
regulations thereunder, the additional first year depreciation deduction 
is not a straight line method.
    (4) Coordination with section 169. The additional first year 
depreciation deduction is allowable in the placed-in-service year of a 
certified pollution control facility (as defined in Sec.  1.169-2(a)) 
that is qualified property or 50-percent bonus depreciation property, 
even if the taxpayer makes the election to amortize the certified 
pollution control facility under section 169 and the regulations 
thereunder in the certified pollution control facility's placed-in-
service year.
    (5) Like-kind exchanges and involuntary conversions--(i) Scope. The 
rules of this paragraph (f)(5) apply to acquired MACRS property or 
acquired computer software that is qualified property or 50-percent 
bonus depreciation property at the time of replacement provided the time 
of replacement is after September 10, 2001, and before January 1, 2005, 
or, in the case of acquired MACRS property or acquired computer software 
that is qualified property, or 50-percent bonus depreciation property, 
described in section 168(k)(2)(B) or (C), the time of replacement is 
after September 10, 2001, and before January 1, 2006 (or the time of 
replacement is after September 10, 2001, and before January 1, 2007, in 
the case of property described in section 168(k)(2)(B) or (C) to which 
section 105 of the Gulf Opportunity Zone Act of 2005 (Pub. L. 109-135, 
119 Stat. 2577) applies (for further guidance, see Announcement 2006-29 
(2006-19 I.R.B. 879) and Sec.  601.601(d)(2)(ii)(b) of this chapter)).
    (ii) Definitions. For purposes of this paragraph (f)(5), the 
following definitions apply:
    (A) Acquired MACRS property is MACRS property in the hands of the 
acquiring taxpayer that is acquired in a transaction described in 
section 1031(a), (b), or (c) for other MACRS property or that is 
acquired in connection with an involuntary conversion of other MACRS 
property in a transaction to which section 1033 applies.
    (B) Exchanged or involuntarily converted MACRS property is MACRS 
property that is transferred by the taxpayer in a transaction described 
in section 1031(a), (b), or (c), or that is converted as a result of an 
involuntary conversion to which section 1033 applies.
    (C) Acquired computer software is computer software (as defined in 
paragraph (b)(2)(i)(B) of this section) in the hands of the acquiring 
taxpayer that is acquired in a like-kind exchange under section 1031 or 
as a result of an involuntary conversion under section 1033.
    (D) Exchanged or involuntarily converted computer software is 
computer software (as defined in paragraph (b)(2)(i)(B) of this section) 
that is transferred by the taxpayer in a like-kind exchange under 
section 1031 or that is converted as a result of an involuntary 
conversion under section 1033.

[[Page 594]]

    (E) Time of disposition is when the disposition of the exchanged or 
involuntarily converted MACRS property or the exchanged or involuntarily 
converted computer software, as applicable, takes place.
    (F) Except as provided in paragraph (f)(5)(v) of this section, the 
time of replacement is the later of--
    (1) When the acquired MACRS property or acquired computer software 
is placed in service; or
    (2) The time of disposition of the exchanged or involuntarily 
converted property.
    (G) Carryover basis is the lesser of:
    (1) The basis in the acquired MACRS property or acquired computer 
software, as applicable and as determined under section 1031(d) or 
1033(b) and the regulations thereunder; or
    (2) The adjusted depreciable basis of the exchanged or involuntarily 
converted MACRS property or the exchanged or involuntarily converted 
computer software, as applicable.
    (H) Excess basis is any excess of the basis in the acquired MACRS 
property or acquired computer software, as applicable and as determined 
under section 1031(d) or 1033(b) and the regulations thereunder, over 
the carryover basis as determined under paragraph (f)(5)(ii)(G) of this 
section.
    (I) Remaining carryover basis is the carryover basis as determined 
under paragraph (f)(5)(ii)(G) of this section reduced by--
    (1) The percentage of the taxpayer's use of property for the taxable 
year other than in the taxpayer's trade or business (or for the 
production of income); and
    (2) Any adjustments to basis provided by other provisions of the 
Code and the regulations thereunder (including section 1016(a)(2) and 
(3)) for periods prior to the disposition of the exchanged or 
involuntarily converted property.
    (J) Remaining excess basis is the excess basis as determined under 
paragraph (f)(5)(ii)(H) of this section reduced by--
    (1) The percentage of the taxpayer's use of property for the taxable 
year other than in the taxpayer's trade or business (or for the 
production of income);
    (2) Any portion of the basis the taxpayer properly elects to treat 
as an expense under section 179 or section 179C;
    (3) Any adjustments to basis provided by other provisions of the 
Code and the regulations thereunder.
    (K) Year of disposition is the taxable year that includes the time 
of disposition.
    (L) Year of replacement is the taxable year that includes the time 
of replacement.
    (iii) Computation--(A) In general. Assuming all other requirements 
of section 168(k) and this section are met, the remaining carryover 
basis for the year of replacement and the remaining excess basis, if 
any, for the year of replacement for the acquired MACRS property or the 
acquired computer software, as applicable, are eligible for the 
additional first year depreciation deduction. The 30-percent additional 
first year depreciation deduction applies to the remaining carryover 
basis and the remaining excess basis, if any, of the acquired MACRS 
property or the acquired computer software if the time of replacement is 
after September 10, 2001, and before May 6, 2003, or if the taxpayer 
made the election provided in paragraph (e)(1)(ii)(A) of this section. 
The 50-percent additional first year depreciation deduction applies to 
the remaining carryover basis and the remaining excess basis, if any, of 
the acquired MACRS property or the acquired computer software if the 
time of replacement is after May 5, 2003, and before January 1, 2005, 
or, in the case of acquired MACRS property or acquired computer software 
that is 50-percent bonus depreciation property described in section 
168(k)(2)(B) or (C), the time of replacement is after May 5, 2003, and 
before January 1, 2006 (or the time of replacement is after May 5, 2003, 
and before January 1, 2007, in the case of 50-percent bonus depreciation 
property described in section 168(k)(2)(B) or (C) to which section 105 
of the Gulf Opportunity Zone Act of 2005 (Pub. L. 109-135, 119 Stat. 
2577) applies (for further guidance, see Announcement 2006-29 (2006-19 
I.R.B. 879) and Sec.  601.601(d)(2)(ii)(b) of this chapter)). The 
additional first year depreciation deduction is computed separately for 
the remaining carryover basis and the remaining excess basis.

[[Page 595]]

    (B) Year of disposition and year of replacement. The additional 
first year depreciation deduction is allowable for the acquired MACRS 
property or acquired computer software in the year of replacement. 
However, the additional first year depreciation deduction is not 
allowable for the exchanged or involuntarily converted MACRS property or 
the exchanged or involuntarily converted computer software if the 
exchanged or involuntarily converted MACRS property or the exchanged or 
involuntarily converted computer software, as applicable, is placed in 
service and disposed of in an exchange or involuntary conversion in the 
same taxable year.
    (C) Property having a longer production period. For purposes of 
paragraph (f)(5)(iii)(A) of this section, the total of the remaining 
carryover basis and the remaining excess basis, if any, of the acquired 
MACRS property that is qualified property or 50-percent bonus 
depreciation property described in section 168(k)(2)(B) is limited to 
the total of the property's remaining carryover basis and remaining 
excess basis, if any, attributable to the property's manufacture, 
construction, or production after September 10, 2001 (for qualified 
property), or May 5, 2003 (for 50-percent bonus depreciation property), 
and before January 1, 2005.
    (D) Alternative minimum tax. The 30-percent or 50-percent additional 
first year depreciation deduction is allowed for alternative minimum tax 
purposes for the year of replacement of acquired MACRS property or 
acquired computer software that is qualified property or 50-percent 
bonus depreciation property. The 30-percent or 50-percent additional 
first year depreciation deduction for alternative minimum tax purposes 
is based on the remaining carryover basis and the remaining excess 
basis, if any, of the acquired MACRS property or the acquired computer 
software for alternative minimum tax purposes.
    (iv) Sale-leaseback transaction. For purposes of this paragraph 
(f)(5), if MACRS property or computer software is sold to a taxpayer and 
leased back to a person by the taxpayer within three months after the 
time of disposition of the MACRS property or computer software, as 
applicable, the time of replacement for this MACRS property or computer 
software, as applicable, shall not be earlier than the date on which the 
MACRS property or computer software, as applicable, is used by the 
lessee under the leaseback.
    (v) Acquired MACRS property or acquired computer software that is 
acquired and placed in service before disposition of involuntarily 
converted MACRS property or involuntarily converted computer software. 
If, in an involuntary conversion, a taxpayer acquires and places in 
service the acquired MACRS property or the acquired computer software 
before the time of disposition of the involuntarily converted MACRS 
property or the involuntarily converted computer software and the time 
of disposition of the involuntarily converted MACRS property or the 
involuntarily converted computer software is after December 31, 2004, 
or, in the case of property described in section 168(k)(2)(B) or (C), 
after December 31, 2005 (or after December 31, 2006, in the case of 
property described in section 168(k)(2)(B) or (C) to which section 105 
of the Gulf Opportunity Zone Act of 2005 (Pub. L. 109-135, 119 Stat. 
2577) applies (for further guidance, see Announcement 2006-29 (2006-19 
I.R.B. 879) and Sec.  601.601(d)(2)(ii)(b) of this chapter)), then--
    (A) Time of replacement. The time of replacement for purposes of 
this paragraph (f)(5) is when the acquired MACRS property or acquired 
computer software is placed in service by the taxpayer, provided the 
threat or imminence of requisition or condemnation of the involuntarily 
converted MACRS property or involuntarily converted computer software 
existed before January 1, 2005, or, in the case of property described in 
section 168(k)(2)(B) or (C), existed before January 1, 2006 (or existed 
before January 1, 2007, in the case of property described in section 
168(k)(2)(B) or (C) to which section 105 of the Gulf Opportunity Zone 
Act of 2005 (Pub. L. 109-135, 119 Stat. 2577) applies (for further 
guidance, see Announcement 2006-29 (2006-19 I.R.B. 879) and Sec.  
601.601(d)(2)(ii)(b) of this chapter)); and
    (B) Depreciation of acquired MACRS property or acquired computer 
software. The taxpayer depreciates the acquired

[[Page 596]]

MACRS property or acquired computer software in accordance with 
paragraph (d) of this section. However, at the time of disposition of 
the involuntarily converted MACRS property, the taxpayer determines the 
exchanged basis (as defined in Sec.  1.168(i)-6(b)(7)) and the excess 
basis (as defined in Sec.  1.168(i)-6(b)(8)) of the acquired MACRS 
property and begins to depreciate the depreciable exchanged basis (as 
defined in Sec.  1.168(i)-6(b)(9) of the acquired MACRS property in 
accordance with Sec.  1.168(i)-6(c). The depreciable excess basis (as 
defined in Sec.  1.168(i)-6(b)(10)) of the acquired MACRS property 
continues to be depreciated by the taxpayer in accordance with the first 
sentence of this paragraph (f)(5)(v)(B). Further, in the year of 
disposition of the involuntarily converted MACRS property, the taxpayer 
must include in taxable income the excess of the depreciation deductions 
allowable, including the additional first year depreciation deduction 
allowable, on the unadjusted depreciable basis of the acquired MACRS 
property over the additional first year depreciation deduction that 
would have been allowable to the taxpayer on the remaining carryover 
basis of the acquired MACRS property at the time of replacement (as 
defined in paragraph (f)(5)(v)(A) of this section) plus the depreciation 
deductions that would have been allowable, including the additional 
first year depreciation deduction allowable, to the taxpayer on the 
depreciable excess basis of the acquired MACRS property from the date 
the acquired MACRS property was placed in service by the taxpayer 
(taking into account the applicable convention) to the time of 
disposition of the involuntarily converted MACRS property. Similar rules 
apply to acquired computer software.
    (vi) Examples. The application of this paragraph (f)(5) is 
illustrated by the following examples:

    Example 1. (i) In December 2002, EE, a calendar-year corporation, 
acquired for $200,000 and placed in service Canopy V1, a gas station 
canopy. Canopy V1 is qualified property under section 168(k)(1) and is 
5-year property under section 168(e). EE depreciated Canopy V1 under the 
general depreciation system of section 168(a) by using the 200-percent 
declining balance method of depreciation, a 5-year recovery period, and 
the half-year convention. EE elected to use the optional depreciation 
tables to compute the depreciation allowance for Canopy V1. On January 
1, 2003, Canopy V1 was destroyed in a fire and was no longer usable in 
EE's business. On June 1, 2003, in an involuntary conversion, EE 
acquired and placed in service new Canopy W1 with all of the $160,000 of 
insurance proceeds EE received due to the loss of Canopy V1. Canopy W1 
is 50-percent bonus depreciation property under section 168(k)(4) and is 
5-year property under section 168(e). Pursuant to paragraph (g)(3)(ii) 
of this section and Sec.  1.168(i)-6(k)(2)(i), EE decided to apply Sec.  
1.168(i)-6 to the involuntary conversion of Canopy V1 with the 
replacement of Canopy W1, the acquired MACRS property.
    (ii) For 2002, EE is allowed a 30-percent additional first year 
depreciation deduction of $60,000 for Canopy V1 (the unadjusted 
depreciable basis of $200,000 multiplied by .30), and a regular MACRS 
depreciation deduction of $28,000 for Canopy V1 (the remaining adjusted 
depreciable basis of $140,000 multiplied by the annual depreciation rate 
of .20 for recovery year 1).
    (iii) For 2003, EE is allowed a regular MACRS depreciation deduction 
of $22,400 for Canopy V1 (the remaining adjusted depreciable basis of 
$140,000 multiplied by the annual depreciation rate of .32 for recovery 
year 2 x \1/2\ year).
    (iv) Pursuant to paragraph (f)(5)(iii)(A) of this section, the 
additional first year depreciation deduction allowable for Canopy W1 
equals $44,800 (.50 of Canopy W1's remaining carryover basis at the time 
of replacement of $89,600 (Canopy V1's remaining adjusted depreciable 
basis of $140,000 minus 2002 regular MACRS depreciation deduction of 
$28,000 minus 2003 regular MACRS depreciation deduction of $22,400)).
    Example 2. (i) Same facts as in Example 1, except EE elected not to 
deduct the additional first year depreciation for 5-year property placed 
in service in 2002. EE deducted the additional first year depreciation 
for 5-year property placed in service in 2003.
    (ii) For 2002, EE is allowed a regular MACRS depreciation deduction 
of $40,000 for Canopy V1 (the unadjusted depreciable basis of $200,000 
multiplied by the annual depreciation rate of .20 for recovery year 1).
    (iii) For 2003, EE is allowed a regular MACRS depreciation deduction 
of $32,000 for Canopy V1 (the unadjusted depreciable basis of $200,000 
multiplied by the annual depreciation rate of .32 for recovery year 2 x 
\1/2\ year).
    (iv) Pursuant to paragraph (f)(5)(iii)(A) of this section, the 
additional first year depreciation deduction allowable for Canopy W1 
equals $64,000 (.50 of Canopy W1's remaining carryover basis at the time 
of replacement of $128,000 (Canopy V1's unadjusted depreciable basis of 
$200,000 minus 2002 regular MACRS depreciation deduction of $40,000 
minus 2003

[[Page 597]]

regular MACRS depreciation deduction of $32,000)).
    Example 3. (i) In December 2001, FF, a calendar-year corporation, 
acquired for $10,000 and placed in service Computer X2. Computer X2 is 
qualified property under section 168(k)(1) and is 5-year property under 
section 168(e). FF depreciated Computer X2 under the general 
depreciation system of section 168(a) by using the 200-percent declining 
balance method of depreciation, a 5-year recovery period, and the half-
year convention. FF elected to use the optional depreciation tables to 
compute the depreciation allowance for Computer X2. On January 1, 2002, 
FF acquired new Computer Y2 by exchanging Computer X2 and $1,000 cash in 
a like-kind exchange. Computer Y2 is qualified property under section 
168(k)(1) and is 5-year property under section 168(e). Pursuant to 
paragraph (g)(3)(ii) of this section and Sec.  1.168(i)-6(k)(2)(i), FF 
decided to apply Sec.  1.168(i)-6 to the exchange of Computer X2 for 
Computer Y2, the acquired MACRS property.
    (ii) For 2001, FF is allowed a 30-percent additional first year 
depreciation deduction of $3,000 for Computer X2 (unadjusted basis of 
$10,000 multiplied by .30), and a regular MACRS depreciation deduction 
of $1,400 for Computer X2 (the remaining adjusted depreciable basis of 
$7,000 multiplied by the annual depreciation rate of .20 for recovery 
year 1).
    (iii) For 2002, FF is allowed a regular MACRS depreciation deduction 
of $1,120 for Computer X2 (the remaining adjusted depreciable basis of 
$7,000 multiplied by the annual depreciation rate of .32 for recovery 
year 2 x \1/2\ year).
    (iv) Pursuant to paragraph (f)(5)(iii)(A) of this section, the 30-
percent additional first year depreciation deduction for Computer Y2 is 
allowable for the remaining carryover basis at the time of replacement 
of $4,480 (Computer X2's unadjusted depreciable basis of $10,000 minus 
additional first year depreciation deduction allowable of $3,000 minus 
2001 regular MACRS depreciation deduction of $1,400 minus 2002 regular 
MACRS depreciation deduction of $1,120) and for the remaining excess 
basis at the time of replacement of $1,000 (cash paid for Computer Y2). 
Thus, the 30-percent additional first year depreciation deduction for 
the remaining carryover basis at the time of replacement equals $1,344 
($4,480 multiplied by .30) and for the remaining excess basis at the 
time of replacement equals $300 ($1,000 multiplied by .30), which totals 
$1,644.
    Example 4. (i) In September 2002, GG, a June 30 year-end 
corporation, acquired for $20,000 and placed in service Equipment X3. 
Equipment X3 is qualified property under section 168(k)(1) and is 5-year 
property under section 168(e). GG depreciated Equipment X3 under the 
general depreciation system of section 168(a) by using the 200-percent 
declining balance method of depreciation, a 5-year recovery period, and 
the half-year convention. GG elected to use the optional depreciation 
tables to compute the depreciation allowance for Equipment X3. In 
December 2002, GG acquired new Equipment Y3 by exchanging Equipment X3 
and $5,000 cash in a like-kind exchange. Equipment Y3 is qualified 
property under section 168(k)(1) and is 5-year property under section 
168(e). Pursuant to paragraph (g)(3)(ii) of this section and Sec.  
1.168(i)-6(k)(2)(i), GG decided to apply Sec.  1.168(i)-6 to the 
exchange of Equipment X3 for Equipment Y3, the acquired MACRS property.
    (ii) Pursuant to paragraph (f)(5)(iii)(B) of this section, no 
additional first year depreciation deduction is allowable for Equipment 
X3 and, pursuant to Sec.  1.168(d)-1T(b)(3)(ii), no regular depreciation 
deduction is allowable for Equipment X3, for the taxable year ended June 
30, 2003.
    (iii) Pursuant to paragraph (f)(5)(iii)(A) of this section, the 30-
percent additional first year depreciation deduction for Equipment Y3 is 
allowable for the remaining carryover basis at the time of replacement 
of $20,000 (Equipment X3's unadjusted depreciable basis of $20,000) and 
for the remaining excess basis at the time of replacement of $5,000 
(cash paid for Equipment Y3). Thus, the 30-percent additional first year 
depreciation deduction for the remaining carryover basis at the time of 
replacement equals $6,000 ($20,000 multiplied by .30) and for the 
remaining excess basis at the time of replacement equals $1,500 ($5,000 
multiplied by .30), which totals $7,500.
    Example 5. (i) Same facts as in Example 4. GG depreciated Equipment 
Y3 under the general depreciation system of section 168(a) by using the 
200-percent declining balance method of depreciation, a 5-year recovery 
period, and the half-year convention. GG elected to use the optional 
depreciation tables to compute the depreciation allowance for Equipment 
Y3. On July 1, 2003, GG acquired new Equipment Z1 by exchanging 
Equipment Y3 in a like-kind exchange. Equipment Z1 is 50-percent bonus 
depreciation property under section 168(k)(4) and is 5-year property 
under section 168(e). Pursuant to paragraph (g)(3)(ii) of this section 
and Sec.  1.168(i)-6(k)(2)(i), GG decided to apply Sec.  1.168(i)-6 to 
the exchange of Equipment Y3 for Equipment Z1, the acquired MACRS 
property.
    (ii) For the taxable year ending June 30, 2003, the regular MACRS 
depreciation deduction allowable for the remaining carryover basis at 
the time of replacement (after taking into account the additional first 
year depreciation deduction) of Equipment Y3 is $2,800 (the remaining 
carryover basis at the time of replacement of $20,000 minus the 
additional first year depreciation deduction of $6,000, multiplied by 
the annual depreciation

[[Page 598]]

rate of .20 for recovery year 1) and for the remaining excess basis at 
the time of replacement (after taking into account the additional first 
year depreciation deduction) of Equipment Y3 is $700 (the remaining 
excess basis at the time of replacement of $5,000 minus the additional 
first year depreciation deduction of $1,500, multiplied by the annual 
depreciation rate of .20 for recovery year 1), which totals $3,500.
    (iii) For the taxable year ending June 30, 2004, the regular MACRS 
depreciation deduction allowable for the remaining carryover basis 
(after taking into account the additional first year depreciation 
deduction) of Equipment Y3 is $2,240 (the remaining carryover basis at 
the time of replacement of $20,000 minus the additional first year 
depreciation deduction of $6,000, multiplied by the annual depreciation 
rate of .32 for recovery year 2 x \1/2\ year) and for the remaining 
excess basis (after taking into account the additional first year 
depreciation deduction) of Equipment Y3 is $560 (the remaining excess 
basis at the time of replacement of $5,000 minus the additional first 
year depreciation deduction of $1,500, multiplied by the annual 
depreciation rate of .32 for recovery year 2 x \1/2\ year), which totals 
$2,800.
    (iv) For the taxable year ending June 30, 2004, pursuant to 
paragraph (f)(5)(iii)(A) of this section, the 50-percent additional 
first year depreciation deduction for Equipment Z1 is allowable for the 
remaining carryover basis at the time of replacement of $11,200 
(Equipment Y3's unadjusted depreciable basis of $25,000 minus the total 
additional first year depreciation deduction of $7,500 minus the total 
2003 regular MACRS depreciation deduction of $3,500 minus the total 2004 
regular depreciation deduction (taking into account the half-year 
convention) of $2,800). Thus, the 50-percent additional first year 
depreciation deduction for the remaining carryover basis at the time of 
replacement equals $5,600 ($11,200 multiplied by .50).
    Example 6. (i) In April 2004, SS, a calendar year-end corporation, 
acquired and placed in service Equipment K89. Equipment K89 is 50-
percent bonus depreciation property under section 168(k)(4). In November 
2004, SS acquired and placed in service used Equipment N78 by exchanging 
Equipment K89 in a like-kind exchange.
    (ii) Pursuant to paragraph (f)(5)(iii)(B) of this section, no 
additional first year deduction is allowable for Equipment K89 and, 
pursuant to Sec.  1.168(d)-1T(b)(3)(ii), no regular depreciation 
deduction is allowable for Equipment K89, for the taxable year ended 
December 31, 2004.
    (iii) Equipment N78 is not qualified property under section 
168(k)(1) or 50-percent bonus depreciation property under section 
168(k)(4) because the original use requirement of paragraph (b)(3) of 
this section is not met. Accordingly, no additional first year 
depreciation deduction is allowable for Equipment N78.

    (6) Change in use--(i) Change in use of depreciable property. The 
determination of whether the use of depreciable property changes is made 
in accordance with section 168(i)(5) and regulations thereunder.
    (ii) Conversion to personal use. If qualified property or 50-percent 
bonus depreciation property is converted from business or income-
producing use to personal use in the same taxable year in which the 
property is placed in service by a taxpayer, the additional first year 
depreciation deduction is not allowable for the property.
    (iii) Conversion to business or income-producing use--(A) During the 
same taxable year. If, during the same taxable year, property is 
acquired by a taxpayer for personal use and is converted by the taxpayer 
from personal use to business or income-producing use, the additional 
first year depreciation deduction is allowable for the property in the 
taxable year the property is converted to business or income-producing 
use (assuming all of the requirements in paragraph (b) of this section 
are met). See paragraph (b)(3)(ii) of this section relating to the 
original use rules for a conversion of property to business or income-
producing use.
    (B) Subsequent to the acquisition year. If property is acquired by a 
taxpayer for personal use and, during a subsequent taxable year, is 
converted by the taxpayer from personal use to business or income-
producing use, the additional first year depreciation deduction is 
allowable for the property in the taxable year the property is converted 
to business or income-producing use (assuming all of the requirements in 
paragraph (b) of this section are met). For purposes of paragraphs 
(b)(4) and (5) of this section, the property must be acquired by the 
taxpayer for personal use after September 10, 2001 (for qualified 
property), or after May 5, 2003 (for 50-percent bonus depreciation 
property), and converted by the taxpayer from personal use to business 
or income-producing use by January 1, 2005. See paragraph (b)(3)(ii) of 
this section relating to the original use rules for a conversion of 
property to business or income-producing use.

[[Page 599]]

    (iv) Depreciable property changes use subsequent to the placed-in-
service year--(A) If the use of qualified property or 50-percent bonus 
depreciation property changes in the hands of the same taxpayer 
subsequent to the taxable year the qualified property or the 50-percent 
bonus depreciation property, as applicable, is placed in service and, as 
a result of the change in use, the property is no longer qualified 
property or 50-percent bonus depreciation property, as applicable, the 
additional first year depreciation deduction allowable for the qualified 
property or the 50-percent bonus depreciation property, as applicable, 
is not redetermined.
    (B) If depreciable property is not qualified property or 50-percent 
bonus depreciation property in the taxable year the property is placed 
in service by the taxpayer, the additional first year depreciation 
deduction is not allowable for the property even if a change in the use 
of the property subsequent to the taxable year the property is placed in 
service results in the property being qualified property or 50-percent 
bonus depreciation property in the taxable year of the change in use.
    (v) Examples. The application of this paragraph (f)(6) is 
illustrated by the following examples:

    Example 1. (i) On January 1, 2002, HH, a calendar year corporation, 
purchased and placed in service several new computers at a total cost of 
$100,000. HH used these computers within the United States for 3 months 
in 2002 and then moved and used the computers outside the United States 
for the remainder of 2002. On January 1, 2003, HH permanently returns 
the computers to the United States for use in its business.
    (ii) For 2002, the computers are considered as used predominantly 
outside the United States in 2002 pursuant to Sec.  1.48-1(g)(1)(i). As 
a result, the computers are required to be depreciated under the 
alternative depreciation system of section 168(g). Pursuant to paragraph 
(b)(2)(ii)(A)2) of this section, the computers are not qualified 
property in 2002, the placed-in-service year. Thus, pursuant to 
(f)(6)(iv)(B) of this section, no additional first year depreciation 
deduction is allowed for these computers, regardless of the fact that 
the computers are permanently returned to the United States in 2003.
    Example 2. (i) On February 8, 2002, II, a calendar year corporation, 
purchased and placed in service new equipment at a cost of $1,000,000 
for use in its California plant. The equipment is 5-year property under 
section 168(e) and is qualified property under section 168(k). II 
depreciates its 5-year property placed in service in 2002 using the 
optional depreciation table that corresponds with the general 
depreciation system, the 200-percent declining balance method, a 5-year 
recovery period, and the half-year convention. On June 4, 2003, due to 
changes in II's business circumstances, II permanently moves the 
equipment to its plant in Mexico.
    (ii) For 2002, II is allowed a 30-percent additional first year 
depreciation deduction of $300,000 (the adjusted depreciable basis of 
$1,000,000 multiplied by .30). In addition, II's depreciation deduction 
allowable in 2002 for the remaining adjusted depreciable basis of 
$700,000 (the unadjusted depreciable basis of $1,000,000 reduced by the 
additional first year depreciation deduction of $300,000) is $140,000 
(the remaining adjusted depreciable basis of $700,000 multiplied by the 
annual depreciation rate of .20 for recovery year 1).
    (iii) For 2003, the equipment is considered as used predominantly 
outside the United States pursuant to Sec.  1.48-1(g)(1)(i). As a result 
of this change in use, the adjusted depreciable basis of $560,000 for 
the equipment is required to be depreciated under the alternative 
depreciation system of section 168(g) beginning in 2003. However, the 
additional first year depreciation deduction of $300,000 allowed for the 
equipment in 2002 is not redetermined.

    (7) Earnings and profits. The additional first year depreciation 
deduction is not allowable for purposes of computing earnings and 
profits.
    (8) Limitation of amount of depreciation for certain passenger 
automobiles. For a passenger automobile as defined in section 
280F(d)(5), the limitation under section 280F(a)(1)(A)(i) is increased 
by--
    (i) $4,600 for qualified property acquired by a taxpayer after 
September 10, 2001, and before May 6, 2003; and
    (ii) $7,650 for qualified property or 50-percent bonus depreciation 
property acquired by a taxpayer after May 5, 2003.
    (9) Section 754 election. In general, for purposes of section 168(k) 
any increase in basis of qualified property or 50-percent bonus 
depreciation property due to a section 754 election is not eligible for 
the additional first year depreciation deduction. However, if qualified 
property or 50-percent bonus depreciation property is placed in service 
by a partnership in the taxable year the partnership terminates under 
section 708(b)(1)(B), any increase in basis of the

[[Page 600]]

qualified property or the 50-percent bonus depreciation property due to 
a section 754 election is eligible for the additional first year 
depreciation deduction.
    (10) Coordination with section 47--(i) In general. If qualified 
rehabilitation expenditures (as defined in section 47(c)(2) and Sec.  
1.48-12(c)) incurred by a taxpayer with respect to a qualified 
rehabilitated building (as defined in section 47(c)(1) and Sec.  1.48-
12(b)) are qualified property or 50-percent bonus depreciation property, 
the taxpayer may claim the rehabilitation credit provided by section 
47(a) (provided the requirements of section 47 are met)--
    (A) With respect to the portion of the basis of the qualified 
rehabilitated building that is attributable to the qualified 
rehabilitation expenditures if the taxpayer makes the applicable 
election under paragraph (e)(1)(i) or (e)(1)(ii)(B) of this section not 
to deduct any additional first year depreciation for the class of 
property that includes the qualified rehabilitation expenditures; or
    (B) With respect to the portion of the remaining rehabilitated basis 
of the qualified rehabilitated building that is attributable to the 
qualified rehabilitation expenditures if the taxpayer claims the 
additional first year depreciation deduction on the unadjusted 
depreciable basis (as defined in paragraph (a)(2)(iii) of this section 
but before the reduction in basis for the amount of the rehabilitation 
credit) of the qualified rehabilitation expenditures and the taxpayer 
depreciates the remaining adjusted depreciable basis (as defined in 
paragraph (d)(2)(i) of this section) of such expenditures using straight 
line cost recovery in accordance with section 47(c)(2)(B)(i) and Sec.  
1.48-12(c)(7)(i). For purposes of this paragraph (f)(10)(i)(B), the 
remaining rehabilitated basis is equal to the unadjusted depreciable 
basis (as defined in paragraph (a)(2)(iii) of this section but before 
the reduction in basis for the amount of the rehabilitation credit) of 
the qualified rehabilitation expenditures that are qualified property or 
50-percent bonus depreciation property reduced by the additional first 
year depreciation allowed or allowable, whichever is greater.
    (ii) Example. The application of this paragraph (f)(10) is 
illustrated by the following example.

    Example. (i) Between February 8, 2004, and June 4, 2004, UU, a 
calendar-year taxpayer, incurred qualified rehabilitation expenditures 
of $200,000 with respect to a qualified rehabilitated building that is 
nonresidential real property under section 168(e). These qualified 
rehabilitation expenditures are 50-percent bonus depreciation property 
and qualify for the 10-percent rehabilitation credit under section 
47(a)(1). UU's basis in the qualified rehabilitated building is zero 
before incurring the qualified rehabilitation expenditures and UU placed 
the qualified rehabilitated building in service in July 2004. UU 
depreciates its nonresidential real property placed in service in 2004 
under the general depreciation system of section 168(a) by using the 
straight line method of depreciation, a 39-year recovery period, and the 
mid-month convention. UU elected to use the optional depreciation tables 
to compute the depreciation allowance for its depreciable property 
placed in service in 2004. Further, for 2004, UU did not make any 
election under paragraph (e) of this section.
    (ii) Because UU did not make any election under paragraph (e) of 
this section, UU is allowed a 50-percent additional first year 
depreciation deduction of $100,000 for the qualified rehabilitation 
expenditures for 2004 (the unadjusted depreciable basis of $200,000 
(before reduction in basis for the rehabilitation credit) multiplied by 
.50). For 2004, UU also is allowed to claim a rehabilitation credit of 
$10,000 for the remaining rehabilitated basis of $100,000 (the 
unadjusted depreciable basis (before reduction in basis for the 
rehabilitation credit) of $200,000 less the additional first year 
depreciation deduction of $100,000). Further, UU's depreciation 
deduction for 2004 for the remaining adjusted depreciable basis of 
$90,000 (the unadjusted depreciable basis (before reduction in basis for 
the rehabilitation credit) of $200,000 less the additional first year 
depreciation deduction of $100,000 less the rehabilitation credit of 
$10,000) is $1,059.30 (the remaining adjusted depreciable basis of 
$90,000 multiplied by the depreciation rate of .01177 for recovery year 
1, placed in service in month 7).

    (11) Coordination with section 514(a)(3). The additional first year 
depreciation deduction is not allowable for purposes of section 
514(a)(3).
    (g) Effective date--(1) In general. Except as provided in paragraphs 
(g)(2), (3), and (5) of this section, this section applies to qualified 
property under section 168(k)(2) acquired by a taxpayer after September 
10, 2001, and to 50-percent bonus depreciation property under

[[Page 601]]

section 168(k)(4) acquired by a taxpayer after May 5, 2003.
    (2) Technical termination of a partnership or section 168(i)(7) 
transactions. If qualified property or 50 percent bonus depreciation 
property is transferred in a technical termination of a partnership 
under section 708(b)(1)(B) or in a transaction described in section 
168(i)(7) for a taxable year ending on or before September 8, 2003, and 
the additional first year depreciation deduction allowable for the 
property was not determined in accordance with paragraph (f)(1)(ii) or 
(iii) of this section, as applicable, the Internal Revenue Service will 
allow any reasonable method of determining the additional first year 
depreciation deduction allowable for the property in the year of the 
transaction that is consistently applied to the property by all parties 
to the transaction.
    (3)(i) Like-kind exchanges and involuntary conversions. If a 
taxpayer did not claim on a federal tax return for a taxable year ending 
on or before September 8, 2003, the additional first year depreciation 
deduction for the remaining carryover basis of qualified property or 50-
percent bonus depreciation property acquired in a transaction described 
in section 1031(a), (b), or (c), or in a transaction to which section 
1033 applies and the taxpayer did not make an election not to deduct the 
additional first year depreciation deduction for the class of property 
applicable to the remaining carryover basis, the Internal Revenue 
Service will treat the taxpayer's method of not claiming the additional 
first year depreciation deduction for the remaining carryover basis as a 
permissible method of accounting and will treat the amount of the 
additional first year depreciation deduction allowable for the remaining 
carryover basis as being equal to zero, provided the taxpayer does not 
claim the additional first year depreciation deduction for the remaining 
carryover basis in accordance with paragraph (g)(4)(ii) of this section.
    (ii) Paragraphs (f)(5)(ii)(F)(2) and (f)(5)(v) of this section apply 
to a like-kind exchange or an involuntary conversion of MACRS property 
and computer software for which the time of disposition and the time of 
replacement both occur after February 27, 2004. For a like-kind exchange 
or an involuntary conversion of MACRS property for which the time of 
disposition, the time of replacement, or both occur on or before 
February 27, 2004, see Sec.  1.168(i)-6(k)(2)(ii). For a like-kind 
exchange or involuntary conversion of computer software for which the 
time of disposition, the time of replacement, or both occur on or before 
February 27, 2004, a taxpayer may rely on prior guidance issued by the 
Internal Revenue Service for determining the depreciation deductions of 
the acquired computer software and the exchanged or involuntarily 
converted computer software (for further guidance, see Sec.  1.168(k)-
1T(f)(5) published in the Federal Register on September 8, 2003 (68 FR 
53000)). In relying on such guidance, a taxpayer may use any reasonable, 
consistent method of determining depreciation in the year of disposition 
and the year of replacement.
    (4) Change in method of accounting--(i) Special rules for 2000 or 
2001 returns. If a taxpayer did not claim on the Federal tax return for 
the taxable year that included September 11, 2001, any additional first 
year depreciation deduction for a class of property that is qualified 
property and did not make an election not to deduct the additional first 
year depreciation deduction for that class of property, the taxpayer 
should refer to the guidance provided by the Internal Revenue Service 
for the time and manner of claiming the additional first year 
depreciation deduction for the class of property (for further guidance, 
see section 4 of Rev. Proc. 2002-33 (2002-1 C.B. 963), Rev. Proc. 2003-
50 (2003-29 I.R.B. 119), and Sec.  601.601(d)(2)(ii)(b) of this 
chapter).
    (ii) Like-kind exchanges and involuntary conversions. If a taxpayer 
did not claim on a federal tax return for any taxable year ending on or 
before September 8, 2003, the additional first year depreciation 
deduction allowable for the remaining carryover basis of qualified 
property or 50-percent bonus depreciation property acquired in a 
transaction described in section 1031(a), (b), or (c), or in a 
transaction to which section 1033 applies and the taxpayer did not make 
an election not to deduct the

[[Page 602]]

additional first year depreciation deduction for the class of property 
applicable to the remaining carryover basis, the taxpayer may claim the 
additional first year depreciation deduction allowable for the remaining 
carryover basis in accordance with paragraph (f)(5) of this section 
either:
    (A) By filing an amended return (or a qualified amended return, if 
applicable (for further guidance, see Rev. Proc. 94-69 (1994-2 C.B. 804) 
and Sec.  601.601(d)(2)(ii)(b) of this chapter)) on or before December 
31, 2003, for the year of replacement and any affected subsequent 
taxable year; or,
    (B) By following the applicable administrative procedures issued 
under Sec.  1.446-1(e)(3)(ii) for obtaining the Commissioner's automatic 
consent to a change in method of accounting (for further guidance, see 
Rev. Proc. 2002-9 (2002-1 C.B. 327) and Sec.  601.601(d)(2)(ii)(b) of 
this chapter).
    (5) Revision to paragraphs (b)(3)(iii)(B) and (b)(5)(ii)(B) of this 
section. The addition of ``(or, in the case of multiple units of 
property subject to the same lease, within three months after the date 
the final unit is placed in service, so long as the period between the 
time the first unit is placed in service and the time the last unit is 
placed in service does not exceed 12 months)'' to paragraphs 
(b)(3)(iii)(B) and (b)(5)(ii)(B) of this section applies to property 
sold after June 4, 2004.
    (6) Rehabilitation credit. If a taxpayer did not claim on a Federal 
tax return for any taxable year ending on or before September 1, 2006, 
the rehabilitation credit provided by section 47(a) with respect to the 
portion of the basis of a qualified rehabilitated building that is 
attributable to qualified rehabilitation expenditures and the qualified 
rehabilitation expenditures are qualified property or 50-percent bonus 
depreciation property, and the taxpayer did not make the applicable 
election specified in paragraph (e)(1)(i) or (e)(1)(ii)(B) of this 
section for the class of property that includes the qualified 
rehabilitation expenditures, the taxpayer may claim the rehabilitation 
credit for the remaining rehabilitated basis (as defined in paragraph 
(f)(10)(i)(B) of this section) of the qualified rehabilitated building 
that is attributable to the qualified rehabilitation expenditures 
(assuming all the requirements of section 47 are met) in accordance with 
paragraph (f)(10)(i)(B) of this section by filing an amended Federal tax 
return for the taxable year for which the rehabilitation credit is to be 
claimed. The amended Federal tax return must include the adjustment to 
the tax liability for the rehabilitation credit and any collateral 
adjustments to taxable income or to the tax liability (for example, the 
amount of depreciation allowed or allowable in that taxable year for the 
qualified rehabilitated building). Such adjustments must also be made on 
amended Federal tax returns for any affected succeeding taxable years.

[T.D. 9091, 68 FR 52992, Sept. 8, 2003; 68 FR 63734, Nov. 10, 2003, as 
amended by T.D. 9115, 69 FR 9546, Mar. 1, 2004; 69 FR 17586, 17587, Apr. 
5, 2004. Redesignated and amended by T.D. 9283, 71 FR 51738, Aug. 31, 
2006; T.D. 9314, 72 FR 9261, Mar. 1, 2007]



Sec.  1.168A-1  Amortization of emergency facilities; general rule.

    (a) A person (including an estate or trust (see section 642(f) and 
Sec.  1.642(f)-1) and a partnership (see section 703 and Sec.  1.703-1)) 
is entitled, by election, to a deduction with respect to the 
amortization of the adjusted basis (for determining gain) of an 
emergency facility, such amortization to be based on a period of 60 
months. As to the adjusted basis of an emergency facility, see Sec.  
1.168A-5. The taxpayer may elect to begin the 60-month amortization 
period with (1) the month following the month in which such facility was 
completed or acquired, or (2) the taxable year succeeding that in which 
such facility was completed or acquired (see Sec.  1.168A-2). The date 
on which, or the month within which, an emergency facility is completed 
or acquired is to be determined upon the facts in the particular case. 
Ordinarily, the taxpayer is in possession of all the facts and, 
therefore, in a position to ascertain such date. A statement of the date 
ascertained by the taxpayer, together with a statement of the pertinent 
facts relied upon, should be filed with the taxpayer's election to take 
amortization deductions with respect to such facility.

[[Page 603]]

    (b) Generally, an amortization deduction will not be allowed with 
respect to an emergency facility for any taxable year unless such 
facility has been certified before the date of filing of the taxpayer's 
income tax return for such taxable year. However, this limitation does 
not apply in the case of a certificate made after August 22, 1957, for 
an emergency facility to provide primary processing for uranium ore or 
uranium concentrate under a program of the Atomic Energy Commission for 
the development of any sources of uranium ore or uranium concentrate, if 
application for such certificate was filed either (1) before September 
2, 1958, and before the expiration of six months after the beginning of 
construction, reconstruction, erection, or installation or the date of 
acquisition of the facility, or (2) after September 1, 1958, and on or 
before December 2, 1958.
    (c) In general, with respect to each month of the 60-month period 
which falls within the taxable year, the amortization deduction is an 
amount equal to the adjusted basis of the facility at the end of each 
month divided by the number of months (including the particular month 
for which the deduction is computed) remaining in the 60-month period. 
The adjusted basis at the end of any month shall be computed without 
regard to the amortization deduction for such month. The total 
amortization deduction with respect to an emergency facility for a 
particular taxable year is the sum of the amortization deductions 
allowable for each month of the 60-month period which falls within such 
taxable year. The amortization deduction taken for any month is in lieu 
of the deduction for depreciation which would otherwise be allowable 
under section 167. See, however, Sec.  1.168A-6, relating to 
depreciation with respect to any portion of the emergency facility not 
subject to amortization.
    (d) This section may be illustrated by the following examples:

    Example 1. On July 1, 1954, the X Corporation, which makes its 
income tax returns on the calendar year basis, begins the construction 
of an emergency facility which is completed on September 30, 1954, at a 
cost of $240,000. The certificate covers the entire construction. The X 
Corporation elects to take amortization deductions with respect to the 
facility and to begin the 60-month amortization period with October, the 
month following its completion. The adjusted basis of the facility at 
the end of October is $240,000. The allowable amortization deduction 
with respect to such facility for the taxable year 1954 is $12,000, 
computed as follows:

Monthly amortization deductions:
  October: $240,000 divided by 60.............................    $4,000
  November: $236,000 ($240,000 minus $4,000) divided by 59....     4,000
  December: $232,000 ($236,000 minus $4,000) divided by 58....     4,000
                                                               ---------
    Total amortization deduction for 1954.....................    12,000
 

    Example 2. The Y Corporation, which makes its income tax returns on 
the basis of a fiscal year ending November 30, purchases an emergency 
facility (No. 1) on July 29, 1955. On June 15, 1955, it begins the 
construction of an emergency facility (No. 2) which is completed on 
August 2, 1955. The entire acquisition and construction of such 
facilities are covered by the certificate. The Y Corporation elects to 
take amortization deductions with respect to both facilities and to 
begin the 60-month amortization period in each case with the month 
following the month of acquisition or completion. At the end of the 
first month of the amortization period the adjusted basis of facility 
No. 1 is $300,000 and the adjusted basis of facility No. 2 is $54,000. 
In September 1955, facility No. 1 is damaged by fire, as a result of 
which its adjusted basis is properly reduced by $25,370. The allowable 
amortization deduction with respect to such facilities for the taxable 
year ending November 30, 1955, is $21,410, computed as follows:

                             Facility No. 1
Monthly amortization deductions:
  August: $300,000 divided by 60..............................    $5,000
  September: $269,630 ($300,000 minus $5,000 and $25,370)          4,570
   divided by 59..............................................
  October: $265,060 ($269,630 minus $4,570) divided by 58.....     4,570
  November: $260,490 ($265,060 minus $4,570) divided by 57....     4,570
                                                               ---------
      Amortization deduction for 1955.........................    18,710
 
                             Facility No. 2
 
Monthly amortization deductions:
  September: $54,000 divided by 60............................      $900
  October: $53,100 divided by 59..............................       900
  November: $52,200 divided by 58.............................       900
                                                               ---------
    Amortization deduction for 1955...........................     2,700
                                                               =========
    Total amortization deduction for 1955.....................    21,410
 

    Example 3. On June 15, 1954, the Z Corporation, which makes its 
income tax returns on the calendar year basis, completes the 
construction of an emergency facility at a cost of $110,000. In its 
income tax return for 1954, filed on March 15, 1955, the Z Corporation 
elects to take amortization deductions with respect to such facility and 
to begin the 60-month amortization period with July 1954,

[[Page 604]]

the month following its completion. No certificate with respect to such 
facility is made until April 10, 1955, and therefore no amortization 
deduction with respect to such facility is allowable for any month in 
the taxable year 1954. The Z Corporation is entitled, however, to take a 
deduction for depreciation of such facility for the taxable year 1954, 
such deduction being assumed, for the purposes of this example, to be 
$2,000. Accordingly, the adjusted basis of such facility at the end of 
January 1955 (without regard to the amortization deduction for such 
month) is $108,000 ($110,000 minus $2,000). For the taxable year 1955, 
the Z Corporation is, with respect to such facility, entitled to an 
amortization deduction of $24,000, computed as follows:

Monthly amortization deductions:
  January: $108,000 divided by 54.............................    $2,000
  February: $106,000 ($108,000 minus $2,000) divided by 53....     2,000
  March: $104,000 ($106,000 minus $2,000) divided by 52.......     2,000
  For the remaining nine months (similarly computed)..........    18,000
                                                               ---------
    Total amortization deduction for 1955.....................    24,000
 


Since the Z Corporation elected in its return for 1954 to take 
amortization deductions with respect to such facility and to begin the 
60-month amortization period with July 1954, it must compute its 
amortization deductions for the 12 months in the taxable year 1955 on 
the basis of the remaining months of the established 60-month 
amortization period, as indicated in the above computation.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960. 
Redesignated and amended by T.D. 8116, 51 FR 46618, Dec. 24, 1986]



Sec.  1.168A-2  Election of amortization.

    (a) General rule. An election by the taxpayer to take amortization 
deductions with respect to an emergency facility and to begin the 60-
month amortization period either with the month following the month in 
which such facility was completed or acquired, or with the taxable year 
succeeding the taxable year in which such facility was completed or 
acquired, shall be made by a statement to that effect in its return for 
the taxable year in which falls the first month of the 60-month 
amortization period so elected. However, if the facility is described in 
section 168(e)(2)(C) and an application for a certificate is filed 
within the period prescribed by section 9(c) of the Technical Amendments 
Act of 1958 (72 Stat. 1609) and paragraph (b) of Sec.  1.168A-1, the 
election may be made by a statement in an amended income tax return for 
the taxable year in which falls the first month of the 60-month 
amortization period so elected. The statement and amended return in such 
case must be filed not later than 90 days after the date the certificate 
is made or not later than April 4, 1960, whichever is later. Amended 
income tax returns or claims for credit or refund should also be filed 
for other taxable years which are within such amortization period and 
which precede the taxable year in which the election is made. Nothing in 
this paragraph should be construed as extending the time specified in 
section 6511 within which a claim for credit or refund may be filed.
    (b) Election not made, in prescribed manner. If the statement of 
election is not made by the taxpayer as prescribed in paragraph (a) of 
this section, it may, in the discretion of the Commissioner and for good 
cause shown, be made in such manner and form and within such time as may 
be approved by the Commissioner.
    (c) Other requirements and considerations. No method of making such 
election other than those prescribed in this section and corresponding 
sections of prior regulations is permitted. Any statement of election 
should contain a description clearly identifying each emergency facility 
for which an amortization deduction is claimed. A taxpayer which does 
not elect, in the manner prescribed in this section or corresponding 
sections of prior regulations, to take amortization deductions with 
respect to an emergency facility shall not be entitled to such 
deductions.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960. 
Redesignated and amended by T.D. 8116, 51 FR 46618, Dec. 24, 1986]



Sec.  1.168A-3  Election to discontinue amortization.

    (a) If a taxpayer has elected to take amortization deductions with 
respect to an emergency facility, it may, after such election and prior 
to the expiration of the 60-month amortization period, discontinue the 
amortization deductions for the remainder of the 60-month period. An 
election to discontinue the amortization deductions shall be made by a 
notice in writing

[[Page 605]]

filed with the district director for the internal revenue district in 
which the return of the taxpayer is required to be filed, specifying the 
month as of the beginning of which the taxpayer elects to discontinue 
such deductions. Such notice shall be filed before the beginning of the 
month specified therein, and shall contain a description clearly 
identifying the emergency facility with respect to which the taxpayer 
elects to discontinue the amortization deductions. If the taxpayer so 
elects to discontinue the amortization deductions, it shall not be 
entitled to any further amortization deductions with respect to such 
facility.
    (b) A taxpayer which thus elects to discontinue amortization 
deductions with respect to an emergency facility is entitled, if such 
facility is depreciable property under section 167 and the regulations 
thereunder, to a deduction for depreciation with respect to such 
facility. The deduction for depreciation shall begin with the first 
month as to which the amortization deduction is not applicable, and 
shall be computed on the adjusted basis of the property as of the 
beginning of such month (see section 1011 and the regulations 
thereunder).
    (c) This section may be illustrated by the following example:

    Example. On July 1, 1954, the X Corporation, which makes its income 
tax returns on the calendar year basis, purchases an emergency facility, 
consisting of land with a building thereon, at a cost of $306,000 of 
which $60,000 is allocable to the land and $246,000 to the building. The 
certificate covers the entire acquisition. The corporation elects to 
take amortization deductions with respect to the facility and to begin 
the 60-month amortization period with the taxable year 1955. 
Depreciation of the building in the amount of $6,000 is deducted and 
allowed for the taxable year 1954. On March 25, 1956, the corporation 
files notice with the district director of its election to discontinue 
the amortization deductions beginning with the month of April 1956. The 
adjusted basis of the facility on January 31, 1955, is $300,000, or the 
cost of the facility ($306,000) less the depreciation allowed for 1954 
($6,000). The amortization deductions for the taxable year 1955 and the 
months of January, February, and March 1956, amount to $75,000, or 
$5,000 per month for 15 months. Since, at the beginning of the 
amortization period (January 1, 1955), the adjusted basis of the land 
($60,000) is one-fifth of the adjusted basis of the entire facility 
($300,000) and since there are no adjustments to basis other than on 
account of amortization during the period, the adjusted basis of the 
land should be reduced by $15,000, or one-fifth of the entire 
amortization deduction, and the adjusted basis of the building should be 
reduced by $60,000, or four-fifths of the entire amortization deduction. 
Accordingly, the adjusted basis of the facility as of April 1, 1956, is 
$225,000, of which $180,000 is allocable to the building for the purpose 
of depreciation deductions under section 167, and $45,000 is allocable 
to the land.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960. 
Redesignated by T.D. 8116, 51 FR 46619, Dec. 24, 1986]



Sec.  1.168A-4  Definitions.

    As used in the regulations under section 168, the term--
    (a) ``Certifying authority'' means the certifying authority 
designated by the President by Executive order.
    (b) ``Emergency facility'' means any facility, land, building, 
machinery, or equipment, or any part thereof, the acquisition of which 
occurred after December 31, 1949, or the construction, reconstruction, 
erection, or installation of which was completed after such date, and 
with respect to which a certificate under section 168(e) has been made. 
In the case of an application for a certificate under section 168(e) 
which is filed after March 23, 1951, only the part of any such facility 
which is constructed, reconstructed, erected, or installed by any person 
not earlier than six months prior to the filing of such application, and 
which is certified in accordance with section 168(e), shall be deemed to 
be an emergency facility, notwithstanding that the other part of such 
facility was constructed, reconstructed, erected, or installed earlier 
than six months prior to the filing of such application. However, if the 
facility is one described in section 168(e)(2)(C) and the application 
was filed after September 1, 1958, and on or before December 2, 1958, 
the preceding sentence shall not apply. The term ``emergency facility,'' 
as so defined, may include, among other things, improvements of land, 
such as the construction of roads, bridges, and airstrips, and the 
dredging of channels.
    (c) ``Emergency period'' means the period beginning on January 1, 
1950, and ending on the date on which the

[[Page 606]]

President proclaims that the utilization of a substantial portion of the 
certified emergency facilities is no longer required in the interest of 
national defense.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960. 
Redesignated by T.D. 8116, 51 FR 46619, Dec. 24, 1986]



Sec.  1.168A-5  Adjusted basis of emergency facility.

    (a) In general. (1) The adjusted basis of an emergency facility for 
the purpose of computing the amortization deduction may differ from what 
would otherwise constitute the adjusted basis of such emergency facility 
in that it shall be the adjusted basis for determining gain (see Part II 
(section 1011 and following), Subchapter 0, Chapter 1 of the Code) and 
in that it may be only a portion of what would otherwise constitute the 
adjusted basis. It will be only a portion of such other adjusted basis 
if only a portion of the basis (unadjusted) is attributable to certified 
construction, reconstruction, erection, installation, or acquisition 
taking place after December 31, 1949. Also, it will be only a portion of 
what would otherwise constitute the adjusted basis of the emergency 
facility if only a portion of the basis (unadjusted) is certified as 
attributable to defense purposes or, in the case of a certification 
after August 22, 1957, if only a portion of the basis (unadjusted) is 
certified as attributable to the national defense program. It is 
therefore necessary first to determine the unadjusted basis of the 
emergency facility from which the adjusted basis for amortization 
purposes is derived.
    (2) The unadjusted basis for amortization purposes is the same as 
the unadjusted basis otherwise determined only when the entire 
construction, reconstruction, erection, installation, or acquisition 
takes place after December 31, 1949, and is certified in its entirety by 
the certifying authority.
    (3) In cases in which only a portion of the construction, 
reconstruction, erection, installation, or acquisition takes place after 
December 31, 1949, and that portion is certified in its entirety by the 
certifying authority, the unadjusted basis for the purpose of 
amortization is so much of the entire unadjusted basis as is 
attributable to the certified construction, reconstruction, erection, 
installation, or acquisition which takes place after December 31, 1949. 
For example, the X Corporation begins the construction of a facility on 
November 15, 1949, and such facility is completed on April 1, 1952, at a 
cost of $5,000,000, of which $4,600,000 is attributable to construction 
after December 31, 1949. The entire construction after December 31, 
1949, is certified by the certifying authority. The unadjusted basis of 
the emergency facility for amortization purposes is therefore 
$4,600,000. For depreciation of the remaining portion ($400,000) of the 
cost see Sec.  1.168A-6.
    (4) If the certifying authority certifies only a portion of the 
construction, reconstruction, erection, installation, or acquisition of 
property which takes place after December 31, 1949, the unadjusted basis 
for amortization purposes is limited to such portion so certified. 
Assuming the same facts as in the example in subparagraph (3) of this 
paragraph, except that only 50 percent of the construction, 
reconstruction, erection, installation, or acquisition after December 
31, 1949, is certified, the unadjusted basis for amortization purposes 
is 50 percent of $4,600,000, or $2,300,000.
    (5) The adjusted basis of an emergency facility for amortization 
purposes is the unadjusted basis for amortization purposes less the 
adjustments properly applicable thereto. Such adjustments are those 
specified in sections 1016 and 1017, except that no adjustments are to 
be taken into account which increase the adjusted basis. (See paragraph 
(b) of this section.) If the taxpayer constructs, reconstructs, erects, 
installs, or acquires an emergency facility pursuant to a cost 
reimbursement contract with an obligation for reimbursement by the 
United States of all or a part of the cost of such facility, the 
unadjusted basis of such facility for amortization purposes shall not 
include that part of the cost for which the taxpayer is entitled to 
reimbursement, and the amount received as reimbursement shall be treated 
as a capital receipt. However, amounts received by a taxpayer which

[[Page 607]]

represent in fact compensation by reason of termination of a government 
contract or payment for articles under such a contract, though 
denominated reimbursements for all or a part of the cost of an emergency 
facility, are not to be treated as capital receipts but are to be taken 
into account in computing income, and are therefore not to be applied in 
reduction of the basis of such facility.
    (6) The following examples will illustrate the computation of the 
adjusted basis of an emergency facility for amortization purposes:

    Example 1. The X Corporation completes an emergency facility on July 
1, 1954, the entire unadjusted basis of which is $500,000, and the 
unadjusted basis of which for the purpose of amortization is $300,000. 
The X Corporation elects to begin amortization as of January 1, 1955. 
The only adjustment to basis for the period July 1, 1954, to January 31, 
1955, other than depreciation or amortization for January 1955, is 
$5,000 for depreciation for the last six months of 1954. The adjusted 
basis for the purpose of amortization is therefore $300,000 less $3,000 
(300,000/500,000 x $5,000), or $297,000.
    Example 2. On July 31, 1956, the Y Corporation has an emergency 
facility (a building) which was completed on July 1, 1952, the entire 
basis of which is $500,000 and the unadjusted basis of which for the 
purpose of amortization is $300,000. The corporation elected to begin 
amortization as of January 1, 1953, at which time it was entitled to 
$5,000 depreciation for the last six months of 1952. On July 1, 1956, 
the facility was damaged by fire, as the result of which its adjusted 
basis is properly reduced by $200,000. The adjusted basis of the 
emergency facility as of July 1956 for the purpose of amortization and 
depreciation, and the adjusted basis for other purposes, are $23,849.18, 
$49,250.82, and $73,100.00, respectively, computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                        For             For          For other
                                                                   amortization    depreciation      purposes
----------------------------------------------------------------------------------------------------------------
Unadjusted basis................................................     $300,000.00     $200,000.00        $500,000
Less depreciation to Jan. 1, 1953...............................        3,000.00        2,000.00           5,000
                                                                 -----------------------------------------------
  Adjusted basis January 1953...................................      297,000.00      198,000.00         495,000
Less amortization for 42 months.................................      207,900.00  ..............         207,900
Less depreciation for 42 months.................................  ..............       14,000.00          14,000
                                                                 -----------------------------------------------
  Adjusted basis at time of fire................................       89,100.00      184,000.00         273,100
Less fire loss (apportioned as explained below).................       65,250.82      134,749.18         200,000
                                                                 -----------------------------------------------
  Adjusted basis after fire loss................................       23,849.18       49,250.82          73,100
----------------------------------------------------------------------------------------------------------------


The $200,000 fire loss is applied against the adjusted basis for the 
purpose of amortization and the adjusted basis for the purpose of 
depreciation in the proportion that each such adjusted basis at the time 
of the fire bears to their sum, i.e., 89,100/273,100 x $200,000 or 
$65,250.82, against the amortization basis, and 184,000/273,100 x 
$200,000, or $134,749.18 against the depreciation basis.

    (b) Capital additions. (1) If, after the completion or acquisition 
of an emergency facility which has been certified by the certifying 
authority, further expenditures are made for construction, 
reconstruction, erection, installation, or acquisition attributable to 
such facility but not covered by such certification, such expenditures 
shall not be added to the adjusted basis of the emergency facility for 
amortization purposes under such certification. If such further 
expenditures are separately certified in accordance with the provisions 
of section 168(e) (1) or (2) and this section, they are treated as 
certified expenditures in connection with a new and separate emergency 
facility and, if proper election is made, will be taken into account in 
computing the adjusted basis of such new and separate emergency facility 
for the purpose of amortization.
    (2) The application of subparagraph (1) of this paragraph may be 
illustrated by the following example:

    Example. On March 1, 1954, the certifying authority certifies as an 
emergency facility a heating plant proposed to be constructed by the Z 
Corporation. Such facility is completed on July 1, 1954. The Z 
Corporation, on August 1, 1954, begins the installation in the plant of 
an additional boiler, which is not included in the certification for the 
plant but is certified as a new and separate emergency facility. For 
amortization purposes, the adjusted basis of the heating plant is 
determined without including the cost of the additional boiler. Such 
cost is taken into account in computing the adjusted basis of the

[[Page 608]]

new and separate emergency facility (the boiler), as to which the 
taxpayer has a separate election for amortization purposes and a 
separate amortization period.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960. 
Redesignated and amended by T.D. 8116, 51 FR 46619, Dec. 24, 1986]



Sec.  1.168A-6  Depreciation of portion of emergency facility 
not subject to amortization.

    (a) The rule that an amortization deduction with respect to an 
emergency facility is in lieu of any deduction for depreciation which 
would otherwise be allowable under section 167 is subject to the 
exception provided in section 168(f). Under this exception, if the 
property constituting such facility is depreciable property under 
section 167 and the regulations thereunder and if the adjusted basis of 
such facility as computed under section 1011 for purposes other than the 
amortization deductions is in excess of the adjusted basis computed for 
the purpose of the amortization deductions, then the excess shall be 
charged off over the useful life of the facility and recovered through 
depreciation deductions. Thus, if the construction of an emergency 
facility is begun on or before December 31, 1949, and completed after 
such date, no amortization deductions are allowable with respect to the 
amount attributable to such construction on or before such date (see 
Sec.  1.168A-5). However, if the property constituting such facility is 
depreciable property under section 167 and the regulations thereunder, 
then the depreciation deduction provided by such section and regulations 
is allowable with respect to the amount attributable to such 
construction on or before December 31, 1949.
    (b) Similarly, if only a portion of the construction, 
reconstruction, erection, installation, or acquisition after December 
31, 1949, of an emergency facility has been certified by the certifying 
authority, and if such facility is depreciable property under section 
167 and the regulations thereunder, then the depreciation deduction 
provided by such section and regulations is allowable with respect to 
the portion which has not been so certified.
    (c) For illustration of the treatment of a depreciable portion of an 
emergency facility, see example (2) in paragraph (a)(6) of Sec.  1.168A-
5.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960. 
Redesignated and amended by T.D. 8116, 51 FR 46619, Dec. 24, 1986]



Sec.  1.168A-7  Payment by United States of unamortized cost of facility.

    (a) Section 168(g) contemplates that certain payments may be made by 
the United States to a taxpayer as compensation for the unamortized cost 
of an emergency facility. If any such payment is properly includible in 
gross income and has been certified, as provided in section 168(g), as 
having been paid under the circumstances described therein, a taxpayer 
which is recovering the adjusted basis of an emergency facility through 
amortization rather than depreciation may elect to take an amount equal 
to such payment as an amortization deduction with respect to such 
facility for the month in which such payment is so includible. Such 
amortization deduction shall be in lieu of the amortization deduction 
otherwise allowable with respect to such facility for such month, but it 
shall not in any case exceed the adjusted basis of such facility (see 
Sec.  1.168A-5) as of the end of such month (computed without regard to 
any amortization deduction for such month). The election referred to in 
this paragraph shall be made in the return for the taxable year in which 
the amount of such payment is includible in gross income.
    (b) If a taxpayer is recovering the adjusted basis of an emergency 
facility through depreciation rather than amortization, the depreciation 
deduction allowable under section 167 for the month in which the amount 
of any such payment is includible in gross income shall, at the 
taxpayer's election, be increased by such amount; but the total 
deduction with respect to the certified portion of such facility shall 
not in any case exceed the adjusted basis of such facility (computed as 
provided in section 168(e) and Sec.  1.168A-5 for amortization purposes) 
as of the end of such month (computed without regard to any amount 
allowable for such month under section 167 or 168(g)(2)). The election 
referred to in this paragraph shall be made in the return for the 
taxable

[[Page 609]]

year in which the amount of such payment is includible in gross income.
    (c) This section may be illustrated by the following examples:

    Example 1. On January 31, 1954, the X Corporation purchases an 
emergency facility at a cost of $600,000. The certificate covers the 
entire acquisition. The X Corporation elects to take amortization 
deductions with respect to such facility and to begin the 60-month 
amortization period with February 1954, the month following the month of 
acquisition. On July 15, 1955, as a result of the cancellation of 
certain contracts with the X Corporation, the United States makes a 
payment of $300,000 to the corporation as compensation for the 
unamortized cost of such facility. The $300,000 payment is includible in 
the X Corporation's gross income for July 1955. The adjusted basis of 
such facility for amortization purposes as of the end of July 1955, 
computed without regard to any amortization deduction for such month, is 
$430,000. Accordingly, the corporation is entitled to take an 
amortization deduction of $300,000 for such month, in lieu of the 
$10,000 amortization deduction which is otherwise allowable.
    Example 2. On November 30, 1954, the Y Corporation purchases an 
emergency facility, consisting of land with a building thereon, at a 
cost of $500,000, of which $200,000 is allocable to the land and 
$300,000 to the building. The certificate covers the entire acquisition. 
The Y Corporation does not elect to take amortization deductions with 
respect to such facility, but is entitled to a depreciation deduction 
with respect to the building at the rate of 3 percent per annum, or $750 
per month. On August 12, 1956, as a result of cancellation of certain 
contracts, the United States makes a payment of $400,000 to the 
corporation as compensation for the unrecovered cost of such facility. 
The $400,000 is includible in the Y Corporation's gross income for 
August 1956. The adjusted basis of the facility as of the end of August 
1956, computed without regard to depreciation for such month, is 
$485,000, of which amount $200,000 is allocable to the land and $285,000 
to the building. Accordingly, the corporation is entitled to increase 
the $750 depreciation deduction for August 1956 by the full amount of 
the $400,000 payment.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960. 
Redesignated and amended by T.D. 8116, 51 FR 46619, Dec. 24, 1986]



Sec.  1.169-1  Amortization of pollution control facilities.

    (a) Allowance of deduction--(1) In general. Under section 169(a), 
every person, at his election, shall be entitled to a deduction with 
respect to the amortization of the amortizable basis (as defined in 
Sec.  1.169-3) of any certified pollution control facility (as defined 
in Sec.  1.169-2), based on a period of 60 months. Under section 169(b) 
and paragraph (a) of Sec.  1.169-4, the taxpayer may further elect to 
begin such 60-month period either with the month following the month in 
which the facility is completed or acquired or with the first month of 
the taxable year succeeding the taxable year in which such facility is 
completed or acquired. Under section 169(c), a taxpayer who has elected 
under section 169(b) to take the amortization deduction provided by 
section 169(a) may, at any time after making such election and prior to 
the expiration of the 60-month amortization period, elect to discontinue 
the amortization deduction for the remainder of the 60-month period in 
the manner prescribed in paragraph (b)(1) of Sec.  1.169-4. In addition, 
if on or before May 18, 1971, an election under section 169(a) has been 
made, consent is hereby given to revoke such election without the 
consent of the Commissioner in the manner prescribed in (b)(2) of Sec.  
1.169-4.
    (2) Amount of deduction. With respect to each month of such 60-month 
period which falls within the taxable year, the amortization deduction 
shall be an amount equal to the amortizable basis of the certified 
pollution control facility at the end of such month divided by the 
number of months (including the month for which the deduction is 
computed) remaining in such 60-month period. The amortizable basis at 
the end of any month shall be computed without regard to the 
amortization deduction for such month. The total amortization deduction 
with respect to a certified pollution control facility for a taxable 
year is the sum of the amortization deductions allowable for each month 
of the 60-month period which falls within such taxable year. If a 
certified pollution control facility is sold or exchanged or otherwise 
disposed of during 1 month, the amortization deduction (if any) 
allowable to the original holder in respect of such month shall be that 
portion of the amount to which such person would be entitled for a full 
month which the number of days in such month during which the facility 
was held by such person bears to

[[Page 610]]

the total number of days in such month.
    (3) Effect on other deductions. (i) The amortization deduction 
provided by section 169 with respect to any month shall be in lieu of 
the depreciation deduction which would otherwise be allowable under 
section 167 or a deduction in lieu of depreciation which would otherwise 
be allowable under paragraph (b) of Sec.  1.162-11 for such month.
    (ii) If the adjusted basis of such facility as computed under 
section 1011 for purposes other than the amortization deduction provided 
by section 169 is in excess of the amortizable basis, as computed under 
Sec.  1.169-3, such excess shall be recovered through depreciation 
deductions under the rules of section 167. See section 169(g).
    (iii) See section 179 and paragraph (e)(1)(ii) of Sec.  1.179-1 and 
paragraph (b)(2) of Sec.  1.169-3 for additional first-year depreciation 
in respect of a certified pollution control facility.
    (4) [Reserved]
    (5) Special rules. (i) In the case of a certified pollution control 
facility held by one person for life with the remainder to another 
person, the amortization deduction under section 169(a) shall be 
computed as if the life tenant were the absolute owner of the property 
and shall be allowable to the life tenant during his life.
    (ii) If the assets of a corporation which has elected to take the 
amortization deduction under section 169(a) are acquired by another 
corporation in a transaction to which section 381 (relating to 
carryovers in certain corporate acquisitions) applies, the acquiring 
corporation is to be treated as if it were the distributor or transferor 
corporation for purposes of this section.
    (iii) For the right of estates and trusts to amortize pollution 
control facilities see section 642(f) and Sec.  1.642 (f)-1. For the 
allowance of the amortization deduction in the case of pollution control 
facilities of partnerships, see section 703 and Sec.  1.703-1.
    (6) Depreciation subsequent to discontinuance or in the case of 
revocation of amortization. A taxpayer which elects in the manner 
prescribed under paragraph (b) (1) of Sec.  1.169-4 to discontinue 
amortization deductions or under paragraph (b) (2) of Sec.  1.169-4 to 
revoke an election under section 169(a) with respect to a certified 
pollution control facility is entitled, if such facility is of a 
character subject to the allowance for depreciation provided in section 
167, to a deduction for depreciation (to the extent allowable) with 
respect to such facility. In the case of an election to discontinue an 
amortization deduction, the deduction for depreciation shall begin with 
the first month as to which such amortization deduction is not 
applicable and shall be computed on the adjusted basis of the property 
as of the beginning of such month (see section 1011 and the regulations 
thereunder). Such depreciation deduction shall be based upon the 
remaining portion of the period authorized under section 167 for the 
facility as determined, as of the first day of the first month as of 
which the amortization deduction is not applicable. If the taxpayer so 
elects to discontinue the amortization deduction under section 169(a), 
such taxpayer shall not be entitled to any further amortization 
deduction under this section and section 169(a) with respect to such 
pollution control facility. In the case of a revocation of an election 
under section 169(a), the deduction for depreciation shall begin as of 
the time such depreciation deduction would have been taken but for the 
election under section 169(a). See paragraph (b)(2) of Sec.  1.169-4 for 
rules as to filing amended returns for years for which amortization 
deductions have been taken.
    (7) Definitions. Except as otherwise provided in Sec.  1.169-2, all 
terms used in section 169 and the regulations thereunder shall have the 
meaning provided by this section and Sec. Sec.  1.169-2 through 1.169-4.
    (b) Examples. This section may be illustrated by the following 
examples:

    Example 1. On September 30, 1970, the X Corporation, which uses the 
calendar year as its taxable year, completes the installation of a 
facility all of which qualifies as a certified pollution control 
facility within the meaning of paragraph (a) of Sec.  1.169-2. The cost 
of the facility is $120,000 and the period referred to in paragraph 
(a)(6) of Sec.  1.169-2 is 10 years in accordance with the rules set 
forth in paragraph (a) of Sec.  1.169-4, on its income tax return filed 
for 1970, X elects to take amortization deductions under section 169(a) 
with

[[Page 611]]

respect to the facility and to begin the 60-month amortization period 
with October 1970, the month following the month in which it was 
completed. The amortizable basis at the end of October 1970 (determined 
without regard to the amortization deduction under section 169(a) for 
that month) is $120,000. The allowable amortization deduction with 
respect to such facility for the taxable year 1970 is $6,000, computed 
as follows:

Monthly amortization deductions:
  October: $120,000 divided by 60.............................    $2,000
  November: $118,000 (that is, $120,000 minus $2,000) divided      2,000
   by 59......................................................
  December: $116,000 (that is, $118,000 minus $2,000) divided      2,000
   by 58......................................................
                                                               ---------
      Total amortization deduction for 1970...................     6,000
 

    Example 2. Assume the same facts as in example (1). Assume further 
that on May 20, 1972, X properly files notice of its election to 
discontinue the amortization deductions with the month of June 1972. The 
adjusted basis of the facility as of June 1, 1972, is $80,000, computed 
as follows:

Yearly amortization deductions:
  1970 (as computed in example (1))...........................    $6,000
  1971 (computed in accordance with example (1))..............    24,000
  1972 (for the first 5 months of 1972 computed in accordance     10,000
   with example (1))..........................................
                                                               ---------
    Total amortization deductions for 20 months...............    40,000
                                                               ---------
Adjusted basis as beginning of amortization period............   120,000
Less: Amortization deductions.................................    40,000
                                                               ---------
Adjusted basis as of June 1, 1972.............................    80,000
                                                               ---------
 


Beginning as of June 1, 1972, the deduction for depreciation under 
section 167 is allowable with respect to the property on its adjusted 
basis of $80,000.

[T.D. 7116, 36 FR 9012, May 18, 1971; 36 FR 9770, May 28, 1971, as 
amended by T.D. 7203, 37 FR 17133, Aug. 25, 1972]



Sec.  1.169-2  Definitions.

    (a) Certified pollution control facility--(1) In general. Under 
section 169 (d), the term ``certified pollution control facility'' means 
a facility which--
    (i) The Federal certifying authority certifies, in accordance with 
the rules prescribed in paragraph (c) of this section, is a ``treatment 
facility'' described in subparagraph (2) of this paragraph, and
    (ii) Is ``a new identifiable facility'' (as defined in paragraph (b) 
of this section).

For profitmaking abatement works limitation, see paragraph (d) of this 
section.
    (2) Treatment facility. For purposes of subparagraph (1)(i) of this 
paragraph, a ``treatment facility'' is a facility which (i) is used to 
abate or control water or atmospheric pollution or contamination by 
removing, altering, disposing, or storing of pollutants, contaminants, 
wastes, or heat and (ii) is used in connection with a plant or other 
property in operation before January 1, 1969. Determinations under 
subdivision (i) of this subparagraph shall be made solely by the Federal 
certifying authority. See subparagraph (3) of this paragraph. For 
meaning of the phrases ``plant or other property'' and ``in operation 
before January 1, 1969,'' see subparagraphs (4) and (5), respectively, 
of this paragraph.
    (3) Facilities performing multiple functions or used in connection 
with several plants, etc. (i) If a facility is designed to perform or 
does perform a function in addition to abating or controlling water or 
atmospheric pollution or contamination by removing, altering, disposing 
or storing pollutants, contaminants, wastes, or heat, such facility 
shall be a treatment facility only with respect to that part of the cost 
thereof which is certified by the Federal certifying authority as 
attributable to abating of controlling water or atmospheric pollution or 
contamination. For example, if a machine which performs a function in 
addition to abating water pollution is installed at a cost of $100,000 
in, and is used only in connection with, a plant which was in operation 
before January 1, 1969, and if the Federal certifying authority 
certifies that $30,000 of the cost of such machine is allocable to its 
function of abating water pollution, such $30,000 will be deemed to be 
the adjusted basis for purposes of determining gain for purposes of 
paragraph (a) of Sec.  1.169-3.
    (ii) If a facility is used in connection with more than one plant or 
other property, and at least one such plant or other property was not in 
operation before January 1, 1969, such facility shall be a treatment 
facility only to the extent of that part of the cost thereof certified 
by the Federal certifying authority as attributable to abating or 
controlling water or atmospheric pollution in connection with plants or 
other property in operation before January 1,

[[Page 612]]

1969. For example, if a machine is constructed after December 31, 1968, 
at a cost of $100,000 and is used in connection with a number of plants 
only some of which were in operation before January 1, 1969, and if the 
Federal certifying authority certifies that $20,000 of the cost of such 
machine is allocable to its function of abating or controlling water 
pollution in connection with the plants or other property in operation 
before January 1, 1969, such $20,000 will be deemed to be the adjusted 
basis for purposes of determining gain for purposes of paragraph (a) of 
Sec.  1.169-3. In a case in which the Federal certifying authority 
certifies the percentage of a facility which is used in connection with 
plants or other property in operation before January 1, 1969, the 
adjusted basis for the purposes of determining gain for purposes of 
paragraph (a) of Sec.  1.169-3 of the portion of the facility so used 
shall be the adjusted basis for determining gain of the entire facility 
multiplied by such percentage.
    (4) Plant or other property. As used in subparagraph (2) of this 
paragraph, the phrase ``plant or other property'' means any tangible 
property whether or not such property is used in the trade or business 
or held for the production of income. Such term includes, for example, a 
papermill, a motor vehicle, or a furnace in an apartment house.
    (5) In operation before January 1, 1969. (i) For purposes of 
subparagraph (2) of this paragraph and section 169 (d), a plant or other 
property will be considered to be in operation before January 1, 1969, 
if prior to that date such plant or other property was actually 
performing the function for which it was constructed or acquired. For 
example, a papermill which is completed in July 1968, but which is not 
actually used to produce paper until 1969 would not be considered to be 
in operation before January 1, 1969. The fact that such plant or other 
property was only operating at partial capacity prior to January 1, 
1969, or was being used as a standby facility prior to such date, shall 
not prevent its being considered to be in operation before such date.
    (ii)(a) A piece of machinery which replaces one which was in 
operation prior to January 1, 1969, and which was a part of the 
manufacturing operation carried on by the plant but which does not 
substantially increase the capacity of the plant will be considered to 
be in operation prior to January 1, 1969. However, an additional machine 
that is added to a plant which was in operation before January 1, 1969, 
and which represents a substantial increase in the plant's capacity will 
not be considered to have been in operation before such date. There 
shall be deemed to be a substantial increase in the capacity of a plant 
or other property as of the time its capacity exceeds by more than 20 
percent its capacity on December 31, 1968.
    (b) In addition, if the total replacements of equipment in any 
single taxable year beginning after December 31, 1968, represents the 
replacement of a substantial portion of a manufacturing plant which had 
been in operation before such date, such replacement shall be considered 
to result in a new plant which was not in operation before such date. 
Thus, if a substantial portion of a plant which was in existence before 
January 1, 1969, is subsequently destroyed by fire and such substantial 
portion is replaced in a taxable year beginning after that date, such 
replacement property shall not be considered to have been in operation 
before January 1, 1969. The replacement of a substantial portion of a 
plant or other property shall be deemed to have occurred if, during a 
single taxable year, the taxpayer replaces manufacturing or production 
facilities or equipment which comprises such plant or other property and 
which has an adjusted basis (determined without regard to the 
adjustments provided in section 1016(a) (2) and (3)) in excess of 20 
percent of the adjusted basis (so determined) of such plant or other 
property determined as of the first day of such taxable year.
    (6) Useful life. For purposes of section 169 and the regulations 
thereunder, the terms ``useful life'' and ``actual useful life'' shall 
mean the shortest period authorized under section 167 and the 
regulations thereunder if an election were not made under section 169.
    (b) New identifiable facility--(1) In general. For purposes of 
paragraph (a)(1)(ii)

[[Page 613]]

of this section, the term ``new identifiable facility'' includes only 
tangible property (not including a building and its structural 
components referred to in subparagraph (2)(i) of this paragraph, other 
than a building and its structural components which under subparagraph 
(2)(ii) of this paragraph is exclusively a treatment facility) which--
    (i) Is of a character subject to the allowance for depreciation 
provided in section 167,
    (ii)(a) Is property the construction, reconstruction, or erection 
(as defined in subparagraph (2)(iii) of this paragraph) of which is 
completed by the taxpayer after December 31, 1968, or
    (b) Is property acquired by the taxpayer after December 31, 1968, if 
the original use of the property commences with the taxpayer and 
commences after such date (see subparagraph (2)(iii) of this paragraph), 
and
    (iii) Is placed in service (as defined in subparagraph (2)(v) of 
this paragraph) prior to January 1, 1975.
    (2) Meaning of terms. (i) For purposes of subparagraph (1) of this 
paragraph, the terms ``building'' and ``structural component'' shall be 
construed in a manner consistent with the principles set forth in 
paragraph (e) of Sec.  1.48-1. Thus, for example, the following rules 
are applicable:
    (a) The term ``building'' generally means any structure or edifice 
enclosing a space within its walls, and usually covered by a roof, the 
purpose of which is, for example, to provide shelter or housing, or to 
provide working, office, parking, display, or sales space. The term 
includes, for example, structures such as apartment houses, factory and 
office buildings, warehouses, barns, garages, railway or bus stations, 
and stores. Such term includes any such structure constructed by, or 
for, a lessee even if such structure must be removed, or ownership of 
such structure reverts to the lessor, at the termination of the lease. 
Such term does not include (1) a structure which is essentially an item 
of machinery or equipment, or (2) an enclosure which is so closely 
combined with the machinery or equipment which it supports, houses, or 
serves that it must be replaced, retired, or abandoned contemporaneously 
with such machinery or equipment, and which is depreciated over the life 
of such machinery or equipment. Thus, the term ``building'' does not 
include such structures as oil and gas storage tanks, grain storage 
bins, silos, fractioning towers, blast furnaces, coke ovens, brick 
kilns, and coal tipples.
    (b) The term ``structural components'' includes, for example, 
chimneys, and other components relating to the operating or maintenance 
of a building. However, the term ``structural components'' does not 
include machinery or a device which serves no function other than the 
abatement or control of water or atmospheric pollution.
    (ii) For purposes of subparagraph (1) of this paragraph, a building 
and its structural components will be considered to be exclusively a 
treatment facility if its only function is the abatement or control of 
air or water pollution. However, the incidental recovery of profits from 
wastes or otherwise shall not be deemed to be a function other than the 
abatement or control of air or water pollution. A building and its 
structural components which serve no function other than the treatment 
of wastes will be considered to be exclusively a treatment facility even 
if it contains areas for employees to operate the treatment facility, 
rest rooms for such workers, and an office for the management of such 
treatment facility. However, for example, if a portion of a building is 
used for the treatment of sewage and another portion of the building is 
used for the manufacture of machinery, the building is not exclusively a 
treatment facility. The Federal certifying authority will not certify as 
to what is a building and its structural components within the meaning 
of subdivision (i) of this subparagraph.
    (iii) For purposes of subparagraph (1)(ii) (a) and (b) of this 
paragraph (relating to construction, reconstruction, or erection after 
December 31, 1968, and original use after December 31, 1968) and 
paragraph (b)(1) of Sec.  1.169-3 (relating to definition of amortizable 
basis), the principles set forth in paragraph (a)

[[Page 614]]

(1) and (2) of Sec.  1.167(c)-1 and in paragraphs (b) and (c) of Sec.  
1.48-2 shall be applied. Thus, for example, the following rules are 
applicable:
    (a) Property is considered as constructed, reconstructed, or erected 
by the taxpayer if the work is done for him in accordance with his 
specifications.
    (b) The portion of the basis of property attributable to 
construction, reconstruction, or erection after December 31, 1968, 
consists of all costs of construction, reconstruction, or erection 
allocable to the period after December 31, 1968, including the cost or 
other basis of materials entering into such work (but not including, in 
the case of reconstruction of property, the adjusted basis of the 
property as of the time such reconstruction is commenced).
    (c) It is not necessary that materials entering into construction, 
reconstruction or erection be acquired after December 31, 1968, or that 
they be new in use.
    (d) If construction or erection by the taxpayer began after December 
31, 1968, the entire cost or other basis of such construction or 
erection may be taken into account for purposes of determining the 
amortizable basis under section 169.
    (e) Construction, reconstruction, or erection by the taxpayer begins 
when physical work is started on such construction, reconstruction, or 
erection.
    (f) Property shall be deemed to be acquired when reduced to physical 
possession or control.
    (g) The term ``original use'' means the first use to which the 
property is put, whether or not such use corresponds to the use of such 
property by the taxpayer. For example, a reconditioned or rebuilt 
machine acquired by the taxpayer after December 31, 1968, for pollution 
control purposes will not be treated as being put to original use by the 
taxpayer regardless of whether it was used for purposes other than 
pollution control by its previous owner. Whether property is 
reconditioned or rebuilt property is a question of fact. Property will 
not be treated as reconditioned or rebuilt merely because it contains 
some used parts.
    (iv) For purposes of subparagraph (1)(iii) of this paragraph 
(relating to property placed in service prior to January 1, 1975), the 
principles set forth in paragraph (d) of Sec.  1.46-3 are applicable. 
Thus, property shall be considered placed in service in the earlier of 
the following taxable years:
    (a) The taxable year in which, under the taxpayer's depreciation 
practice, the period for depreciation with respect to such property 
begins or would have begun; or
    (b) The taxable year in which the property is placed in a condition 
or state of readiness and availability for the abatement or control of 
water or atmospheric pollution.

Thus, if property meets the conditions of (b) of this subdivision in a 
taxable year, it shall be considered placed in service in such year 
notwithstanding that the period for depreciation with respect to such 
property begins or would have begun in a succeeding taxable year 
because, for example, under the taxpayer's depreciation practice such 
property is or would have been accounted for in a multiple asset account 
and depreciation is or would have been computed under an ``averaging 
convention'' (Sec.  1.167(a)-10), or depreciation with respect to such 
property would have been computed under the completed contract method, 
the unit of production method, or the retirement method. In the case of 
property acquired by a taxpayer for use in his trade or business (or in 
the production of income), property shall be considered in a condition 
or state of readiness and availability for the abatement or control of 
water or atmospheric pollution if, for example, equipment is acquired 
for the abatement or control of water or atmospheric pollution and is 
operational but is undergoing testing to eliminate any defects. However, 
materials and parts acquired to be used in the construction of an item 
of equipment shall not be considered in a condition or state of 
readiness and availability for the abatement or control of water or 
atmospheric pollution.
    (c) Certification--(1) In general. For purposes of paragraph (a)(1) 
of this section, a facility is certified in accordance with the rules 
prescribed in this paragraph if--

[[Page 615]]

    (i) The State certifying authority (as defined in subparagraph (2) 
of this paragraph) having jurisdiction with respect to such facility has 
certified to the Federal certifying authority (as defined in 
subparagraph (3) of this paragraph) that the facility was constructed, 
reconstructed, erected, or acquired in conformity with the State program 
or requirements for the abatement or control of water or atmospheric 
pollution or contamination applicable at the time of such certification, 
and
    (ii) The Federal certifying authority has certified such facility to 
the Secretary or his delegate as (a) being in compliance with the 
applicable regulations of Federal agencies (such as, for example, the 
Atomic Energy Commission's regulations pertaining to radiological 
discharge (10 CFR Part 20)) and (b) being in furtherance of the general 
policy of the United States for cooperation with the States in the 
prevention and abatement of water pollution under the Federal Water 
Pollution Control Act, as amended (33 U.S.C. 1151-1175) or in the 
prevention and abatement of atmospheric pollution and contamination 
under the Clean Air Act, as amended (42 U.S.C. 1857 et seq.).
    (2) State certifying authority. The term ``state certifying 
authority'' means--
    (i) In the case of water pollution, the State water pollution 
control agency as defined in section 23(a) of the Federal Water 
Pollution Control Act, as amended (33 U.S.C. 1173(a)),
    (ii) In the case of air pollution, the air pollution control agency 
designated pursuant to section 302(b)(1) of the Clean Air Act, as 
amended (42 U.S.C. 1857h(b)), and
    (iii) Any interstate agency authorized to act in place of a 
certifying authority of a State. See section 23(a) of the Federal Water 
Pollution Control Act, as amended (33 U.S.C. 1173(b)) and section 302(c) 
of the Clean Air Act, as amended (42 U.S.C. 1857h(c)).
    (3) Federal certifying authority. The term ``Federal certifying 
authority'' means the Administrator of the Environmental Protection 
Agency (see Reorganization Plan No. 3 of 1970, 35 FR 15623).
    (d) Profitmaking abatement works, etc.--(1) In general. Section 
169(e) provides that the Federal certifying authority shall not certify 
any property to the extent it appears that by reason of estimated 
profits to be derived through the recovery of wastes or otherwise in the 
operation of such property its costs will be recovered over the period 
referred to in paragraph (a) (6) of this section for such property. The 
Federal certifying authority need not certify the amount of estimated 
profits to be derived from such recovery of wastes or otherwise with 
respect to such facility. Such estimated profits shall be determined 
pursuant to subparagraph (2) of this paragraph. However, the Federal 
certifying authority shall certify--
    (i) Whether, in connection with any treatment facility so certified, 
there is potential cost recovery through the recovery of wastes or 
otherwise, and
    (ii) A specific description of the wastes which will be recovered, 
or the nature of such cost recovery if otherwise than through the 
recovery of wastes.

For effect on computation of amortizable basis, see paragraph (c) of 
Sec.  1.169-3.
    (2) Estimated profits. For purpose of this paragraph, the term 
``estimated profits'' means the estimated gross receipts from the sale 
of recovered wastes reduced by the sum of the (i) estimated average 
annual maintenance and operating expenses, including utilities and 
labor, allocable to that portion of the facility which is certified as a 
treatment facility pursuant to paragraph (a)(1)(i) of this section which 
produces the recovered waste from which the gross receipts are derived, 
and (ii) estimated selling expenses. However, in determining expenses to 
be subtracted neither depreciation nor amortization of the facility is 
to be taken into account. Estimated profits shall not include any 
estimated savings to the taxpayer by reason of the taxpayer's reuse or 
recycling of wastes or other items recovered in connection with the 
operation of the plant or other property served by the treatment 
facility.
    (3) Special rules. The estimates of cost recovery required by 
subparagraph (2) of this paragraph shall be based on the period referred 
to in paragraph (a)(6) of this section. Such estimates shall be made at 
the time the election provided

[[Page 616]]

for by section 169 is made and shall also be set out in the application 
for certification made to the Federal certifying authority. There shall 
be no redetermination of estimated profits due to unanticipated 
fluctuations in the market price for wastes or other items, to an 
unanticipated increase or decrease in the costs of extracting them from 
the gas or liquid released, or to other unanticipated factors or events 
occurring after certification.

[T.D. 7116, 36 FR 9013, May 18, 1971; 36 FR 9770, May 28, 1971]



Sec.  1.169-3  Amortizable basis.

    (a) In general. The amortizable basis of a certified pollution 
control facility for the purpose of computing the amortization deduction 
under section 169 is the adjusted basis of the facility for purposes of 
determining gain (see part II (section 1011 and following), subchapter 
O, chapter 1 of the Internal Revenue Code), in conjunction with 
paragraphs (b), (c), and (d) of this section. The adjusted basis for 
purposes of determining gain (computed without regard to paragraphs (b), 
(c), and (d) of this section) of a facility that performs a function in 
addition to pollution control, or that is used in connection with more 
than one plant or other property, or both, is determined under Sec.  
1.169-2(a)(3). For rules as to additions and improvements to such a 
facility, see paragraph (f) of this section. Before computing the 
amortization deduction allowable under section 169, the adjusted basis 
for purposes of determining gain for a facility that is placed in 
service by a taxpayer after September 10, 2001, and that is qualified 
property under section 168(k)(2) or Sec.  1.168(k)-1, 50-percent bonus 
depreciation property under section 168(k)(4) or Sec.  1.168(k)-1, or 
qualified New York Liberty Zone property under section 1400L(b) or Sec.  
1.1400L(b)-1 must be reduced by the amount of the additional first year 
depreciation deduction allowed or allowable, whichever is greater, under 
section 168(k) or section 1400L(b), as applicable, for the facility.
    (b) Limitation to post-1968 construction, reconstruction, or 
erection. (1) If the construction, reconstruction, or erection was begun 
before January 1, 1969, there shall be included in the amortizable basis 
only so much of the adjusted basis of such facility for purposes of 
determining gain (referred to in paragraph (a) of this section) as is 
properly attributable under the rules set forth in paragraph (b)(2)(iii) 
of Sec.  1.169-2 to construction, reconstruction, or erection after 
December 31, 1968. See section 169 (d)(4). For example, assume a 
certified pollution control facility for which the shortest period 
authorized under section 167 is 10 years has a cost of $500,000, of 
which $450,000 is attributable to construction after December 31, 1968. 
Further, assume such facility does not perform a function in addition to 
pollution control and is used only in connection with a plant in 
operation before January 1, 1969. The facility would have an amortizable 
basis of $450,000 (computed without regard to paragraphs (c) and (d) of 
this section). For depreciation of the remaining portion ($50,000) of 
the cost, see section 169(g) and paragraph (a)(3)(ii) of Sec.  1.169-1. 
For the definition of the term ``certified pollution control facility'' 
see paragraph (a) of Sec.  1.169-2.
    (2) If the taxpayer elects to begin the 60-month amortization period 
with the first month of the taxable year succeeding the taxable year in 
which the facility is completed or acquired and a depreciation deduction 
is allowable under section 167 (including an additional first-year 
depreciation allowance under former section 179; for a facility that is 
acquired by the taxpayer after September 10, 2001, and that is qualified 
property under section 168(k)(2) or Sec.  1.168(k)-1 or qualified New 
York Liberty Zone property under section 1400L(b) or Sec.  1.1400L(b)-1, 
the additional first year depreciation deduction under section 168(k)(1) 
or 1400L(b), as applicable; and for a facility that is acquired by the 
taxpayer after May 5, 2003, and that is 50-percent bonus depreciation 
property under section 168(k)(4) or Sec.  1.168(k)-1, the additional 
first year depreciation deduction under section 168(k)(4)) with respect 
to the facility for the taxable year in which it is completed or 
acquired, the amount determined under paragraph (b)(1) of this section 
shall be reduced by an amount equal to the amount of the depreciation 
deduction allowed or allowable, whichever is greater, multiplied

[[Page 617]]

by a fraction the numerator of which is the amount determined under 
paragraph (b)(1) of this section, and the denominator of which is the 
facility's total cost. The additional first-year allowance for 
depreciation under former section 179 will be allowable only for the 
taxable year in which the facility is completed or acquired and only if 
the taxpayer elects to begin the amortization deduction under section 
169 with the taxable year succeeding the taxable year in which such 
facility is completed or acquired. For a facility that is acquired by a 
taxpayer after September 10, 2001, and that is qualified property under 
section 168(k)(2) or Sec.  1.168(k)-1 or qualified New York Liberty Zone 
property under section 1400L(b) or Sec.  1.1400L(b)-1, see Sec.  
1.168(k)-1(f)(4) or Sec.  1.1400L(b)-1(f)(4), as applicable, with 
respect to when the additional first year depreciation deduction under 
section 168(k)(1) or 1400L(b) is allowable. For a facility that is 
acquired by a taxpayer after May 5, 2003, and that is 50-percent bonus 
depreciation property under section 168(k)(4) or Sec.  1.168(k)-1, see 
Sec.  1.168(k)-1(f)(4) with respect to when the additional first year 
depreciation deduction under section 168(k)(4) is allowable.
    (c) Modification for profitmaking abatement works, etc. If it 
appears that by reason of estimated profits to be derived through the 
recovery of wastes or otherwise (as determined by applying the rules 
prescribed in paragraph (d) of Sec.  1.169-2) a portion or all of the 
total costs of the certified pollution control facility will be 
recovered over the period referred to in paragraph (a)(b) of Sec.  
1.169-2, its amortizable basis (computed without regard to this 
paragraph and paragraph (d) of this section) shall be reduced by an 
amount equal to (1) its amortizable basis (so computed) multiplied by 
(2) a fraction the numerator of which is such estimated profits and the 
denominator of which is its adjusted basis for purposes of determining 
gain. See section 169(e).
    (d) Cases in which the period referred to in paragraph (a)(6) of 
Sec.  1.169-2 exceeds 15 years. If as to a certified pollution control 
facility the period referred to in paragraph (a)(6) of Sec.  1.169-2 
exceeds 15 years (determined as of the first day of the first month for 
which a deduction is allowable under the election made under the section 
169(b) and paragraph (a) of Sec.  1.169-4), the amortizable basis of 
such facility shall be an amount equal to (1) its amortizable basis 
(computed without regard to this paragraph) multiplied by (2) a fraction 
the numerator of which is 15 years and the denominator of which is the 
number of years of such period. See section 169(f) (2)(A).
    (e) Examples. This section may be illustrated by the following 
example:

    Example 1. The X Corporation, which uses the calendar year as its 
taxable year, began the installation of a facility on November 1, 1968, 
and completed the installation on June 30, 1970, at a cost of $400,000. 
All of the facility qualifies as a certified pollution control facility 
within the meaning of paragraph (a) of Sec.  1.169-2. $40,000 of such 
cost is attributable to construction prior to January 1, 1969. The X 
Corporation elects to take amortization deductions under section 169(a) 
with respect to the facility and to begin the 60-month amortization 
period with January 1, 1971. The corporation takes a depreciation 
deduction under sections 167 and 179 of $10,000 (the amount allowable, 
of which $2,000 is for additional first year depreciation under section 
179) for the last 6 months of 1970. It is estimated that over the period 
referred to in paragraph (a) (6) of Sec.  1.169-2 (20 years) as to such 
facility, $80,000 in profits will be realized from the sale of wastes 
recovered in its operation. The amortizable basis of the facility for 
purposes of computing the amortization deduction as of January 1, 1971, 
is $210,600, computed as follows:

(1) Portion of $400,000 cost attributable to post-1968          $360,000
 construction, reconstruction, or erection...................
(2) Reduction for portion of depreciation
 deduction taken for the taxable year in which the
 facility was completed:
  (a) $10,000 depreciation deduction taken for        $10,000
   last 6 months of 1970 including $2,000 for
   additional first year depreciation under
   section 179....................................
  (b) Multiplied by the amount in line (1) and            0.9     $9,000
   divided by the total cost of the facility
   ($360,000/ $400,000)...........................
                                                   ---------------------
(3) Subtotal.................................................   $351,000
(4) Modification for profitmaking abatement works:
 Multiply line (3) by estimated profits through
 waste recovery ($80,000) and divide by the
 adjusted basis for determining gain of the
 facility ($400,000).
(5) Reduction................................................    $70,200
                                                   ------------
(6) Subtotal.................................................   $280,800

[[Page 618]]

 
(7) Modification for period referred to in paragraph (a)(6)         0.75
 of Sec.   1.169-2 exceeding 15 years: Multiply by 15 years
 and divide by such period (determined in accordance with
 paragraph (d) of this section) (20 years)...................
                                                   ------------
(8) Amortizable basis........................................   $210,600
 

    Example 2. Assume the same facts as in example (1) except that the 
facility is used in connection with a number of separate plants some of 
which were in operation before January 1, 1969, that the Federal 
certifying authority certifies that 80 percent of the capacity of the 
facility is allocable to the plants which were in operation before such 
date, and that all of the waste recovery is allocable to the portion of 
the facility used in connection with the plants in operation before 
January 1, 1969. The amortizable basis of such facility, for purposes of 
computing the amortization deduction as of January 1, 1971, is $157,950 
computed as follows:

(1) Adjusted basis for purposes of determining gain: Multiply   $320,000
 percent certified as allocable to plants in operation before
 January 1, 1969 (80 percent) by cost of entire facility
 ($400,000)..................................................
                                                   ============
(2) Portion of adjusted basis for determining gain              $288,000
 attributable to post-1968 construction, reconstruction, or
 rection: Multiply line (1) by portion of total cost of
 facility attributable to post-1968 construction,
 reconstruction, or erection ($360,000) and divide by the
 total cost of the facility ($400,000).......................
(3) Reduction for portion of depreciation deduction taken for
 the taxable year in which the facility was completed:
  (a) $10,000 depreciation deduction taken for        $10,000
   last 6 months of 1970 including $2,000 for
   additional first year depreciation under
   section 170....................................
  (b) Multiplied by the amount in line (2) and           0.72     $7,200
   divided by the total cost of the facility
   ($288,000/$400,000)............................
                                                   ---------------------
(4) Subtotal.................................................   $280,800
(5) Modification for profitmaking abatement works; Multiply
 line (4) by estimated profits through waste recovery
 ($80,000) and divide by the amount in line (1) ($320,000).
(6) Reduction................................................    $70,200
                                                   ------------
(7) Subtotal.................................................   $210,600
(8) Modification for period referred to in paragraph (a)(6)         0.75
 of Sec.   1.169-2 exceeding 15 years: Multiply by 15 years
 and divide by such period (determined in accordance with
 paragraph (d) of this section) (20 years)...................
                                                   ------------
(9) Amortizable basis........................................   $157,950
 

    (f) Additions or improvements. (1) If after the completion or 
acquisition of a certified pollution control facility further 
expenditures are made for additional construction, reconstruction, or 
improvements, the cost of such additions or improvements made prior to 
the beginning of the amortization period shall increase the amortizable 
basis of such facility, but the cost of additions or improvements made 
after the amortization period has begun, shall not increase the 
amortizable basis. See section 169(f)(2)(B).
    (2) If expenditures for such additional construction, 
reconstruction, or improvements result in a facility which is new and is 
separately certified as a certified pollution control facility as 
defined in section 169(d)(1) and paragraph (a) of Sec.  1.169-2, and, if 
proper election is made, such expenditures shall be taken into account 
in computing under paragraph (a) of this section the amortizable basis 
of such new and separately certified pollution control facility.
    (g) Effective date for qualified property, 50-percent bonus 
depreciation property, and qualified New York Liberty Zone property. 
This section applies to a certified pollution control facility. This 
section also applies to a certified pollution control facility that is 
qualified property under section 168(k)(2) or qualified New York Liberty 
Zone property under section 1400L(b) acquired by a taxpayer after 
September 10, 2001, and to a certified pollution control facility that 
is 50-percent bonus depreciation property under section 168(k)(4) 
acquired by a taxpayer after May 5, 2003.

[T.D. 7116, 36 FR 9015, May 18, 1971; 36 FR 9770, May 28, 1971, as 
amended by T.D. 9091, 68 FR 53004, Sept. 8, 2003; T.D. 9283, 71 FR 
51746, Aug. 31, 2006]



Sec.  1.169-4  Time and manner of making elections.

    (a) Election of amortization--(1) In general. Under section 169(b), 
an election by the taxpayer to take an amortization deduction with 
respect to a certified pollution control facility and to begin the 60-
month amortization period (either with the month following the month in 
which the facility is completed or acquired, or with the first month of 
the taxable year succeeding the taxable year in which such facility is 
completed or acquired) shall be made by a statement to that effect 
attached to its return for the taxable year in which falls the first 
month of the 60-month amortization period so elected. Such statement 
shall include the following information (if not otherwise

[[Page 619]]

included in the documents referred to in subdivision (ix) of this 
subparagraph):
    (i) A description clearly identifying each certified pollution 
control facility for which an amortization deduction is claimed;
    (ii) The date on which such facility was completed or acquired (see 
paragraph (b)(2)(iii) of Sec.  1.169-2);
    (iii) The period referred to in paragraph (a)(6) of Sec.  1.169-2 
for the facility as of the date the property is placed in service;
    (iv) The date as of which the amortization period is to begin;
    (v) The date the plant or other property to which the facility is 
connected began operating (see paragraph (a)(5) of Sec.  1.169-2);
    (vi) The total costs and expenditures paid or incurred in the 
acquisition, construction, and installation of such facility;
    (vii) A description of any wastes which the facility will recover 
during the course of its operation, and a reasonable estimate of the 
profits which will be realized by the sale of such wastes whether 
pollutants or otherwise, over the period referred to in paragraph (a)(6) 
of Sec.  1.169-2 as to the facility. Such estimate shall include a 
schedule setting forth a detailed computation illustrating how the 
estimate was arrived at including every element prescribed in the 
definition of estimated profits in paragraph (d)(2) of Sec.  1.169-2;
    (viii) A computation showing the amortizable basis (as defined in 
Sec.  1.169-3) of the facility as of the first month for which the 
amortization deduction provided for by section 169(a) is elected; and
    (ix)(a) A statement that the facility has been certified by the 
Federal certifying authority, together with a copy of such 
certification, and a copy of the application for certification which was 
filed with and approved by the Federal certifying authority or (b), if 
the facility has not been certified by the Federal certifying authority, 
a statement that application has been made to the proper State 
certifying authority (see paragraph (c)(2) of Sec.  1.169-2) together 
with a copy of such application and (except in the case of an election 
to which subparagraph (4) of this paragraph applies) a copy of the 
application filed or to be filed with the Federal certifying authority.

If subdivision (ix)(b) of this subparagraph applies, within 90 days 
after receipt by the taxpayer, the certification from the Federal 
certifying authority shall be filed by the taxpayer with the district 
director, or with the director of the internal revenue service center, 
with whom the return referred to in this subparagraph was filed.
    (2) Special rule. If the return for the taxable year in which falls 
the first month of the 60-month amortization period to be elected is 
filed before November 16, 1971, without making the election for such 
year, then on or before December 31, 1971 (or if there is no State 
certifying authority in existence on November 16, 1971, on or before the 
90th day after such authority is established), the election may be made 
by a statement attached to an amended income tax return for the taxable 
year in which falls the first month of the 60-month amortization period 
so elected. Amended income tax returns or claims for credit or refund 
must also be filed at this time for other taxable years which are within 
the amortization period and which are subsequent to the taxable year for 
which the election is made. Nothing in this paragraph should be 
construed as extending the time specified in section 6511 within which a 
claim for credit or refund may be filed.
    (3) Other requirements and considerations. No method of making the 
election provided for in section 169(a) other than that prescribed in 
this section shall be permitted on or after May 18, 1971. A taxpayer 
which does not elect in the manner prescribed in this section to take 
amortization deductions with respect to a certified pollution control 
facility shall not be entitled to such deductions. In the case of a 
taxpayer which elects prior to May 18, 1971, the statement required by 
subparagraph (1) of this paragraph shall be attached to its income tax 
return for either its taxable year in which December 31, 1971, occurs or 
its taxable year preceding such year.
    (4) Elections filed before February 29, 1972. If a statement of 
election required

[[Page 620]]

by subparagraph (1) of this paragraph is attached to a return (including 
an amended return referred to in subparagraph (2) of this paragraph) 
filed before February 29, 1972, such statement of election need not 
include a copy of the Federal application to be filed with the Federal 
certifying authority but a copy of such application must be filed no 
later than February 29, 1972, by the taxpayer with the district 
director, or with the director of the internal revenue service center, 
with whom the return or amended return referred to in this subparagraph 
was filed.
    (b) Election to discontinue or revoke amortization--(1) Election to 
discontinue. An election to discontinue the amortization deduction 
provided by section 169(c) and paragraph (a)(1) of Sec.  1.169-1 shall 
be made by a statement in writing filed with the district director, or 
with the director of the internal revenue service center, with whom the 
return of the taxpayer is required to be filed for its taxable year in 
which falls the first month for which the election terminates. Such 
statement shall specify the month as of the beginning of which the 
taxpayer elects to discontinue such deductions. Unless the election to 
discontinue amortization is one to which subparagraph (2) of this 
paragraph applies, such statement shall be filed before the beginning of 
the month specified therein. In addition, such statement shall contain a 
description clearly identifying the certified pollution control facility 
with respect to which the taxpayer elects to discontinue the 
amortization deduction, and, if a certification has previously been 
issued, a copy of the certification by the Federal certifying authority. 
If at the time of such election a certification has not been issued (or 
if one has been issued it has not been filed as provided in paragraph 
(a)(1) of this section), the taxpayer shall file, with respect to any 
taxable year or years for which a deduction under section 169 has been 
taken, a copy of such certification within 90 days after receipt 
thereof. For purposes of this paragraph, notification to the Secretary 
or his delegate from the Federal certifying authority that the facility 
no longer meets the requirements under which certification was 
originally granted by the State or Federal certifying authority shall 
have the same effect as a notice from the taxpayer electing to terminate 
amortization as of the month following the month such facility ceased 
functioning in accordance with such requirements.
    (2) Revocation of elections made prior to May 18, 1971. If on or 
before May 18, 1971, an election under section 169(a) has been made, 
such election may be revoked (see paragraph (a)(1) of Sec.  1.169-1) by 
filing on or before August 16, 1971, a statement of revocation of an 
election under section 169(a) in accordance with the requirements in 
subparagraph (1) of this paragraph for filing a notice to discontinue an 
election. If such election to revoke is for a period which falls within 
one or more taxable years for which an income tax return has been filed, 
amended income tax returns shall be filed for any such taxable years in 
which deductions were taken under section 169 on or before August 16, 
1971.

[T.D. 7116, 36 FR 9016, May 18, 1971, as amended by T.D. 7135, 36 FR 
14183, July 31, 1971; 36 FR 24995, Dec. 28, 1971]

[[Page 621]]



                              FINDING AIDS




  --------------------------------------------------------------------

  A list of CFR titles, subtitles, chapters, subchapters and parts and 
an alphabetical list of agencies publishing in the CFR are included in 
the CFR Index and Finding Aids volume to the Code of Federal Regulations 
which is published separately and revised annually.

  Table of CFR Titles and Chapters
  Alphabetical List of Agencies Appearing in the CFR
  Table of OMB Control Numbers
  List of CFR Sections Affected

[[Page 623]]



                    Table of CFR Titles and Chapters




                      (Revised as of April 1, 2019)

                      Title 1--General Provisions

         I  Administrative Committee of the Federal Register 
                (Parts 1--49)
        II  Office of the Federal Register (Parts 50--299)
       III  Administrative Conference of the United States (Parts 
                300--399)
        IV  Miscellaneous Agencies (Parts 400--599)
        VI  National Capital Planning Commission (Parts 600--699)

                    Title 2--Grants and Agreements

            Subtitle A--Office of Management and Budget Guidance 
                for Grants and Agreements
         I  Office of Management and Budget Governmentwide 
                Guidance for Grants and Agreements (Parts 2--199)
        II  Office of Management and Budget Guidance (Parts 200--
                299)
            Subtitle B--Federal Agency Regulations for Grants and 
                Agreements
       III  Department of Health and Human Services (Parts 300--
                399)
        IV  Department of Agriculture (Parts 400--499)
        VI  Department of State (Parts 600--699)
       VII  Agency for International Development (Parts 700--799)
      VIII  Department of Veterans Affairs (Parts 800--899)
        IX  Department of Energy (Parts 900--999)
         X  Department of the Treasury (Parts 1000--1099)
        XI  Department of Defense (Parts 1100--1199)
       XII  Department of Transportation (Parts 1200--1299)
      XIII  Department of Commerce (Parts 1300--1399)
       XIV  Department of the Interior (Parts 1400--1499)
        XV  Environmental Protection Agency (Parts 1500--1599)
     XVIII  National Aeronautics and Space Administration (Parts 
                1800--1899)
        XX  United States Nuclear Regulatory Commission (Parts 
                2000--2099)
      XXII  Corporation for National and Community Service (Parts 
                2200--2299)
     XXIII  Social Security Administration (Parts 2300--2399)
      XXIV  Department of Housing and Urban Development (Parts 
                2400--2499)
       XXV  National Science Foundation (Parts 2500--2599)
      XXVI  National Archives and Records Administration (Parts 
                2600--2699)

[[Page 624]]

     XXVII  Small Business Administration (Parts 2700--2799)
    XXVIII  Department of Justice (Parts 2800--2899)
      XXIX  Department of Labor (Parts 2900--2999)
       XXX  Department of Homeland Security (Parts 3000--3099)
      XXXI  Institute of Museum and Library Services (Parts 3100--
                3199)
     XXXII  National Endowment for the Arts (Parts 3200--3299)
    XXXIII  National Endowment for the Humanities (Parts 3300--
                3399)
     XXXIV  Department of Education (Parts 3400--3499)
      XXXV  Export-Import Bank of the United States (Parts 3500--
                3599)
     XXXVI  Office of National Drug Control Policy, Executive 
                Office of the President (Parts 3600--3699)
    XXXVII  Peace Corps (Parts 3700--3799)
     LVIII  Election Assistance Commission (Parts 5800--5899)
       LIX  Gulf Coast Ecosystem Restoration Council (Parts 5900--
                5999)

                        Title 3--The President

         I  Executive Office of the President (Parts 100--199)

                           Title 4--Accounts

         I  Government Accountability Office (Parts 1--199)

                   Title 5--Administrative Personnel

         I  Office of Personnel Management (Parts 1--1199)
        II  Merit Systems Protection Board (Parts 1200--1299)
       III  Office of Management and Budget (Parts 1300--1399)
        IV  Office of Personnel Management and Office of the 
                Director of National Intelligence (Parts 1400--
                1499)
         V  The International Organizations Employees Loyalty 
                Board (Parts 1500--1599)
        VI  Federal Retirement Thrift Investment Board (Parts 
                1600--1699)
      VIII  Office of Special Counsel (Parts 1800--1899)
        IX  Appalachian Regional Commission (Parts 1900--1999)
        XI  Armed Forces Retirement Home (Parts 2100--2199)
       XIV  Federal Labor Relations Authority, General Counsel of 
                the Federal Labor Relations Authority and Federal 
                Service Impasses Panel (Parts 2400--2499)
       XVI  Office of Government Ethics (Parts 2600--2699)
       XXI  Department of the Treasury (Parts 3100--3199)
      XXII  Federal Deposit Insurance Corporation (Parts 3200--
                3299)
     XXIII  Department of Energy (Parts 3300--3399)
      XXIV  Federal Energy Regulatory Commission (Parts 3400--
                3499)
       XXV  Department of the Interior (Parts 3500--3599)
      XXVI  Department of Defense (Parts 3600--3699)

[[Page 625]]

    XXVIII  Department of Justice (Parts 3800--3899)
      XXIX  Federal Communications Commission (Parts 3900--3999)
       XXX  Farm Credit System Insurance Corporation (Parts 4000--
                4099)
      XXXI  Farm Credit Administration (Parts 4100--4199)
    XXXIII  Overseas Private Investment Corporation (Parts 4300--
                4399)
     XXXIV  Securities and Exchange Commission (Parts 4400--4499)
      XXXV  Office of Personnel Management (Parts 4500--4599)
     XXXVI  Department of Homeland Security (Parts 4600--4699)
    XXXVII  Federal Election Commission (Parts 4700--4799)
        XL  Interstate Commerce Commission (Parts 5000--5099)
       XLI  Commodity Futures Trading Commission (Parts 5100--
                5199)
      XLII  Department of Labor (Parts 5200--5299)
     XLIII  National Science Foundation (Parts 5300--5399)
       XLV  Department of Health and Human Services (Parts 5500--
                5599)
      XLVI  Postal Rate Commission (Parts 5600--5699)
     XLVII  Federal Trade Commission (Parts 5700--5799)
    XLVIII  Nuclear Regulatory Commission (Parts 5800--5899)
      XLIX  Federal Labor Relations Authority (Parts 5900--5999)
         L  Department of Transportation (Parts 6000--6099)
       LII  Export-Import Bank of the United States (Parts 6200--
                6299)
      LIII  Department of Education (Parts 6300--6399)
       LIV  Environmental Protection Agency (Parts 6400--6499)
        LV  National Endowment for the Arts (Parts 6500--6599)
       LVI  National Endowment for the Humanities (Parts 6600--
                6699)
      LVII  General Services Administration (Parts 6700--6799)
     LVIII  Board of Governors of the Federal Reserve System 
                (Parts 6800--6899)
       LIX  National Aeronautics and Space Administration (Parts 
                6900--6999)
        LX  United States Postal Service (Parts 7000--7099)
       LXI  National Labor Relations Board (Parts 7100--7199)
      LXII  Equal Employment Opportunity Commission (Parts 7200--
                7299)
     LXIII  Inter-American Foundation (Parts 7300--7399)
      LXIV  Merit Systems Protection Board (Parts 7400--7499)
       LXV  Department of Housing and Urban Development (Parts 
                7500--7599)
      LXVI  National Archives and Records Administration (Parts 
                7600--7699)
     LXVII  Institute of Museum and Library Services (Parts 7700--
                7799)
    LXVIII  Commission on Civil Rights (Parts 7800--7899)
      LXIX  Tennessee Valley Authority (Parts 7900--7999)
       LXX  Court Services and Offender Supervision Agency for the 
                District of Columbia (Parts 8000--8099)
      LXXI  Consumer Product Safety Commission (Parts 8100--8199)
    LXXIII  Department of Agriculture (Parts 8300--8399)

[[Page 626]]

     LXXIV  Federal Mine Safety and Health Review Commission 
                (Parts 8400--8499)
     LXXVI  Federal Retirement Thrift Investment Board (Parts 
                8600--8699)
    LXXVII  Office of Management and Budget (Parts 8700--8799)
      LXXX  Federal Housing Finance Agency (Parts 9000--9099)
   LXXXIII  Special Inspector General for Afghanistan 
                Reconstruction (Parts 9300--9399)
    LXXXIV  Bureau of Consumer Financial Protection (Parts 9400--
                9499)
    LXXXVI  National Credit Union Administration (Parts 9600--
                9699)
     XCVII  Department of Homeland Security Human Resources 
                Management System (Department of Homeland 
                Security--Office of Personnel Management) (Parts 
                9700--9799)
    XCVIII  Council of the Inspectors General on Integrity and 
                Efficiency (Parts 9800--9899)
      XCIX  Military Compensation and Retirement Modernization 
                Commission (Parts 9900--9999)
         C  National Council on Disability (Parts 10000--10049)
        CI  National Mediation Board (Part 10101)

                      Title 6--Domestic Security

         I  Department of Homeland Security, Office of the 
                Secretary (Parts 1--199)
         X  Privacy and Civil Liberties Oversight Board (Parts 
                1000--1099)

                         Title 7--Agriculture

            Subtitle A--Office of the Secretary of Agriculture 
                (Parts 0--26)
            Subtitle B--Regulations of the Department of 
                Agriculture
         I  Agricultural Marketing Service (Standards, 
                Inspections, Marketing Practices), Department of 
                Agriculture (Parts 27--209)
        II  Food and Nutrition Service, Department of Agriculture 
                (Parts 210--299)
       III  Animal and Plant Health Inspection Service, Department 
                of Agriculture (Parts 300--399)
        IV  Federal Crop Insurance Corporation, Department of 
                Agriculture (Parts 400--499)
         V  Agricultural Research Service, Department of 
                Agriculture (Parts 500--599)
        VI  Natural Resources Conservation Service, Department of 
                Agriculture (Parts 600--699)
       VII  Farm Service Agency, Department of Agriculture (Parts 
                700--799)
      VIII  Grain Inspection, Packers and Stockyards 
                Administration (Federal Grain Inspection Service), 
                Department of Agriculture (Parts 800--899)

[[Page 627]]

        IX  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Fruits, Vegetables, Nuts), Department 
                of Agriculture (Parts 900--999)
         X  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Milk), Department of Agriculture 
                (Parts 1000--1199)
        XI  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Miscellaneous Commodities), Department 
                of Agriculture (Parts 1200--1299)
       XIV  Commodity Credit Corporation, Department of 
                Agriculture (Parts 1400--1499)
        XV  Foreign Agricultural Service, Department of 
                Agriculture (Parts 1500--1599)
       XVI  Rural Telephone Bank, Department of Agriculture (Parts 
                1600--1699)
      XVII  Rural Utilities Service, Department of Agriculture 
                (Parts 1700--1799)
     XVIII  Rural Housing Service, Rural Business-Cooperative 
                Service, Rural Utilities Service, and Farm Service 
                Agency, Department of Agriculture (Parts 1800--
                2099)
        XX  Local Television Loan Guarantee Board (Parts 2200--
                2299)
       XXV  Office of Advocacy and Outreach, Department of 
                Agriculture (Parts 2500--2599)
      XXVI  Office of Inspector General, Department of Agriculture 
                (Parts 2600--2699)
     XXVII  Office of Information Resources Management, Department 
                of Agriculture (Parts 2700--2799)
    XXVIII  Office of Operations, Department of Agriculture (Parts 
                2800--2899)
      XXIX  Office of Energy Policy and New Uses, Department of 
                Agriculture (Parts 2900--2999)
       XXX  Office of the Chief Financial Officer, Department of 
                Agriculture (Parts 3000--3099)
      XXXI  Office of Environmental Quality, Department of 
                Agriculture (Parts 3100--3199)
     XXXII  Office of Procurement and Property Management, 
                Department of Agriculture (Parts 3200--3299)
    XXXIII  Office of Transportation, Department of Agriculture 
                (Parts 3300--3399)
     XXXIV  National Institute of Food and Agriculture (Parts 
                3400--3499)
      XXXV  Rural Housing Service, Department of Agriculture 
                (Parts 3500--3599)
     XXXVI  National Agricultural Statistics Service, Department 
                of Agriculture (Parts 3600--3699)
    XXXVII  Economic Research Service, Department of Agriculture 
                (Parts 3700--3799)
   XXXVIII  World Agricultural Outlook Board, Department of 
                Agriculture (Parts 3800--3899)
       XLI  [Reserved]
      XLII  Rural Business-Cooperative Service and Rural Utilities 
                Service, Department of Agriculture (Parts 4200--
                4299)

[[Page 628]]

                    Title 8--Aliens and Nationality

         I  Department of Homeland Security (Immigration and 
                Naturalization) (Parts 1--499)
         V  Executive Office for Immigration Review, Department of 
                Justice (Parts 1000--1399)

                 Title 9--Animals and Animal Products

         I  Animal and Plant Health Inspection Service, Department 
                of Agriculture (Parts 1--199)
        II  Grain Inspection, Packers and Stockyards 
                Administration (Packers and Stockyards Programs), 
                Department of Agriculture (Parts 200--299)
       III  Food Safety and Inspection Service, Department of 
                Agriculture (Parts 300--599)

                           Title 10--Energy

         I  Nuclear Regulatory Commission (Parts 0--199)
        II  Department of Energy (Parts 200--699)
       III  Department of Energy (Parts 700--999)
         X  Department of Energy (General Provisions) (Parts 
                1000--1099)
      XIII  Nuclear Waste Technical Review Board (Parts 1300--
                1399)
      XVII  Defense Nuclear Facilities Safety Board (Parts 1700--
                1799)
     XVIII  Northeast Interstate Low-Level Radioactive Waste 
                Commission (Parts 1800--1899)

                      Title 11--Federal Elections

         I  Federal Election Commission (Parts 1--9099)
        II  Election Assistance Commission (Parts 9400--9499)

                      Title 12--Banks and Banking

         I  Comptroller of the Currency, Department of the 
                Treasury (Parts 1--199)
        II  Federal Reserve System (Parts 200--299)
       III  Federal Deposit Insurance Corporation (Parts 300--399)
        IV  Export-Import Bank of the United States (Parts 400--
                499)
         V  (Parts 500--599) [Reserved]
        VI  Farm Credit Administration (Parts 600--699)
       VII  National Credit Union Administration (Parts 700--799)
      VIII  Federal Financing Bank (Parts 800--899)
        IX  Federal Housing Finance Board (Parts 900--999)
         X  Bureau of Consumer Financial Protection (Parts 1000--
                1099)
        XI  Federal Financial Institutions Examination Council 
                (Parts 1100--1199)
       XII  Federal Housing Finance Agency (Parts 1200--1299)
      XIII  Financial Stability Oversight Council (Parts 1300--
                1399)

[[Page 629]]

       XIV  Farm Credit System Insurance Corporation (Parts 1400--
                1499)
        XV  Department of the Treasury (Parts 1500--1599)
       XVI  Office of Financial Research (Parts 1600--1699)
      XVII  Office of Federal Housing Enterprise Oversight, 
                Department of Housing and Urban Development (Parts 
                1700--1799)
     XVIII  Community Development Financial Institutions Fund, 
                Department of the Treasury (Parts 1800--1899)

               Title 13--Business Credit and Assistance

         I  Small Business Administration (Parts 1--199)
       III  Economic Development Administration, Department of 
                Commerce (Parts 300--399)
        IV  Emergency Steel Guarantee Loan Board (Parts 400--499)
         V  Emergency Oil and Gas Guaranteed Loan Board (Parts 
                500--599)

                    Title 14--Aeronautics and Space

         I  Federal Aviation Administration, Department of 
                Transportation (Parts 1--199)
        II  Office of the Secretary, Department of Transportation 
                (Aviation Proceedings) (Parts 200--399)
       III  Commercial Space Transportation, Federal Aviation 
                Administration, Department of Transportation 
                (Parts 400--1199)
         V  National Aeronautics and Space Administration (Parts 
                1200--1299)
        VI  Air Transportation System Stabilization (Parts 1300--
                1399)

                 Title 15--Commerce and Foreign Trade

            Subtitle A--Office of the Secretary of Commerce (Parts 
                0--29)
            Subtitle B--Regulations Relating to Commerce and 
                Foreign Trade
         I  Bureau of the Census, Department of Commerce (Parts 
                30--199)
        II  National Institute of Standards and Technology, 
                Department of Commerce (Parts 200--299)
       III  International Trade Administration, Department of 
                Commerce (Parts 300--399)
        IV  Foreign-Trade Zones Board, Department of Commerce 
                (Parts 400--499)
       VII  Bureau of Industry and Security, Department of 
                Commerce (Parts 700--799)
      VIII  Bureau of Economic Analysis, Department of Commerce 
                (Parts 800--899)
        IX  National Oceanic and Atmospheric Administration, 
                Department of Commerce (Parts 900--999)
        XI  National Technical Information Service, Department of 
                Commerce (Parts 1100--1199)

[[Page 630]]

      XIII  East-West Foreign Trade Board (Parts 1300--1399)
       XIV  Minority Business Development Agency (Parts 1400--
                1499)
            Subtitle C--Regulations Relating to Foreign Trade 
                Agreements
        XX  Office of the United States Trade Representative 
                (Parts 2000--2099)
            Subtitle D--Regulations Relating to Telecommunications 
                and Information
     XXIII  National Telecommunications and Information 
                Administration, Department of Commerce (Parts 
                2300--2399) [Reserved]

                    Title 16--Commercial Practices

         I  Federal Trade Commission (Parts 0--999)
        II  Consumer Product Safety Commission (Parts 1000--1799)

             Title 17--Commodity and Securities Exchanges

         I  Commodity Futures Trading Commission (Parts 1--199)
        II  Securities and Exchange Commission (Parts 200--399)
        IV  Department of the Treasury (Parts 400--499)

          Title 18--Conservation of Power and Water Resources

         I  Federal Energy Regulatory Commission, Department of 
                Energy (Parts 1--399)
       III  Delaware River Basin Commission (Parts 400--499)
        VI  Water Resources Council (Parts 700--799)
      VIII  Susquehanna River Basin Commission (Parts 800--899)
      XIII  Tennessee Valley Authority (Parts 1300--1399)

                       Title 19--Customs Duties

         I  U.S. Customs and Border Protection, Department of 
                Homeland Security; Department of the Treasury 
                (Parts 0--199)
        II  United States International Trade Commission (Parts 
                200--299)
       III  International Trade Administration, Department of 
                Commerce (Parts 300--399)
        IV  U.S. Immigration and Customs Enforcement, Department 
                of Homeland Security (Parts 400--599) [Reserved]

                     Title 20--Employees' Benefits

         I  Office of Workers' Compensation Programs, Department 
                of Labor (Parts 1--199)
        II  Railroad Retirement Board (Parts 200--399)
       III  Social Security Administration (Parts 400--499)

[[Page 631]]

        IV  Employees' Compensation Appeals Board, Department of 
                Labor (Parts 500--599)
         V  Employment and Training Administration, Department of 
                Labor (Parts 600--699)
        VI  Office of Workers' Compensation Programs, Department 
                of Labor (Parts 700--799)
       VII  Benefits Review Board, Department of Labor (Parts 
                800--899)
      VIII  Joint Board for the Enrollment of Actuaries (Parts 
                900--999)
        IX  Office of the Assistant Secretary for Veterans' 
                Employment and Training Service, Department of 
                Labor (Parts 1000--1099)

                       Title 21--Food and Drugs

         I  Food and Drug Administration, Department of Health and 
                Human Services (Parts 1--1299)
        II  Drug Enforcement Administration, Department of Justice 
                (Parts 1300--1399)
       III  Office of National Drug Control Policy (Parts 1400--
                1499)

                      Title 22--Foreign Relations

         I  Department of State (Parts 1--199)
        II  Agency for International Development (Parts 200--299)
       III  Peace Corps (Parts 300--399)
        IV  International Joint Commission, United States and 
                Canada (Parts 400--499)
         V  Broadcasting Board of Governors (Parts 500--599)
       VII  Overseas Private Investment Corporation (Parts 700--
                799)
        IX  Foreign Service Grievance Board (Parts 900--999)
         X  Inter-American Foundation (Parts 1000--1099)
        XI  International Boundary and Water Commission, United 
                States and Mexico, United States Section (Parts 
                1100--1199)
       XII  United States International Development Cooperation 
                Agency (Parts 1200--1299)
      XIII  Millennium Challenge Corporation (Parts 1300--1399)
       XIV  Foreign Service Labor Relations Board; Federal Labor 
                Relations Authority; General Counsel of the 
                Federal Labor Relations Authority; and the Foreign 
                Service Impasse Disputes Panel (Parts 1400--1499)
        XV  African Development Foundation (Parts 1500--1599)
       XVI  Japan-United States Friendship Commission (Parts 
                1600--1699)
      XVII  United States Institute of Peace (Parts 1700--1799)

                          Title 23--Highways

         I  Federal Highway Administration, Department of 
                Transportation (Parts 1--999)

[[Page 632]]

        II  National Highway Traffic Safety Administration and 
                Federal Highway Administration, Department of 
                Transportation (Parts 1200--1299)
       III  National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 1300--1399)

                Title 24--Housing and Urban Development

            Subtitle A--Office of the Secretary, Department of 
                Housing and Urban Development (Parts 0--99)
            Subtitle B--Regulations Relating to Housing and Urban 
                Development
         I  Office of Assistant Secretary for Equal Opportunity, 
                Department of Housing and Urban Development (Parts 
                100--199)
        II  Office of Assistant Secretary for Housing-Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Parts 200--299)
       III  Government National Mortgage Association, Department 
                of Housing and Urban Development (Parts 300--399)
        IV  Office of Housing and Office of Multifamily Housing 
                Assistance Restructuring, Department of Housing 
                and Urban Development (Parts 400--499)
         V  Office of Assistant Secretary for Community Planning 
                and Development, Department of Housing and Urban 
                Development (Parts 500--599)
        VI  Office of Assistant Secretary for Community Planning 
                and Development, Department of Housing and Urban 
                Development (Parts 600--699) [Reserved]
       VII  Office of the Secretary, Department of Housing and 
                Urban Development (Housing Assistance Programs and 
                Public and Indian Housing Programs) (Parts 700--
                799)
      VIII  Office of the Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Section 8 Housing Assistance 
                Programs, Section 202 Direct Loan Program, Section 
                202 Supportive Housing for the Elderly Program and 
                Section 811 Supportive Housing for Persons With 
                Disabilities Program) (Parts 800--899)
        IX  Office of Assistant Secretary for Public and Indian 
                Housing, Department of Housing and Urban 
                Development (Parts 900--1699)
       XII  Office of Inspector General, Department of Housing and 
                Urban Development (Parts 2000--2099)
        XV  Emergency Mortgage Insurance and Loan Programs, 
                Department of Housing and Urban Development (Parts 
                2700--2799) [Reserved]
        XX  Office of Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Parts 3200--3899)
      XXIV  Board of Directors of the HOPE for Homeowners Program 
                (Parts 4000--4099) [Reserved]
       XXV  Neighborhood Reinvestment Corporation (Parts 4100--
                4199)

[[Page 633]]

                           Title 25--Indians

         I  Bureau of Indian Affairs, Department of the Interior 
                (Parts 1--299)
        II  Indian Arts and Crafts Board, Department of the 
                Interior (Parts 300--399)
       III  National Indian Gaming Commission, Department of the 
                Interior (Parts 500--599)
        IV  Office of Navajo and Hopi Indian Relocation (Parts 
                700--899)
         V  Bureau of Indian Affairs, Department of the Interior, 
                and Indian Health Service, Department of Health 
                and Human Services (Part 900--999)
        VI  Office of the Assistant Secretary, Indian Affairs, 
                Department of the Interior (Parts 1000--1199)
       VII  Office of the Special Trustee for American Indians, 
                Department of the Interior (Parts 1200--1299)

                      Title 26--Internal Revenue

         I  Internal Revenue Service, Department of the Treasury 
                (Parts 1--End)

           Title 27--Alcohol, Tobacco Products and Firearms

         I  Alcohol and Tobacco Tax and Trade Bureau, Department 
                of the Treasury (Parts 1--399)
        II  Bureau of Alcohol, Tobacco, Firearms, and Explosives, 
                Department of Justice (Parts 400--699)

                   Title 28--Judicial Administration

         I  Department of Justice (Parts 0--299)
       III  Federal Prison Industries, Inc., Department of Justice 
                (Parts 300--399)
         V  Bureau of Prisons, Department of Justice (Parts 500--
                599)
        VI  Offices of Independent Counsel, Department of Justice 
                (Parts 600--699)
       VII  Office of Independent Counsel (Parts 700--799)
      VIII  Court Services and Offender Supervision Agency for the 
                District of Columbia (Parts 800--899)
        IX  National Crime Prevention and Privacy Compact Council 
                (Parts 900--999)
        XI  Department of Justice and Department of State (Parts 
                1100--1199)

                            Title 29--Labor

            Subtitle A--Office of the Secretary of Labor (Parts 
                0--99)
            Subtitle B--Regulations Relating to Labor
         I  National Labor Relations Board (Parts 100--199)

[[Page 634]]

        II  Office of Labor-Management Standards, Department of 
                Labor (Parts 200--299)
       III  National Railroad Adjustment Board (Parts 300--399)
        IV  Office of Labor-Management Standards, Department of 
                Labor (Parts 400--499)
         V  Wage and Hour Division, Department of Labor (Parts 
                500--899)
        IX  Construction Industry Collective Bargaining Commission 
                (Parts 900--999)
         X  National Mediation Board (Parts 1200--1299)
       XII  Federal Mediation and Conciliation Service (Parts 
                1400--1499)
       XIV  Equal Employment Opportunity Commission (Parts 1600--
                1699)
      XVII  Occupational Safety and Health Administration, 
                Department of Labor (Parts 1900--1999)
        XX  Occupational Safety and Health Review Commission 
                (Parts 2200--2499)
       XXV  Employee Benefits Security Administration, Department 
                of Labor (Parts 2500--2599)
     XXVII  Federal Mine Safety and Health Review Commission 
                (Parts 2700--2799)
        XL  Pension Benefit Guaranty Corporation (Parts 4000--
                4999)

                      Title 30--Mineral Resources

         I  Mine Safety and Health Administration, Department of 
                Labor (Parts 1--199)
        II  Bureau of Safety and Environmental Enforcement, 
                Department of the Interior (Parts 200--299)
        IV  Geological Survey, Department of the Interior (Parts 
                400--499)
         V  Bureau of Ocean Energy Management, Department of the 
                Interior (Parts 500--599)
       VII  Office of Surface Mining Reclamation and Enforcement, 
                Department of the Interior (Parts 700--999)
       XII  Office of Natural Resources Revenue, Department of the 
                Interior (Parts 1200--1299)

                 Title 31--Money and Finance: Treasury

            Subtitle A--Office of the Secretary of the Treasury 
                (Parts 0--50)
            Subtitle B--Regulations Relating to Money and Finance
         I  Monetary Offices, Department of the Treasury (Parts 
                51--199)
        II  Fiscal Service, Department of the Treasury (Parts 
                200--399)
        IV  Secret Service, Department of the Treasury (Parts 
                400--499)
         V  Office of Foreign Assets Control, Department of the 
                Treasury (Parts 500--599)
        VI  Bureau of Engraving and Printing, Department of the 
                Treasury (Parts 600--699)
       VII  Federal Law Enforcement Training Center, Department of 
                the Treasury (Parts 700--799)

[[Page 635]]

      VIII  Office of Investment Security, Department of the 
                Treasury (Parts 800--899)
        IX  Federal Claims Collection Standards (Department of the 
                Treasury--Department of Justice) (Parts 900--999)
         X  Financial Crimes Enforcement Network, Department of 
                the Treasury (Parts 1000--1099)

                      Title 32--National Defense

            Subtitle A--Department of Defense
         I  Office of the Secretary of Defense (Parts 1--399)
         V  Department of the Army (Parts 400--699)
        VI  Department of the Navy (Parts 700--799)
       VII  Department of the Air Force (Parts 800--1099)
            Subtitle B--Other Regulations Relating to National 
                Defense
       XII  Defense Logistics Agency (Parts 1200--1299)
       XVI  Selective Service System (Parts 1600--1699)
      XVII  Office of the Director of National Intelligence (Parts 
                1700--1799)
     XVIII  National Counterintelligence Center (Parts 1800--1899)
       XIX  Central Intelligence Agency (Parts 1900--1999)
        XX  Information Security Oversight Office, National 
                Archives and Records Administration (Parts 2000--
                2099)
       XXI  National Security Council (Parts 2100--2199)
      XXIV  Office of Science and Technology Policy (Parts 2400--
                2499)
     XXVII  Office for Micronesian Status Negotiations (Parts 
                2700--2799)
    XXVIII  Office of the Vice President of the United States 
                (Parts 2800--2899)

               Title 33--Navigation and Navigable Waters

         I  Coast Guard, Department of Homeland Security (Parts 
                1--199)
        II  Corps of Engineers, Department of the Army, Department 
                of Defense (Parts 200--399)
        IV  Saint Lawrence Seaway Development Corporation, 
                Department of Transportation (Parts 400--499)

                          Title 34--Education

            Subtitle A--Office of the Secretary, Department of 
                Education (Parts 1--99)
            Subtitle B--Regulations of the Offices of the 
                Department of Education
         I  Office for Civil Rights, Department of Education 
                (Parts 100--199)
        II  Office of Elementary and Secondary Education, 
                Department of Education (Parts 200--299)
       III  Office of Special Education and Rehabilitative 
                Services, Department of Education (Parts 300--399)

[[Page 636]]

        IV  Office of Career, Technical and Adult Education, 
                Department of Education (Parts 400--499)
         V  Office of Bilingual Education and Minority Languages 
                Affairs, Department of Education (Parts 500--599) 
                [Reserved]
        VI  Office of Postsecondary Education, Department of 
                Education (Parts 600--699)
       VII  Office of Educational Research and Improvement, 
                Department of Education (Parts 700--799) 
                [Reserved]
            Subtitle C--Regulations Relating to Education
        XI  (Parts 1100--1199) [Reserved]
       XII  National Council on Disability (Parts 1200--1299)

                          Title 35 [Reserved]

             Title 36--Parks, Forests, and Public Property

         I  National Park Service, Department of the Interior 
                (Parts 1--199)
        II  Forest Service, Department of Agriculture (Parts 200--
                299)
       III  Corps of Engineers, Department of the Army (Parts 
                300--399)
        IV  American Battle Monuments Commission (Parts 400--499)
         V  Smithsonian Institution (Parts 500--599)
        VI  [Reserved]
       VII  Library of Congress (Parts 700--799)
      VIII  Advisory Council on Historic Preservation (Parts 800--
                899)
        IX  Pennsylvania Avenue Development Corporation (Parts 
                900--999)
         X  Presidio Trust (Parts 1000--1099)
        XI  Architectural and Transportation Barriers Compliance 
                Board (Parts 1100--1199)
       XII  National Archives and Records Administration (Parts 
                1200--1299)
        XV  Oklahoma City National Memorial Trust (Parts 1500--
                1599)
       XVI  Morris K. Udall Scholarship and Excellence in National 
                Environmental Policy Foundation (Parts 1600--1699)

             Title 37--Patents, Trademarks, and Copyrights

         I  United States Patent and Trademark Office, Department 
                of Commerce (Parts 1--199)
        II  U.S. Copyright Office, Library of Congress (Parts 
                200--299)
       III  Copyright Royalty Board, Library of Congress (Parts 
                300--399)
        IV  National Institute of Standards and Technology, 
                Department of Commerce (Parts 400--599)

           Title 38--Pensions, Bonuses, and Veterans' Relief

         I  Department of Veterans Affairs (Parts 0--199)
        II  Armed Forces Retirement Home (Parts 200--299)

[[Page 637]]

                       Title 39--Postal Service

         I  United States Postal Service (Parts 1--999)
       III  Postal Regulatory Commission (Parts 3000--3099)

                  Title 40--Protection of Environment

         I  Environmental Protection Agency (Parts 1--1099)
        IV  Environmental Protection Agency and Department of 
                Justice (Parts 1400--1499)
         V  Council on Environmental Quality (Parts 1500--1599)
        VI  Chemical Safety and Hazard Investigation Board (Parts 
                1600--1699)
       VII  Environmental Protection Agency and Department of 
                Defense; Uniform National Discharge Standards for 
                Vessels of the Armed Forces (Parts 1700--1799)
      VIII  Gulf Coast Ecosystem Restoration Council (Parts 1800--
                1899)

          Title 41--Public Contracts and Property Management

            Subtitle A--Federal Procurement Regulations System 
                [Note]
            Subtitle B--Other Provisions Relating to Public 
                Contracts
        50  Public Contracts, Department of Labor (Parts 50-1--50-
                999)
        51  Committee for Purchase From People Who Are Blind or 
                Severely Disabled (Parts 51-1--51-99)
        60  Office of Federal Contract Compliance Programs, Equal 
                Employment Opportunity, Department of Labor (Parts 
                60-1--60-999)
        61  Office of the Assistant Secretary for Veterans' 
                Employment and Training Service, Department of 
                Labor (Parts 61-1--61-999)
   62--100  [Reserved]
            Subtitle C--Federal Property Management Regulations 
                System
       101  Federal Property Management Regulations (Parts 101-1--
                101-99)
       102  Federal Management Regulation (Parts 102-1--102-299)
  103--104  [Reserved]
       105  General Services Administration (Parts 105-1--105-999)
       109  Department of Energy Property Management Regulations 
                (Parts 109-1--109-99)
       114  Department of the Interior (Parts 114-1--114-99)
       115  Environmental Protection Agency (Parts 115-1--115-99)
       128  Department of Justice (Parts 128-1--128-99)
  129--200  [Reserved]
            Subtitle D--Other Provisions Relating to Property 
                Management [Reserved]
            Subtitle E--Federal Information Resources Management 
                Regulations System [Reserved]
            Subtitle F--Federal Travel Regulation System
       300  General (Parts 300-1--300-99)
       301  Temporary Duty (TDY) Travel Allowances (Parts 301-1--
                301-99)

[[Page 638]]

       302  Relocation Allowances (Parts 302-1--302-99)
       303  Payment of Expenses Connected with the Death of 
                Certain Employees (Part 303-1--303-99)
       304  Payment of Travel Expenses from a Non-Federal Source 
                (Parts 304-1--304-99)

                        Title 42--Public Health

         I  Public Health Service, Department of Health and Human 
                Services (Parts 1--199)
   II--III  [Reserved]
        IV  Centers for Medicare & Medicaid Services, Department 
                of Health and Human Services (Parts 400--699)
         V  Office of Inspector General-Health Care, Department of 
                Health and Human Services (Parts 1000--1099)

                   Title 43--Public Lands: Interior

            Subtitle A--Office of the Secretary of the Interior 
                (Parts 1--199)
            Subtitle B--Regulations Relating to Public Lands
         I  Bureau of Reclamation, Department of the Interior 
                (Parts 400--999)
        II  Bureau of Land Management, Department of the Interior 
                (Parts 1000--9999)
       III  Utah Reclamation Mitigation and Conservation 
                Commission (Parts 10000--10099)

             Title 44--Emergency Management and Assistance

         I  Federal Emergency Management Agency, Department of 
                Homeland Security (Parts 0--399)
        IV  Department of Commerce and Department of 
                Transportation (Parts 400--499)

                       Title 45--Public Welfare

            Subtitle A--Department of Health and Human Services 
                (Parts 1--199)
            Subtitle B--Regulations Relating to Public Welfare
        II  Office of Family Assistance (Assistance Programs), 
                Administration for Children and Families, 
                Department of Health and Human Services (Parts 
                200--299)
       III  Office of Child Support Enforcement (Child Support 
                Enforcement Program), Administration for Children 
                and Families, Department of Health and Human 
                Services (Parts 300--399)
        IV  Office of Refugee Resettlement, Administration for 
                Children and Families, Department of Health and 
                Human Services (Parts 400--499)

[[Page 639]]

         V  Foreign Claims Settlement Commission of the United 
                States, Department of Justice (Parts 500--599)
        VI  National Science Foundation (Parts 600--699)
       VII  Commission on Civil Rights (Parts 700--799)
      VIII  Office of Personnel Management (Parts 800--899)
        IX  Denali Commission (Parts 900--999)
         X  Office of Community Services, Administration for 
                Children and Families, Department of Health and 
                Human Services (Parts 1000--1099)
        XI  National Foundation on the Arts and the Humanities 
                (Parts 1100--1199)
       XII  Corporation for National and Community Service (Parts 
                1200--1299)
      XIII  Administration for Children and Families, Department 
                of Health and Human Services (Parts 1300--1399)
       XVI  Legal Services Corporation (Parts 1600--1699)
      XVII  National Commission on Libraries and Information 
                Science (Parts 1700--1799)
     XVIII  Harry S. Truman Scholarship Foundation (Parts 1800--
                1899)
       XXI  Commission of Fine Arts (Parts 2100--2199)
     XXIII  Arctic Research Commission (Parts 2300--2399)
      XXIV  James Madison Memorial Fellowship Foundation (Parts 
                2400--2499)
       XXV  Corporation for National and Community Service (Parts 
                2500--2599)

                          Title 46--Shipping

         I  Coast Guard, Department of Homeland Security (Parts 
                1--199)
        II  Maritime Administration, Department of Transportation 
                (Parts 200--399)
       III  Coast Guard (Great Lakes Pilotage), Department of 
                Homeland Security (Parts 400--499)
        IV  Federal Maritime Commission (Parts 500--599)

                      Title 47--Telecommunication

         I  Federal Communications Commission (Parts 0--199)
        II  Office of Science and Technology Policy and National 
                Security Council (Parts 200--299)
       III  National Telecommunications and Information 
                Administration, Department of Commerce (Parts 
                300--399)
        IV  National Telecommunications and Information 
                Administration, Department of Commerce, and 
                National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 400--499)
         V  The First Responder Network Authority (Parts 500--599)

[[Page 640]]

           Title 48--Federal Acquisition Regulations System

         1  Federal Acquisition Regulation (Parts 1--99)
         2  Defense Acquisition Regulations System, Department of 
                Defense (Parts 200--299)
         3  Department of Health and Human Services (Parts 300--
                399)
         4  Department of Agriculture (Parts 400--499)
         5  General Services Administration (Parts 500--599)
         6  Department of State (Parts 600--699)
         7  Agency for International Development (Parts 700--799)
         8  Department of Veterans Affairs (Parts 800--899)
         9  Department of Energy (Parts 900--999)
        10  Department of the Treasury (Parts 1000--1099)
        12  Department of Transportation (Parts 1200--1299)
        13  Department of Commerce (Parts 1300--1399)
        14  Department of the Interior (Parts 1400--1499)
        15  Environmental Protection Agency (Parts 1500--1599)
        16  Office of Personnel Management, Federal Employees 
                Health Benefits Acquisition Regulation (Parts 
                1600--1699)
        17  Office of Personnel Management (Parts 1700--1799)
        18  National Aeronautics and Space Administration (Parts 
                1800--1899)
        19  Broadcasting Board of Governors (Parts 1900--1999)
        20  Nuclear Regulatory Commission (Parts 2000--2099)
        21  Office of Personnel Management, Federal Employees 
                Group Life Insurance Federal Acquisition 
                Regulation (Parts 2100--2199)
        23  Social Security Administration (Parts 2300--2399)
        24  Department of Housing and Urban Development (Parts 
                2400--2499)
        25  National Science Foundation (Parts 2500--2599)
        28  Department of Justice (Parts 2800--2899)
        29  Department of Labor (Parts 2900--2999)
        30  Department of Homeland Security, Homeland Security 
                Acquisition Regulation (HSAR) (Parts 3000--3099)
        34  Department of Education Acquisition Regulation (Parts 
                3400--3499)
        51  Department of the Army Acquisition Regulations (Parts 
                5100--5199)
        52  Department of the Navy Acquisition Regulations (Parts 
                5200--5299)
        53  Department of the Air Force Federal Acquisition 
                Regulation Supplement (Parts 5300--5399) 
                [Reserved]
        54  Defense Logistics Agency, Department of Defense (Parts 
                5400--5499)
        57  African Development Foundation (Parts 5700--5799)
        61  Civilian Board of Contract Appeals, General Services 
                Administration (Parts 6100--6199)
        99  Cost Accounting Standards Board, Office of Federal 
                Procurement Policy, Office of Management and 
                Budget (Parts 9900--9999)

[[Page 641]]

                       Title 49--Transportation

            Subtitle A--Office of the Secretary of Transportation 
                (Parts 1--99)
            Subtitle B--Other Regulations Relating to 
                Transportation
         I  Pipeline and Hazardous Materials Safety 
                Administration, Department of Transportation 
                (Parts 100--199)
        II  Federal Railroad Administration, Department of 
                Transportation (Parts 200--299)
       III  Federal Motor Carrier Safety Administration, 
                Department of Transportation (Parts 300--399)
        IV  Coast Guard, Department of Homeland Security (Parts 
                400--499)
         V  National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 500--599)
        VI  Federal Transit Administration, Department of 
                Transportation (Parts 600--699)
       VII  National Railroad Passenger Corporation (AMTRAK) 
                (Parts 700--799)
      VIII  National Transportation Safety Board (Parts 800--999)
         X  Surface Transportation Board (Parts 1000--1399)
        XI  Research and Innovative Technology Administration, 
                Department of Transportation (Parts 1400--1499) 
                [Reserved]
       XII  Transportation Security Administration, Department of 
                Homeland Security (Parts 1500--1699)

                   Title 50--Wildlife and Fisheries

         I  United States Fish and Wildlife Service, Department of 
                the Interior (Parts 1--199)
        II  National Marine Fisheries Service, National Oceanic 
                and Atmospheric Administration, Department of 
                Commerce (Parts 200--299)
       III  International Fishing and Related Activities (Parts 
                300--399)
        IV  Joint Regulations (United States Fish and Wildlife 
                Service, Department of the Interior and National 
                Marine Fisheries Service, National Oceanic and 
                Atmospheric Administration, Department of 
                Commerce); Endangered Species Committee 
                Regulations (Parts 400--499)
         V  Marine Mammal Commission (Parts 500--599)
        VI  Fishery Conservation and Management, National Oceanic 
                and Atmospheric Administration, Department of 
                Commerce (Parts 600--699)

[[Page 643]]





           Alphabetical List of Agencies Appearing in the CFR




                      (Revised as of April 1, 2019)

                                                  CFR Title, Subtitle or 
                     Agency                               Chapter

Administrative Conference of the United States    1, III
Advisory Council on Historic Preservation         36, VIII
Advocacy and Outreach, Office of                  7, XXV
Afghanistan Reconstruction, Special Inspector     5, LXXXIII
     General for
African Development Foundation                    22, XV
  Federal Acquisition Regulation                  48, 57
Agency for International Development              2, VII; 22, II
  Federal Acquisition Regulation                  48, 7
Agricultural Marketing Service                    7, I, IX, X, XI
Agricultural Research Service                     7, V
Agriculture, Department of                        2, IV; 5, LXXIII
  Advocacy and Outreach, Office of                7, XXV
  Agricultural Marketing Service                  7, I, IX, X, XI
  Agricultural Research Service                   7, V
  Animal and Plant Health Inspection Service      7, III; 9, I
  Chief Financial Officer, Office of              7, XXX
  Commodity Credit Corporation                    7, XIV
  Economic Research Service                       7, XXXVII
  Energy Policy and New Uses, Office of           2, IX; 7, XXIX
  Environmental Quality, Office of                7, XXXI
  Farm Service Agency                             7, VII, XVIII
  Federal Acquisition Regulation                  48, 4
  Federal Crop Insurance Corporation              7, IV
  Food and Nutrition Service                      7, II
  Food Safety and Inspection Service              9, III
  Foreign Agricultural Service                    7, XV
  Forest Service                                  36, II
  Grain Inspection, Packers and Stockyards        7, VIII; 9, II
       Administration
  Information Resources Management, Office of     7, XXVII
  Inspector General, Office of                    7, XXVI
  National Agricultural Library                   7, XLI
  National Agricultural Statistics Service        7, XXXVI
  National Institute of Food and Agriculture      7, XXXIV
  Natural Resources Conservation Service          7, VI
  Operations, Office of                           7, XXVIII
  Procurement and Property Management, Office of  7, XXXII
  Rural Business-Cooperative Service              7, XVIII, XLII
  Rural Development Administration                7, XLII
  Rural Housing Service                           7, XVIII, XXXV
  Rural Telephone Bank                            7, XVI
  Rural Utilities Service                         7, XVII, XVIII, XLII
  Secretary of Agriculture, Office of             7, Subtitle A
  Transportation, Office of                       7, XXXIII
  World Agricultural Outlook Board                7, XXXVIII
Air Force, Department of                          32, VII
  Federal Acquisition Regulation Supplement       48, 53
Air Transportation Stabilization Board            14, VI
Alcohol and Tobacco Tax and Trade Bureau          27, I
Alcohol, Tobacco, Firearms, and Explosives,       27, II
     Bureau of
AMTRAK                                            49, VII
American Battle Monuments Commission              36, IV
American Indians, Office of the Special Trustee   25, VII
Animal and Plant Health Inspection Service        7, III; 9, I

[[Page 644]]

Appalachian Regional Commission                   5, IX
Architectural and Transportation Barriers         36, XI
     Compliance Board
Arctic Research Commission                        45, XXIII
Armed Forces Retirement Home                      5, XI
Army, Department of                               32, V
  Engineers, Corps of                             33, II; 36, III
  Federal Acquisition Regulation                  48, 51
Bilingual Education and Minority Languages        34, V
     Affairs, Office of
Blind or Severely Disabled, Committee for         41, 51
     Purchase from People Who Are
Broadcasting Board of Governors                   22, V
  Federal Acquisition Regulation                  48, 19
Career, Technical, and Adult Education, Office    34, IV
     of
Census Bureau                                     15, I
Centers for Medicare & Medicaid Services          42, IV
Central Intelligence Agency                       32, XIX
Chemical Safety and Hazardous Investigation       40, VI
     Board
Chief Financial Officer, Office of                7, XXX
Child Support Enforcement, Office of              45, III
Children and Families, Administration for         45, II, III, IV, X, XIII
Civil Rights, Commission on                       5, LXVIII; 45, VII
Civil Rights, Office for                          34, I
Council of the Inspectors General on Integrity    5, XCVIII
     and Efficiency
Court Services and Offender Supervision Agency    5, LXX
     for the District of Columbia
Coast Guard                                       33, I; 46, I; 49, IV
Coast Guard (Great Lakes Pilotage)                46, III
Commerce, Department of                           2, XIII; 44, IV; 50, VI
  Census Bureau                                   15, I
  Economic Analysis, Bureau of                    15, VIII
  Economic Development Administration             13, III
  Emergency Management and Assistance             44, IV
  Federal Acquisition Regulation                  48, 13
  Foreign-Trade Zones Board                       15, IV
  Industry and Security, Bureau of                15, VII
  International Trade Administration              15, III; 19, III
  National Institute of Standards and Technology  15, II; 37, IV
  National Marine Fisheries Service               50, II, IV
  National Oceanic and Atmospheric                15, IX; 50, II, III, IV, 
       Administration                             VI
  National Technical Information Service          15, XI
  National Telecommunications and Information     15, XXIII; 47, III, IV
       Administration
  National Weather Service                        15, IX
  Patent and Trademark Office, United States      37, I
  Secretary of Commerce, Office of                15, Subtitle A
Commercial Space Transportation                   14, III
Commodity Credit Corporation                      7, XIV
Commodity Futures Trading Commission              5, XLI; 17, I
Community Planning and Development, Office of     24, V, VI
     Assistant Secretary for
Community Services, Office of                     45, X
Comptroller of the Currency                       12, I
Construction Industry Collective Bargaining       29, IX
     Commission
Consumer Financial Protection Bureau              5, LXXXIV; 12, X
Consumer Product Safety Commission                5, LXXI; 16, II
Copyright Royalty Board                           37, III
Corporation for National and Community Service    2, XXII; 45, XII, XXV
Cost Accounting Standards Board                   48, 99
Council on Environmental Quality                  40, V
Court Services and Offender Supervision Agency    5, LXX; 28, VIII
     for the District of Columbia
Customs and Border Protection                     19, I
Defense Contract Audit Agency                     32, I
Defense, Department of                            2, XI; 5, XXVI; 32, 
                                                  Subtitle A; 40, VII
  Advanced Research Projects Agency               32, I
  Air Force Department                            32, VII

[[Page 645]]

  Army Department                                 32, V; 33, II; 36, III; 
                                                  48, 51
  Defense Acquisition Regulations System          48, 2
  Defense Intelligence Agency                     32, I
  Defense Logistics Agency                        32, I, XII; 48, 54
  Engineers, Corps of                             33, II; 36, III
  National Imagery and Mapping Agency             32, I
  Navy Department                                 32, VI; 48, 52
  Secretary of Defense, Office of                 2, XI; 32, I
Defense Contract Audit Agency                     32, I
Defense Intelligence Agency                       32, I
Defense Logistics Agency                          32, XII; 48, 54
Defense Nuclear Facilities Safety Board           10, XVII
Delaware River Basin Commission                   18, III
Denali Commission                                 45, IX
Disability, National Council on                   5, C; 34, XII
District of Columbia, Court Services and          5, LXX; 28, VIII
     Offender Supervision Agency for the
Drug Enforcement Administration                   21, II
East-West Foreign Trade Board                     15, XIII
Economic Analysis, Bureau of                      15, VIII
Economic Development Administration               13, III
Economic Research Service                         7, XXXVII
Education, Department of                          2, XXXIV; 5, LIII
  Bilingual Education and Minority Languages      34, V
       Affairs, Office of
  Career, Technical, and Adult Education, Office  34, IV
       of
  Civil Rights, Office for                        34, I
  Educational Research and Improvement, Office    34, VII
       of
  Elementary and Secondary Education, Office of   34, II
  Federal Acquisition Regulation                  48, 34
  Postsecondary Education, Office of              34, VI
  Secretary of Education, Office of               34, Subtitle A
  Special Education and Rehabilitative Services,  34, III
       Office of
Educational Research and Improvement, Office of   34, VII
Election Assistance Commission                    2, LVIII; 11, II
Elementary and Secondary Education, Office of     34, II
Emergency Oil and Gas Guaranteed Loan Board       13, V
Emergency Steel Guarantee Loan Board              13, IV
Employee Benefits Security Administration         29, XXV
Employees' Compensation Appeals Board             20, IV
Employees Loyalty Board                           5, V
Employment and Training Administration            20, V
Employment Policy, National Commission for        1, IV
Employment Standards Administration               20, VI
Endangered Species Committee                      50, IV
Energy, Department of                             2, IX; 5, XXIII; 10, II, 
                                                  III, X
  Federal Acquisition Regulation                  48, 9
  Federal Energy Regulatory Commission            5, XXIV; 18, I
  Property Management Regulations                 41, 109
Energy, Office of                                 7, XXIX
Engineers, Corps of                               33, II; 36, III
Engraving and Printing, Bureau of                 31, VI
Environmental Protection Agency                   2, XV; 5, LIV; 40, I, IV, 
                                                  VII
  Federal Acquisition Regulation                  48, 15
  Property Management Regulations                 41, 115
Environmental Quality, Office of                  7, XXXI
Equal Employment Opportunity Commission           5, LXII; 29, XIV
Equal Opportunity, Office of Assistant Secretary  24, I
     for
Executive Office of the President                 3, I
  Environmental Quality, Council on               40, V
  Management and Budget, Office of                2, Subtitle A; 5, III, 
                                                  LXXVII; 14, VI; 48, 99
  National Drug Control Policy, Office of         2, XXXVI; 21, III
  National Security Council                       32, XXI; 47, 2

[[Page 646]]

  Presidential Documents                          3
  Science and Technology Policy, Office of        32, XXIV; 47, II
  Trade Representative, Office of the United      15, XX
       States
Export-Import Bank of the United States           2, XXXV; 5, LII; 12, IV
Family Assistance, Office of                      45, II
Farm Credit Administration                        5, XXXI; 12, VI
Farm Credit System Insurance Corporation          5, XXX; 12, XIV
Farm Service Agency                               7, VII, XVIII
Federal Acquisition Regulation                    48, 1
Federal Aviation Administration                   14, I
  Commercial Space Transportation                 14, III
Federal Claims Collection Standards               31, IX
Federal Communications Commission                 5, XXIX; 47, I
Federal Contract Compliance Programs, Office of   41, 60
Federal Crop Insurance Corporation                7, IV
Federal Deposit Insurance Corporation             5, XXII; 12, III
Federal Election Commission                       5, XXXVII; 11, I
Federal Emergency Management Agency               44, I
Federal Employees Group Life Insurance Federal    48, 21
     Acquisition Regulation
Federal Employees Health Benefits Acquisition     48, 16
     Regulation
Federal Energy Regulatory Commission              5, XXIV; 18, I
Federal Financial Institutions Examination        12, XI
     Council
Federal Financing Bank                            12, VIII
Federal Highway Administration                    23, I, II
Federal Home Loan Mortgage Corporation            1, IV
Federal Housing Enterprise Oversight Office       12, XVII
Federal Housing Finance Agency                    5, LXXX; 12, XII
Federal Housing Finance Board                     12, IX
Federal Labor Relations Authority                 5, XIV, XLIX; 22, XIV
Federal Law Enforcement Training Center           31, VII
Federal Management Regulation                     41, 102
Federal Maritime Commission                       46, IV
Federal Mediation and Conciliation Service        29, XII
Federal Mine Safety and Health Review Commission  5, LXXIV; 29, XXVII
Federal Motor Carrier Safety Administration       49, III
Federal Prison Industries, Inc.                   28, III
Federal Procurement Policy Office                 48, 99
Federal Property Management Regulations           41, 101
Federal Railroad Administration                   49, II
Federal Register, Administrative Committee of     1, I
Federal Register, Office of                       1, II
Federal Reserve System                            12, II
  Board of Governors                              5, LVIII
Federal Retirement Thrift Investment Board        5, VI, LXXVI
Federal Service Impasses Panel                    5, XIV
Federal Trade Commission                          5, XLVII; 16, I
Federal Transit Administration                    49, VI
Federal Travel Regulation System                  41, Subtitle F
Financial Crimes Enforcement Network              31, X
Financial Research Office                         12, XVI
Financial Stability Oversight Council             12, XIII
Fine Arts, Commission of                          45, XXI
Fiscal Service                                    31, II
Fish and Wildlife Service, United States          50, I, IV
Food and Drug Administration                      21, I
Food and Nutrition Service                        7, II
Food Safety and Inspection Service                9, III
Foreign Agricultural Service                      7, XV
Foreign Assets Control, Office of                 31, V
Foreign Claims Settlement Commission of the       45, V
     United States
Foreign Service Grievance Board                   22, IX
Foreign Service Impasse Disputes Panel            22, XIV
Foreign Service Labor Relations Board             22, XIV
Foreign-Trade Zones Board                         15, IV
Forest Service                                    36, II
General Services Administration                   5, LVII; 41, 105

[[Page 647]]

  Contract Appeals, Board of                      48, 61
  Federal Acquisition Regulation                  48, 5
  Federal Management Regulation                   41, 102
  Federal Property Management Regulations         41, 101
  Federal Travel Regulation System                41, Subtitle F
  General                                         41, 300
  Payment From a Non-Federal Source for Travel    41, 304
       Expenses
  Payment of Expenses Connected With the Death    41, 303
       of Certain Employees
  Relocation Allowances                           41, 302
  Temporary Duty (TDY) Travel Allowances          41, 301
Geological Survey                                 30, IV
Government Accountability Office                  4, I
Government Ethics, Office of                      5, XVI
Government National Mortgage Association          24, III
Grain Inspection, Packers and Stockyards          7, VIII; 9, II
     Administration
Gulf Coast Ecosystem Restoration Council          2, LIX; 40, VIII
Harry S. Truman Scholarship Foundation            45, XVIII
Health and Human Services, Department of          2, III; 5, XLV; 45, 
                                                  Subtitle A
  Centers for Medicare & Medicaid Services        42, IV
  Child Support Enforcement, Office of            45, III
  Children and Families, Administration for       45, II, III, IV, X, XIII
  Community Services, Office of                   45, X
  Family Assistance, Office of                    45, II
  Federal Acquisition Regulation                  48, 3
  Food and Drug Administration                    21, I
  Indian Health Service                           25, V
  Inspector General (Health Care), Office of      42, V
  Public Health Service                           42, I
  Refugee Resettlement, Office of                 45, IV
Homeland Security, Department of                  2, XXX; 5, XXXVI; 6, I; 8, 
                                                  I
  Coast Guard                                     33, I; 46, I; 49, IV
  Coast Guard (Great Lakes Pilotage)              46, III
  Customs and Border Protection                   19, I
  Federal Emergency Management Agency             44, I
  Human Resources Management and Labor Relations  5, XCVII
       Systems
  Immigration and Customs Enforcement Bureau      19, IV
  Transportation Security Administration          49, XII
HOPE for Homeowners Program, Board of Directors   24, XXIV
     of
Housing and Urban Development, Department of      2, XXIV; 5, LXV; 24, 
                                                  Subtitle B
  Community Planning and Development, Office of   24, V, VI
       Assistant Secretary for
  Equal Opportunity, Office of Assistant          24, I
       Secretary for
  Federal Acquisition Regulation                  48, 24
  Federal Housing Enterprise Oversight, Office    12, XVII
       of
  Government National Mortgage Association        24, III
  Housing--Federal Housing Commissioner, Office   24, II, VIII, X, XX
       of Assistant Secretary for
  Housing, Office of, and Multifamily Housing     24, IV
       Assistance Restructuring, Office of
  Inspector General, Office of                    24, XII
  Public and Indian Housing, Office of Assistant  24, IX
       Secretary for
  Secretary, Office of                            24, Subtitle A, VII
Housing--Federal Housing Commissioner, Office of  24, II, VIII, X, XX
     Assistant Secretary for
Housing, Office of, and Multifamily Housing       24, IV
     Assistance Restructuring, Office of
Immigration and Customs Enforcement Bureau        19, IV
Immigration Review, Executive Office for          8, V
Independent Counsel, Office of                    28, VII
Independent Counsel, Offices of                   28, VI
Indian Affairs, Bureau of                         25, I, V
Indian Affairs, Office of the Assistant           25, VI
   Secretary
[[Page 648]]

Indian Arts and Crafts Board                      25, II
Indian Health Service                             25, V
Industry and Security, Bureau of                  15, VII
Information Resources Management, Office of       7, XXVII
Information Security Oversight Office, National   32, XX
     Archives and Records Administration
Inspector General
  Agriculture Department                          7, XXVI
  Health and Human Services Department            42, V
  Housing and Urban Development Department        24, XII, XV
Institute of Peace, United States                 22, XVII
Inter-American Foundation                         5, LXIII; 22, X
Interior, Department of                           2, XIV
  American Indians, Office of the Special         25, VII
       Trustee
  Endangered Species Committee                    50, IV
  Federal Acquisition Regulation                  48, 14
  Federal Property Management Regulations System  41, 114
  Fish and Wildlife Service, United States        50, I, IV
  Geological Survey                               30, IV
  Indian Affairs, Bureau of                       25, I, V
  Indian Affairs, Office of the Assistant         25, VI
       Secretary
  Indian Arts and Crafts Board                    25, II
  Land Management, Bureau of                      43, II
  National Indian Gaming Commission               25, III
  National Park Service                           36, I
  Natural Resource Revenue, Office of             30, XII
  Ocean Energy Management, Bureau of              30, V
  Reclamation, Bureau of                          43, I
  Safety and Enforcement Bureau, Bureau of        30, II
  Secretary of the Interior, Office of            2, XIV; 43, Subtitle A
  Surface Mining Reclamation and Enforcement,     30, VII
       Office of
Internal Revenue Service                          26, I
International Boundary and Water Commission,      22, XI
     United States and Mexico, United States 
     Section
International Development, United States Agency   22, II
     for
  Federal Acquisition Regulation                  48, 7
International Development Cooperation Agency,     22, XII
     United States
International Joint Commission, United States     22, IV
     and Canada
International Organizations Employees Loyalty     5, V
     Board
International Trade Administration                15, III; 19, III
International Trade Commission, United States     19, II
Interstate Commerce Commission                    5, XL
Investment Security, Office of                    31, VIII
James Madison Memorial Fellowship Foundation      45, XXIV
Japan-United States Friendship Commission         22, XVI
Joint Board for the Enrollment of Actuaries       20, VIII
Justice, Department of                            2, XXVIII; 5, XXVIII; 28, 
                                                  I, XI; 40, IV
  Alcohol, Tobacco, Firearms, and Explosives,     27, II
       Bureau of
  Drug Enforcement Administration                 21, II
  Federal Acquisition Regulation                  48, 28
  Federal Claims Collection Standards             31, IX
  Federal Prison Industries, Inc.                 28, III
  Foreign Claims Settlement Commission of the     45, V
       United States
  Immigration Review, Executive Office for        8, V
  Independent Counsel, Offices of                 28, VI
  Prisons, Bureau of                              28, V
  Property Management Regulations                 41, 128
Labor, Department of                              2, XXIX; 5, XLII
  Employee Benefits Security Administration       29, XXV
  Employees' Compensation Appeals Board           20, IV
  Employment and Training Administration          20, V
  Employment Standards Administration             20, VI
  Federal Acquisition Regulation                  48, 29
  Federal Contract Compliance Programs, Office    41, 60
     of
[[Page 649]]

  Federal Procurement Regulations System          41, 50
  Labor-Management Standards, Office of           29, II, IV
  Mine Safety and Health Administration           30, I
  Occupational Safety and Health Administration   29, XVII
  Public Contracts                                41, 50
  Secretary of Labor, Office of                   29, Subtitle A
  Veterans' Employment and Training Service,      41, 61; 20, IX
       Office of the Assistant Secretary for
  Wage and Hour Division                          29, V
  Workers' Compensation Programs, Office of       20, I, VII
Labor-Management Standards, Office of             29, II, IV
Land Management, Bureau of                        43, II
Legal Services Corporation                        45, XVI
Libraries and Information Science, National       45, XVII
     Commission on
Library of Congress                               36, VII
  Copyright Royalty Board                         37, III
  U.S. Copyright Office                           37, II
Local Television Loan Guarantee Board             7, XX
Management and Budget, Office of                  5, III, LXXVII; 14, VI; 
                                                  48, 99
Marine Mammal Commission                          50, V
Maritime Administration                           46, II
Merit Systems Protection Board                    5, II, LXIV
Micronesian Status Negotiations, Office for       32, XXVII
Military Compensation and Retirement              5, XCIX
     Modernization Commission
Millennium Challenge Corporation                  22, XIII
Mine Safety and Health Administration             30, I
Minority Business Development Agency              15, XIV
Miscellaneous Agencies                            1, IV
Monetary Offices                                  31, I
Morris K. Udall Scholarship and Excellence in     36, XVI
     National Environmental Policy Foundation
Museum and Library Services, Institute of         2, XXXI
National Aeronautics and Space Administration     2, XVIII; 5, LIX; 14, V
  Federal Acquisition Regulation                  48, 18
National Agricultural Library                     7, XLI
National Agricultural Statistics Service          7, XXXVI
National and Community Service, Corporation for   2, XXII; 45, XII, XXV
National Archives and Records Administration      2, XXVI; 5, LXVI; 36, XII
  Information Security Oversight Office           32, XX
National Capital Planning Commission              1, IV, VI
National Counterintelligence Center               32, XVIII
National Credit Union Administration              5, LXXXVI; 12, VII
National Crime Prevention and Privacy Compact     28, IX
     Council
National Drug Control Policy, Office of           2, XXXVI; 21, III
National Endowment for the Arts                   2, XXXII
National Endowment for the Humanities             2, XXXIII
National Foundation on the Arts and the           45, XI
     Humanities
National Geospatial-Intelligence Agency           32, I
National Highway Traffic Safety Administration    23, II, III; 47, VI; 49, V
National Imagery and Mapping Agency               32, I
National Indian Gaming Commission                 25, III
National Institute of Food and Agriculture        7, XXXIV
National Institute of Standards and Technology    15, II; 37, IV
National Intelligence, Office of Director of      5, IV; 32, XVII
National Labor Relations Board                    5, LXI; 29, I
National Marine Fisheries Service                 50, II, IV
National Mediation Board                          5, CI; 29, X
National Oceanic and Atmospheric Administration   15, IX; 50, II, III, IV, 
                                                  VI
National Park Service                             36, I
National Railroad Adjustment Board                29, III
National Railroad Passenger Corporation (AMTRAK)  49, VII
National Science Foundation                       2, XXV; 5, XLIII; 45, VI
  Federal Acquisition Regulation                  48, 25
National Security Council                         32, XXI

[[Page 650]]

National Security Council and Office of Science   47, II
     and Technology Policy
National Technical Information Service            15, XI
National Telecommunications and Information       15, XXIII; 47, III, IV, V
     Administration
National Transportation Safety Board              49, VIII
Natural Resources Conservation Service            7, VI
Natural Resource Revenue, Office of               30, XII
Navajo and Hopi Indian Relocation, Office of      25, IV
Navy, Department of                               32, VI
  Federal Acquisition Regulation                  48, 52
Neighborhood Reinvestment Corporation             24, XXV
Northeast Interstate Low-Level Radioactive Waste  10, XVIII
     Commission
Nuclear Regulatory Commission                     2, XX; 5, XLVIII; 10, I
  Federal Acquisition Regulation                  48, 20
Occupational Safety and Health Administration     29, XVII
Occupational Safety and Health Review Commission  29, XX
Ocean Energy Management, Bureau of                30, V
Oklahoma City National Memorial Trust             36, XV
Operations Office                                 7, XXVIII
Overseas Private Investment Corporation           5, XXXIII; 22, VII
Patent and Trademark Office, United States        37, I
Payment From a Non-Federal Source for Travel      41, 304
     Expenses
Payment of Expenses Connected With the Death of   41, 303
     Certain Employees
Peace Corps                                       2, XXXVII; 22, III
Pennsylvania Avenue Development Corporation       36, IX
Pension Benefit Guaranty Corporation              29, XL
Personnel Management, Office of                   5, I, XXXV; 5, IV; 45, 
                                                  VIII
  Human Resources Management and Labor Relations  5, XCVII
       Systems, Department of Homeland Security
  Federal Acquisition Regulation                  48, 17
  Federal Employees Group Life Insurance Federal  48, 21
       Acquisition Regulation
  Federal Employees Health Benefits Acquisition   48, 16
       Regulation
Pipeline and Hazardous Materials Safety           49, I
     Administration
Postal Regulatory Commission                      5, XLVI; 39, III
Postal Service, United States                     5, LX; 39, I
Postsecondary Education, Office of                34, VI
President's Commission on White House             1, IV
     Fellowships
Presidential Documents                            3
Presidio Trust                                    36, X
Prisons, Bureau of                                28, V
Privacy and Civil Liberties Oversight Board       6, X
Procurement and Property Management, Office of    7, XXXII
Public Contracts, Department of Labor             41, 50
Public and Indian Housing, Office of Assistant    24, IX
     Secretary for
Public Health Service                             42, I
Railroad Retirement Board                         20, II
Reclamation, Bureau of                            43, I
Refugee Resettlement, Office of                   45, IV
Relocation Allowances                             41, 302
Research and Innovative Technology                49, XI
     Administration
Rural Business-Cooperative Service                7, XVIII, XLII
Rural Development Administration                  7, XLII
Rural Housing Service                             7, XVIII, XXXV
Rural Telephone Bank                              7, XVI
Rural Utilities Service                           7, XVII, XVIII, XLII
Safety and Environmental Enforcement, Bureau of   30, II
Saint Lawrence Seaway Development Corporation     33, IV
Science and Technology Policy, Office of          32, XXIV
Science and Technology Policy, Office of, and     47, II
     National Security Council
Secret Service                                    31, IV
Securities and Exchange Commission                5, XXXIV; 17, II

[[Page 651]]

Selective Service System                          32, XVI
Small Business Administration                     2, XXVII; 13, I
Smithsonian Institution                           36, V
Social Security Administration                    2, XXIII; 20, III; 48, 23
Soldiers' and Airmen's Home, United States        5, XI
Special Counsel, Office of                        5, VIII
Special Education and Rehabilitative Services,    34, III
     Office of
State, Department of                              2, VI; 22, I; 28, XI
  Federal Acquisition Regulation                  48, 6
Surface Mining Reclamation and Enforcement,       30, VII
     Office of
Surface Transportation Board                      49, X
Susquehanna River Basin Commission                18, VIII
Tennessee Valley Authority                        5, LXIX; 18, XIII
Trade Representative, United States, Office of    15, XX
Transportation, Department of                     2, XII; 5, L
  Commercial Space Transportation                 14, III
  Emergency Management and Assistance             44, IV
  Federal Acquisition Regulation                  48, 12
  Federal Aviation Administration                 14, I
  Federal Highway Administration                  23, I, II
  Federal Motor Carrier Safety Administration     49, III
  Federal Railroad Administration                 49, II
  Federal Transit Administration                  49, VI
  Maritime Administration                         46, II
  National Highway Traffic Safety Administration  23, II, III; 47, IV; 49, V
  Pipeline and Hazardous Materials Safety         49, I
       Administration
  Saint Lawrence Seaway Development Corporation   33, IV
  Secretary of Transportation, Office of          14, II; 49, Subtitle A
  Transportation Statistics Bureau                49, XI
Transportation, Office of                         7, XXXIII
Transportation Security Administration            49, XII
Transportation Statistics Bureau                  49, XI
Travel Allowances, Temporary Duty (TDY)           41, 301
Treasury, Department of the                       2, X;5, XXI; 12, XV; 17, 
                                                  IV; 31, IX
  Alcohol and Tobacco Tax and Trade Bureau        27, I
  Community Development Financial Institutions    12, XVIII
       Fund
  Comptroller of the Currency                     12, I
  Customs and Border Protection                   19, I
  Engraving and Printing, Bureau of               31, VI
  Federal Acquisition Regulation                  48, 10
  Federal Claims Collection Standards             31, IX
  Federal Law Enforcement Training Center         31, VII
  Financial Crimes Enforcement Network            31, X
  Fiscal Service                                  31, II
  Foreign Assets Control, Office of               31, V
  Internal Revenue Service                        26, I
  Investment Security, Office of                  31, VIII
  Monetary Offices                                31, I
  Secret Service                                  31, IV
  Secretary of the Treasury, Office of            31, Subtitle A
Truman, Harry S. Scholarship Foundation           45, XVIII
United States and Canada, International Joint     22, IV
     Commission
United States and Mexico, International Boundary  22, XI
     and Water Commission, United States Section
U.S. Copyright Office                             37, II
Utah Reclamation Mitigation and Conservation      43, III
     Commission
Veterans Affairs, Department of                   2, VIII; 38, I
  Federal Acquisition Regulation                  48, 8
Veterans' Employment and Training Service,        41, 61; 20, IX
     Office of the Assistant Secretary for
Vice President of the United States, Office of    32, XXVIII
Wage and Hour Division                            29, V
Water Resources Council                           18, VI
Workers' Compensation Programs, Office of         20, I, VII
World Agricultural Outlook Board                  7, XXXVIII

[[Page 653]]







                      Table of OMB Control Numbers



The OMB control numbers for chapter I of title 26 were consolidated into 
Sec. Sec.  601.9000 and 602.101 at 50 FR 10221, Mar. 14, 1985. At 61 FR 
58008, Nov. 12, 1996, Sec.  601.9000 was removed. Section 602.101 is 
reprinted below for the convenience of the user.



PART 602_OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT--
Table of Contents





Sec.  602.101  OMB Control numbers.

    (a) Purpose. This part collects and displays the control numbers 
assigned to collections of information in Internal Revenue Service 
regulations by the Office of Management and Budget (OMB) under the 
Paperwork Reduction Act of 1980. The Internal Revenue Service intends 
that this part comply with the requirements of Sec. Sec.  1320.7(f), 
1320.12, 1320.13, and 1320.14 of 5 CFR part 1320 (OMB regulations 
implementing the Paperwork Reduction Act), for the display of control 
numbers assigned by OMB to collections of information in Internal 
Revenue Service regulations. This part does not display control numbers 
assigned by the Office of Management and Budget to collections of 
information of the Bureau of Alcohol, Tobacco, and Firearms.
    (b) Display.

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
1.1(h)-1(e)................................................    1545-1654
1.25-1T....................................................    1545-0922
                                                               1545-0930
1.25-2T....................................................    1545-0922
                                                               1545-0930
1.25-3T....................................................    1545-0922
                                                               1545-0930
1.25-4T....................................................    1545-0922
1.25-5T....................................................    1545-0922
1.25-6T....................................................    1545-0922
1.25-7T....................................................    1545-0922
1.25-8T....................................................    1545-0922
1.25A-1....................................................    1545-1630
1.28-1.....................................................    1545-0619
1.31-2.....................................................    1545-0074
1.32-2.....................................................    1545-0074
1.32-3.....................................................    1545-1575
1.36B-5....................................................    1545-2232
1.37-1.....................................................    1545-0074
1.37-3.....................................................    1545-0074
1.41-2.....................................................    1545-0619
1.41-3.....................................................    1545-0619
1.41-4A....................................................    1545-0074
1.41-4 (b) and (c).........................................    1545-0074
1.41-8(b)..................................................    1545-1625
1.41-8(d)..................................................    1545-0732
1.41-9.....................................................    1545-0619
1.42-1T....................................................    1545-0984
                                                               1545-0988
1.42-5.....................................................    1545-1357
1.42-6.....................................................    1545-1102
1.42-8.....................................................    1545-1102
1.42-10....................................................    1545-1102
1.42-13....................................................    1545-1357
1.42-14....................................................    1545-1423
1.42-17....................................................    1545-1357
1.42-18....................................................    1545-2088
1.43-3(a)(3)...............................................    1545-1292
1.43-3(b)(3)...............................................    1545-1292
1.44B-1....................................................    1545-0219
1.45D-1....................................................    1545-1765
1.45G-1....................................................    1545-2031
1.46-1.....................................................    1545-0123
                                                               1545-0155
1.46-3.....................................................    1545-0155
1.46-4.....................................................    1545-0155
1.46-5.....................................................    1545-0155
1.46-6.....................................................    1545-0155
1.46-8.....................................................    1545-0155
1.46-9.....................................................    1545-0155
1.46-10....................................................    1545-0118
1.47-1.....................................................    1545-0155
                                                               1545-0166
1.47-3.....................................................    1545-0155
                                                               1545-0166
1.47-4.....................................................    1545-0123
1.47-5.....................................................    1545-0092
1.47-6.....................................................    1545-0099
1.48-3.....................................................    1545-0155
1.48-4.....................................................    1545-0155
                                                               1545-0808
1.48-5.....................................................    1545-0155
1.48-6.....................................................    1545-0155
1.48-12....................................................    1545-0155
                                                               1545-1783
1.50A-1....................................................    1545-0895
1.50A-2....................................................    1545-0895
1.50A-3....................................................    1545-0895
1.50A-4....................................................    1545-0895
1.50A-5....................................................    1545-0895
1.50A-6....................................................    1545-0895
1.50A-7....................................................    1545-0895
1.50B-1....................................................    1545-0895
1.50B-2....................................................    1545-0895
1.50B-3....................................................    1545-0895
1.50B-4....................................................    1545-0895
1.50B-5....................................................    1545-0895
1.51-1.....................................................    1545-0219

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1.167(a)-5T................................................    1545-1021
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1.167(f)-11................................................    1545-0172
1.167(l)-1.................................................    1545-0172
1.168(d)-1.................................................    1545-1146
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1.170A-4(A)(b).............................................    1545-0123
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1.263(a)-1.................................................    1545-2248
1.263(a)-3.................................................    1545-2248
1.263(a)-5.................................................    1545-1870
1.263(e)-1.................................................    1545-0123
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1.263A-1T..................................................    1545-0187
1.263A-2...................................................    1545-0987
1.263A-3...................................................    1545-0987
1.263A-8(b)(2)(iii)........................................    1545-1265
1.263A-9(d)(1).............................................    1545-1265
1.263A-9(f)(1)(ii).........................................    1545-1265
1.263A-9(f)(2)(iv).........................................    1545-1265
1.263A-9(g)(2)(iv)(C)......................................    1545-1265
1.263A-9(g)(3)(iv).........................................    1545-1265
1.265-1....................................................    1545-0074
1.265-2....................................................    1545-0123
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1.338-5....................................................    1545-1658
1.338-10...................................................    1545-1658
1.338-11...................................................    1545-1990
1.338(h)(10)-1.............................................    1545-1658
1.338(i)-1.................................................    1545-1990
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1.355-5....................................................    1545-2019
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1.367(a)-2T................................................    1545-0026
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1.381(c)(11)-1(k)..........................................    1545-0123
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1.381(c)(22)-1.............................................    1545-1990
1.381(c)(25)-1.............................................    1545-0045
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1.382-9....................................................    1545-1120
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1.383-1....................................................    1545-0074
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1.401-1....................................................    1545-0020
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                                                               1545-0534
                                                               1545-0710
1.401(a)-11................................................    1545-0710
1.401(a)-20................................................    1545-0928
1.401(a)-31................................................    1545-1341
1.401(a)-50................................................    1545-0710
1.401(a)(9)-1..............................................    1545-1573
1.401(a)(9)-3..............................................    1545-1466
1.401(a)(9)-4..............................................    1545-1573
1.401(a)(9)-6..............................................    1545-2234
1.401(a)(31)-1.............................................    1545-1341
1.401(b)-1.................................................    1545-0197
1.401(f)-1.................................................    1545-0710
1.401(k)-1.................................................    1545-1039
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                                                               1545-1930
1.401(k)-2.................................................    1545-1669
1.401(k)-3.................................................    1545-1669
1.401(k)-4.................................................    1545-1669
1.401(m)-3.................................................    1545-1699
1.401-14...................................................    1545-0710
1.402(c)-2.................................................    1545-1341
1.402(f)-1.................................................    1545-1341
                                                               1545-1632
1.402A-1...................................................    1545-1992
1.403(b)-1.................................................    1545-0710
1.403(b)-3.................................................    1545-0996
1.403(b)-7.................................................    1545-1341
1.403(b)-10................................................    1545-2068
1.404(a)-12................................................    1545-0710
1.404A-2...................................................    1545-0123
1.404A-6...................................................    1545-0123
1.408-2....................................................    1545-0390
1.408-5....................................................    1545-0747
1.408-6....................................................    1545-0203
                                                               1545-0390
1.408-7....................................................    1545-0119
1.408(q)-1.................................................    1545-1841
1.408A-2...................................................    1545-1616
1.408A-4...................................................    1545-1616
1.408A-5...................................................    1545-1616
1.408A-7...................................................    1545-1616
1.410(a)-2.................................................    1545-0710
1.410(d)-1.................................................    1545-0710
1.411(a)-11................................................    1545-1471
                                                               1545-1632
1.411(d)-4.................................................    1545-1545
1.411(d)-6.................................................    1545-1477
1.412(c)(1)-2..............................................    1545-0710
1.412(c)(2)-1..............................................    1545-0710
1.412(c)(3)-2..............................................    1545-0710
1.414(c)-5.................................................    1545-0797
1.414(r)-1.................................................    1545-1221
1.415-2....................................................    1545-0710
1.415-6....................................................    1545-0710
1.417(a)(3)-1..............................................    1545-0928
1.417(e)-1.................................................    1545-1471
                                                               1545-1724
1.417(e)-1T................................................    1545-1471
1.419A(f)(6)-1.............................................    1545-1795
1.422-1....................................................    1545-0820
1.430(f)-1.................................................    1545-2095
1.430(g)-1.................................................    1545-2095
1.430(h)(2)-1..............................................    1545-2095
1.432(e)(9)-1T.............................................    1545-2260
1.436-1....................................................    1545-2095
1.441-2....................................................    1545-1748
1.442-1....................................................    1545-0074
                                                               1545-0123
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1.443-1....................................................    1545-0123
1.444-3T...................................................    1545-1036
1.444-4....................................................    1545-1591
1.446-1....................................................    1545-0074
                                                               1545-0152
1.446-4(d).................................................    1545-1412
1.448-1(g).................................................    1545-0152
1.448-1(h).................................................    1545-0152
1.448-1(i).................................................    1545-0152
1.448-2....................................................    1545-1855
1.448-2T...................................................    1545-0152
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1.451-1....................................................    1545-0091
1.451-4....................................................    1545-0123
1.451-5....................................................    1545-0074
1.451-6....................................................    1545-0074
1.451-7....................................................    1545-0074
1.453-1....................................................    1545-0152
1.453-2....................................................    1545-0152
1.453-8....................................................    1545-0152
                                                               1545-0228
1.453A-1...................................................    1545-0152
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1.453A-3...................................................    1545-0963
1.454-1....................................................    1545-0074
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1.456-7....................................................    1545-0123
1.457-8....................................................    1545-1580
1.458-1....................................................    1545-0879
1.458-2....................................................    1545-0152
1.460-1....................................................    1545-1650
1.460-6....................................................    1545-1031
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1.461-1....................................................    1545-0074
1.461-2....................................................    1545-0096
1.461-4....................................................    1545-0917
1.461-5....................................................    1545-0917
1.463-1T...................................................    1545-0916
1.465-1T...................................................    1545-0712
1.466-1T...................................................    1545-0152
1.466-4....................................................    1545-0152
1.468A-3...................................................    1545-1269
                                                               1545-1378
                                                               1545-1511
1.468A-3(h), 1.468A-7, and 1.468A-8(d).....................    1545-2091
1.468A-4...................................................    1545-0954
1.468A-7...................................................    1545-0954
                                                               1545-1511
1.468A-8...................................................    1545-1269
1.468B-1...................................................    1545-1631
1.468B-1(j)................................................    1545-1299
1.468B-2(k)................................................    1545-1299
1.468B-2(l)................................................    1545-1299
1.468B-3(b)................................................    1545-1299
1.468B-3(e)................................................    1545-1299
1.468B-5(b)................................................    1545-1299
1.468B-9...................................................    1545-1631
1.469-1....................................................    1545-1008
1.469-2T...................................................    1545-0712
                                                               1545-1091
1.469-4T...................................................    1545-0985
                                                               1545-1037
1.469-7....................................................    1545-1244
1.471-2....................................................    1545-0123
1.471-5....................................................    1545-0123
1.471-6....................................................    1545-0123
1.471-8....................................................    1545-0123
1.471-11...................................................    1545-0123
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1.472-1....................................................    1545-0042
                                                               1545-0152
1.472-2....................................................    1545-0152
1.472-3....................................................    1545-0042
1.472-5....................................................    1545-0152
1.472-8....................................................    1545-0028
                                                               1545-0042
                                                               1545-1767
1.475(a)-4.................................................    1545-1945
1.481-4....................................................    1545-0152
1.481-5....................................................    1545-0152
1.482-1....................................................    1545-1364
1.482-4....................................................    1545-1364
1.482-7....................................................    1545-1364
                                                               1545-1794
1.482-9(b).................................................    1545-2149
1.501(a)-1.................................................    1545-0056
                                                               1545-0057
1.501(c)(3)-1..............................................    1545-0056
1.501(c)(9)-5..............................................    1545-0047
1.501(c)(17)-3.............................................    1545-0047
1.501(e)-1.................................................    1545-0814
1.501(r)-3.................................................    1545-0047
1.501(r)-4.................................................    1545-0047
1.501(r)-6.................................................    1545-0047
1.503(c)-1.................................................    1545-0047
                                                               1545-0052
1.505(c)-1T................................................    1545-0916
1.506-1T...................................................    1545-2268
1.507-1....................................................    1545-0052
1.507-2....................................................    1545-0052
1.508-1....................................................    1545-0052
                                                               1545-0056
1.509(a)-3.................................................    1545-0047
1.509(a)-4.................................................    1545-2157
1.509(a)-5.................................................    1545-0047
1.509(c)-1.................................................    1545-0052
1.512(a)-1.................................................    1545-0687
1.512(a)-4.................................................    1545-0047
                                                               1545-0687
1.521-1....................................................    1545-0051
                                                               1545-0058
1.527-2....................................................    1545-0129
1.527-5....................................................    1545-0129
1.527-6....................................................    1545-0129
1.527-9....................................................    1545-0129
1.528-8....................................................    1545-0127
1.533-2....................................................    1545-0123
1.534-2....................................................    1545-0123
1.542-3....................................................    1545-0123
1.545-2....................................................    1545-0123
1.545-3....................................................    1545-0123
1.547-2....................................................    1545-0045
                                                               1545-0123
1.547-3....................................................    1545-0123
1.561-1....................................................    1545-0044
1.561-2....................................................    1545-0123
1.562-3....................................................    1545-0123
1.563-2....................................................    1545-0123
1.564-1....................................................    1545-0123
1.565-1....................................................    1545-0043
                                                               1545-0123
1.565-2....................................................    1545-0043
1.565-3....................................................    1545-0043
1.565-5....................................................    1545-0043
1.565-6....................................................    1545-0043
1.585-1....................................................    1545-0123
1.585-3....................................................    1545-0123
1.585-8....................................................    1545-1290
1.597-2....................................................    1545-1300
1.597-4....................................................    1545-1300
1.597-6....................................................    1545-1300
1.597-7....................................................    1545-1300
1.611-2....................................................    1545-0099
1.611-3....................................................    1545-0007
                                                               1545-0099
                                                               1545-1784
1.612-4....................................................    1545-0074
1.612-5....................................................    1545-0099
1.613-3....................................................    1545-0099
1.613-4....................................................    1545-0099
1.613-6....................................................    1545-0099
1.613-7....................................................    1545-0099
1.613A-3...................................................    1545-0919
1.613A-3(e)................................................    1545-1251
1.613A-3(l)................................................    1545-0919
1.613A-5...................................................    1545-0099
1.613A-6...................................................    1545-0099
1.614-2....................................................    1545-0099
1.614-3....................................................    1545-0099
1.614-5....................................................    1545-0099
1.614-6....................................................    1545-0099
1.614-8....................................................    1545-0099
1.617-1....................................................    1545-0099
1.617-3....................................................    1545-0099
1.617-4....................................................    1545-0099
1.631-1....................................................    1545-0007

[[Page 658]]

 
1.631-2....................................................    1545-0007
1.641(b)-2.................................................    1545-0092
1.642(c)-1.................................................    1545-0092
1.642(c)-2.................................................    1545-0092
1.642(c)-5.................................................    1545-0074
1.642(c)-6.................................................    1545-0020
                                                               1545-0074
                                                               1545-0092
1.642(g)-1.................................................    1545-0092
1.642(i)-1.................................................    1545-0092
1.645-1....................................................    1545-1578
1.663(b)-2.................................................    1545-0092
1.664-1....................................................    1545-0196
1.664-1(a)(7)..............................................    1545-1536
1.664-1(c).................................................    1545-2101
1.664-2....................................................    1545-0196
1.664-3....................................................    1545-0196
1.664-4....................................................    1545-0020
                                                               1545-0196
1.665(a)-0A through
1.665(g)-2A................................................    1545-0192
1.666(d)-1A................................................    1545-0092
1.671-4....................................................    1545-1442
1.671-5....................................................    1545-1540
1.701-1....................................................    1545-0099
1.702-1....................................................    1545-0074
1.703-1....................................................    1545-0099
1.704-2....................................................    1545-1090
1.706-1....................................................    1545-0074
                                                               1545-0099
                                                               1545-0134
1.706-1T...................................................    1545-0099
1.706-4(f).................................................    1545-0123
1.707-3(c)(2)..............................................    1545-1243
1.707-5(a)(7)(ii)..........................................    1545-1243
1.707-6(c).................................................    1545-1243
1.707-8....................................................    1545-1243
1.708-1....................................................    1545-0099
1.732-1....................................................    1545-0099
                                                               1545-1588
1.736-1....................................................    1545-0074
1.743-1....................................................    1545-0074
                                                               1545-1588
1.751-1....................................................    1545-0074
                                                               1545-0099
                                                               1545-0941
1.752-2....................................................    1545-1905
1.752-5....................................................    1545-1090
1.752-7....................................................    1545-1843
1.754-1....................................................    1545-0099
1.755-1....................................................    1545-0099
1.761-2....................................................    1545-1338
1.801-1....................................................    1545-0123
                                                               1545-0128
1.801-3....................................................    1545-0123
1.801-5....................................................    1545-0128
1.801-8....................................................    1545-0128
1.804-4....................................................    1545-0128
1.811-2....................................................    1545-0128
1.812-2....................................................    1545-0128
1.815-6....................................................    1545-0128
1.818-4....................................................    1545-0128
1.818-5....................................................    1545-0128
1.818-8....................................................    1545-0128
1.819-2....................................................    1545-0128
1.822-5....................................................    1545-1027
1.822-6....................................................    1545-1027
1.822-8....................................................    1545-1027
1.822-9....................................................    1545-1027
1.826-1....................................................    1545-1027
1.826-2....................................................    1545-1027
1.826-3....................................................    1545-1027
1.826-4....................................................    1545-1027
1.826-6....................................................    1545-1027
1.831-3....................................................    1545-0123
1.832-4....................................................    1545-1227
1.832-5....................................................    1545-0123
1.848-2(g)(8)..............................................    1545-1287
1.848-2(h)(3)..............................................    1545-1287
1.848-2(i)(4)..............................................    1545-1287
1.851-2....................................................    1545-1010
1.851-4....................................................    1545-0123
1.852-1....................................................    1545-0123
1.852-4....................................................    1545-0123
                                                               1545-0145
1.852-6....................................................    1545-0123
                                                               1545-0144
1.852-7....................................................    1545-0074
1.852-9....................................................    1545-0074
                                                               1545-0123
                                                               1545-0144
                                                               1545-0145
                                                               1545-1783
1.852-11...................................................    1545-1094
1.853-3....................................................    1545-2035
1.853-4....................................................    1545-2035
1.854-2....................................................    1545-0123
1.855-1....................................................    1545-0123
1.856-2....................................................    1545-0123
                                                               1545-1004
1.856-6....................................................    1545-0123
1.856-7....................................................    1545-0123
1.856-8....................................................    1545-0123
1.857-8....................................................    1545-0123
1.857-9....................................................    1545-0074
1.858-1....................................................    1545-0123
1.860-2....................................................    1545-0045
1.860-4....................................................    1545-0045
                                                               1545-1054
                                                               1545-1057
1.860E-1...................................................    1545-1675
1.860E-2(a)(5).............................................    1545-1276
1.860E-2(a)(7).............................................    1545-1276
1.860E-2(b)(2).............................................    1545-1276
1.860G-2...................................................    1545-2110
1.861-2....................................................    1545-0089
1.861-3....................................................    1545-0089
1.861-4....................................................    1545-1900
1.861-8....................................................    1545-0126
1.861-8(e)(6) and (g)......................................    1545-1224
1.861-9T...................................................    1545-0121
                                                               1545-1072
1.861-18...................................................    1545-1594
1.863-1....................................................    1545-1476
1.863-3....................................................    1545-1476
                                                               1545-1556
1.863-3A...................................................    1545-0126
1.863-4....................................................    1545-0126
1.863-7....................................................    1545-0132
1.863-8....................................................    1545-1718
1.863-9....................................................    1545-1718
1.864-4....................................................    1545-0126
1.871-1....................................................    1545-0096
1.871-6....................................................    1545-0795
1.871-7....................................................    1545-0089
1.871-10...................................................    1545-0089
                                                               1545-0165
1.874-1....................................................    1545-0089
1.881-4....................................................    1545-1440
1.882-4....................................................    1545-0126
1.883-0....................................................    1545-1677
1.883-1....................................................    1545-1677
1.883-2....................................................    1545-1677
1.883-3....................................................    1545-1677

[[Page 659]]

 
1.883-4....................................................    1545-1677
1.883-5....................................................    1545-1677
1.884-0....................................................    1545-1070
1.884-1....................................................    1545-1070
1.884-2....................................................    1545-1070
1.884-2T...................................................    1545-0126
                                                               1545-1070
1.884-4....................................................    1545-1070
1.884-5....................................................    1545-1070
1.892-1T...................................................    1545-1053
1.892-2T...................................................    1545-1053
1.892-3T...................................................    1545-1053
1.892-4T...................................................    1545-1053
1.892-5T...................................................    1545-1053
1.892-6T...................................................    1545-1053
1.892-7T...................................................    1545-1053
1.897-2....................................................    1545-0123
                                                               1545-0902
1.897-3....................................................    1545-0123
1.897-5T...................................................    1545-0902
1.897-6T...................................................    1545-0902
1.901-2....................................................    1545-0746
1.901-2A...................................................    1545-0746
1.901-3....................................................    1545-0122
1.902-1....................................................    1545-0122
                                                               1545-1458
1.904-1....................................................    1545-0121
                                                               1545-0122
1.904-2....................................................    1545-0121
                                                               1545-0122
1.904-3....................................................    1545-0121
1.904-4....................................................    1545-0121
1.904-5....................................................    1545-0121
1.904-7....................................................    1545-2104
1.904-7T...................................................    1545-2104
1.904(f)-1.................................................    1545-0121
                                                               1545-0122
1.904(f)-2.................................................    1545-0121
1.904(f)-3.................................................    1545-0121
1.904(f)-4.................................................    1545-0121
1.904(f)-5.................................................    1545-0121
1.904(f)-6.................................................    1545-0121
1.904(f)-7.................................................    1545-1127
1.905-2....................................................    1545-0122
1.905-3T...................................................    1545-1056
1.905-4T...................................................    1545-1056
1.905-5T...................................................    1545-1056
1.911-1....................................................    1545-0067
                                                               1545-0070
1.911-2....................................................    1545-0067
                                                               1545-0070
1.911-3....................................................    1545-0067
                                                               1545-0070
1.911-4....................................................    1545-0067
                                                               1545-0070
1.911-5....................................................    1545-0067
                                                               1545-0070
1.911-6....................................................    1545-0067
                                                               1545-0070
1.911-7....................................................    1545-0067
                                                               1545-0070
1.913-13...................................................    1545-0067
1.921-1T...................................................    1545-0190
                                                               1545-0884
                                                               1545-0935
                                                               1545-0939
1.921-2....................................................    1545-0884
1.927(a)-1T................................................    1545-0935
1.927(d)-2T................................................    1545-0935
1.931-1....................................................    1545-0074
                                                               1545-0123
1.934-1....................................................    1545-0782
1.935-1....................................................    1545-0074
                                                               1545-0087
                                                               1545-0803
1.936-1....................................................    1545-0215
                                                               1545-0217
1.936-4....................................................    1545-0215
1.936-5....................................................    1545-0704
1.936-6....................................................    1545-0215
1.936-7....................................................    1545-0215
1.936-10(c)................................................    1545-1138
1.937-1....................................................    1545-1930
1.952-2....................................................    1545-0126
1.953-2....................................................    1545-0126
1.954-1....................................................    1545-1068
1.954-2....................................................    1545-1068
1.955-2....................................................    1545-0123
1.955-3....................................................    1545-0123
1.955A-2...................................................    1545-0755
1.955A-3...................................................    1545-0755
1.956-1....................................................    1545-0704
1.956-2....................................................    1545-0704
1.959-1....................................................    1545-0704
1.959-2....................................................    1545-0704
1.960-1....................................................    1545-0122
1.962-2....................................................    1545-0704
1.962-3....................................................    1545-0704
1.964-1....................................................    1545-0126
                                                               1545-0704
                                                               1545-1072
                                                               1545-2104
1.964-3....................................................    1545-0126
1.970-2....................................................    1545-0126
1.985-2....................................................    1545-1051
                                                               1545-1131
1.985-3....................................................    1545-1051
1.987-1....................................................    1545-2265
1.987-3....................................................    1545-2265
1.987-9....................................................    1545-2265
1.987-10...................................................    1545-2265
1.988-0....................................................    1545-1131
1.988-1....................................................    1545-1131
1.988-2....................................................    1545-1131
1.988-3....................................................    1545-1131
1.988-4....................................................    1545-1131
1.988-5....................................................    1545-1131
1.988-6....................................................    1545-1831
1.992-1....................................................    1545-0190
                                                               1545-0938
1.992-2....................................................    1545-0190
                                                               1545-0884
                                                               1545-0938
1.992-3....................................................    1545-0190
                                                               1545-0938
1.992-4....................................................    1545-0190
                                                               1545-0938
1.993-3....................................................    1545-0938
1.993-4....................................................    1545-0938
1.994-1....................................................    1545-0938
1.995-5....................................................    1545-0938
1.1001-1...................................................    1545-1902
1.1012-1...................................................    1545-0074
                                                               1545-1139
1.1014-4...................................................    1545-0184
1.1015-1...................................................    1545-0020
1.1017-1...................................................    1545-1539
1.1031(d)-1T...............................................    1545-1021
1.1033(a)-2................................................    1545-0184
1.1033(g)-1................................................    1545-0184
1.1039-1...................................................    1545-0184
1.1041-1T..................................................    1545-0074
1.1041-2...................................................    1545-1751
1.1042-1T..................................................    1545-0916

[[Page 660]]

 
1.1044(a)-1................................................    1545-1421
1.1045-1...................................................    1545-1893
1.1060-1...................................................    1545-1658
                                                               1545-1990
1.1071-1...................................................    1545-0184
1.1071-4...................................................    1545-0184
1.1081-4...................................................    1545-0028
                                                               1545-0046
                                                               1545-0123
1.1081-11..................................................    1545-2019
1.1082-1...................................................    1545-0046
1.1082-2...................................................    1545-0046
1.1082-3...................................................    1545-0046
                                                               1545-0184
1.1082-4...................................................    1545-0046
1.1082-5...................................................    1545-0046
1.1082-6...................................................    1545-0046
1.1083-1...................................................    1545-0123
1.1092(b)-1T...............................................    1545-0644
1.1092(b)-2T...............................................    1545-0644
1.1092(b)-3T...............................................    1545-0644
1.1092(b)-4T...............................................    1545-0644
1.1092(b)-5T...............................................    1545-0644
1.1211-1...................................................    1545-0074
1.1212-1...................................................    1545-0074
1.1221-2...................................................    1545-1480
1.1231-1...................................................    1545-0177
                                                               1545-0184
1.1231-2...................................................    1545-0177
                                                               1545-0184
1.1231-2...................................................    1545-0074
1.1232-3...................................................    1545-0074
1.1237-1...................................................    1545-0184
1.1239-1...................................................    1545-0091
1.1242-1...................................................    1545-0184
1.1243-1...................................................    1545-0123
1.1244(e)-1................................................    1545-0123
                                                               1545-1447
1.1245-1...................................................    1545-0184
1.1245-2...................................................    1545-0184
1.1245-3...................................................    1545-0184
1.1245-4...................................................    1545-0184
1.1245-5...................................................    1545-0184
1.1245-6...................................................    1545-0184
1.1248-7...................................................    1545-0074
1.1248(f)-2................................................    1545-2183
1.1248(f)-3T...............................................    1545-2183
1.1250-1...................................................    1545-0184
1.1250-2...................................................    1545-0184
1.1250-3...................................................    1545-0184
1.1250-4...................................................    1545-0184
1.1250-5...................................................    1545-0184
1.1251-1...................................................    1545-0184
1.1251-2...................................................    1545-0074
                                                               1545-0184
1.1251-3...................................................    1545-0184
1.1251-4...................................................    1545-0184
1.1252-1...................................................    1545-0184
1.1252-2...................................................    1545-0184
1.1254-1(c)(3).............................................    1545-1352
1.1254-4...................................................    1545-1493
1.1254-5(d)(2).............................................    1545-1352
1.1258-1...................................................    1545-1452
1.1272-3...................................................    1545-1353
1.1273-2(f)(9).............................................    1545-1353
1.1273-2(h)(2).............................................    1545-1353
1.1274-3(d)................................................    1545-1353
1.1274-5(b)................................................    1545-1353
1.1274A-1(c)...............................................    1545-1353
1.1275-2...................................................    1545-1450
1.1275-3...................................................    1545-0887
                                                               1545-1353
                                                               1545-1450
1.1275-4...................................................    1545-1450
1.1275-6...................................................    1545-1450
1.1287-1...................................................    1545-0786
1.1291-9...................................................    1545-1507
1.1291-10..................................................    1545-1304
                                                               1545-1507
1.1294-1T..................................................    1545-1002
                                                               1545-1028
1.1295-1...................................................    1545-1555
1.1295-3...................................................    1545-1555
1.1298-3...................................................    1545-1507
1.1301-1...................................................    1545-1662
1.1311(a)-1................................................    1545-0074
1.1361-1...................................................    1545-0731
                                                               1545-1591
                                                               1545-2114
1.1361-3...................................................    1545-1590
1.1361-5...................................................    1545-1590
1.1362-1...................................................    1545-1308
1.1362-2...................................................    1545-1308
1.1362-3...................................................    1545-1308
1.1362-4...................................................    1545-1308
1.1362-5...................................................    1545-1308
1.1362-6...................................................    1545-1308
1.1362-7...................................................    1545-1308
1.1362-8...................................................    1545-1590
1.1363-2...................................................    1545-1906
1.1366-1...................................................    1545-1613
1.1367-1(f)................................................    1545-1139
1.1368-1(f)(2).............................................    1545-1139
1.1368-1(f)(3).............................................    1545-1139
1.1368-1(f)(4).............................................    1545-1139
1.1368-1(g)(2).............................................    1545-1139
1.1374-1A..................................................    1545-0130
1.1377-1...................................................    1545-1462
1.1378-1...................................................    1545-1748
1.1383-1...................................................    1545-0074
1.1385-1...................................................    1545-0074
                                                               1545-0098
1.1388-1...................................................    1545-0118
                                                               1545-0123
1.1397E-1..................................................    1545-1908
1.1398-1...................................................    1545-1375
1.1398-2...................................................    1545-1375
1.1402(a)-2................................................    1545-0074
1.1402(a)-5................................................    1545-0074
1.1402(a)-11...............................................    1545-0074
1.1402(a)-15...............................................    1545-0074
1.1402(a)-16...............................................    1545-0074
1.1402(b)-1................................................    1545-0171
1.1402(c)-2................................................    1545-0074
1.1402(e)(1)-1.............................................    1545-0074
1.1402(e)(2)-1.............................................    1545-0074
1.1402(e)-1A...............................................    1545-0168
1.1402(e)-2A...............................................    1545-0168
1.1402(e)-3A...............................................    1545-0168
1.1402(e)-4A...............................................    1545-0168
1.1402(e)-5A...............................................    1545-0168
1.1402(f)-1................................................    1545-0074
1.1402(h)-1................................................    1545-0064
1.1411-10(g)...............................................    1545-2227
1.1441-1...................................................    1545-1484
1.1441-2...................................................    1545-0795
1.1441-3...................................................    1545-0165
                                                               1545-0795
1.1441-4...................................................    1545-1484
1.1441-5...................................................    1545-0096
                                                               1545-0795
                                                               1545-1484
1.1441-6...................................................    1545-0055
                                                               1545-0795

[[Page 661]]

 
                                                               1545-1484
1.1441-7...................................................    1545-0795
1.1441-8...................................................    1545-1053
                                                               1545-1484
1.1441-9...................................................    1545-1484
1.1443-1...................................................    1545-0096
1.1445-1...................................................    1545-0902
1.1445-2...................................................    1545-0902
                                                               1545-1060
                                                               1545-1797
1.1445-3...................................................    1545-0902
                                                               1545-1060
                                                               1545-1797
1.1445-4...................................................    1545-0902
1.1445-5...................................................    1545-0902
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1.1445-7...................................................    1545-0902
1.1445-8...................................................    1545-0096
1.1445-9T..................................................    1545-0902
1.1445-10T.................................................    1545-0902
1.1446-1...................................................    1545-1934
1.1446-3...................................................    1545-1934
1.1446-4...................................................    1545-1934
1.1446-5...................................................    1545-1934
1.1446-6...................................................    1545-1934
1.1451-1...................................................    1545-0054
1.1451-2...................................................    1545-0054
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1.1461-2...................................................    1545-0054
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1.1462-1...................................................    1545-0795
1.1502-5...................................................    1545-0257
1.1502-9...................................................    1545-1634
1.1502-9A..................................................    1545-0121
1.1502-13..................................................    1545-0123
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1.1502-16..................................................    1545-0123
1.1502-18..................................................    1545-0123
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1.1502-20..................................................    1545-1774
1.1502-21..................................................    1545-1237
1.1502-21T.................................................    1545-2171
1.1502-31..................................................    1545-1344
1.1502-32..................................................    1545-1344
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1.1502-33..................................................    1545-1344
1.1502-35..................................................    1545-1828
1.1502-36..................................................    1545-2096
1.1502-47..................................................    1545-0123
1.1502-75..................................................    1545-0025
                                                               1545-0123
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1.1502-76..................................................    1545-1344
1.1502-76T.................................................    1545-2019
1.1502-77..................................................    1545-1699
1.1502-77A.................................................    1545-0123
                                                               1545-1046
1.1502-77B.................................................    1545-1699
1.1502-78..................................................    1545-0582
1.1502-95..................................................    1545-1218
1.1502-95A.................................................    1545-1218
1.1502-96..................................................    1545-1218
1.1503-2...................................................    1545-1583
1.1503-2A..................................................    1545-1083
1.1503(d)-1................................................    1545-1946
1.1503(d)-3................................................    1545-1946
1.1503(d)-4................................................    1545-1946
1.1503(d)-5................................................    1545-1946
1.1503(d)-6................................................    1545-1946
1.1552-1...................................................    1545-0123
1.1561-3...................................................    1545-0123
1.1563-1...................................................    1545-0123
                                                               1545-0797
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1.1563-3...................................................    1545-0123
1.5000A-3..................................................    1545-0074
1.5000A-4..................................................    1545-0074
1.5000C-2..................................................    1545-0096
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1.5000C-3..................................................    1545-0096
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1.5000C-4..................................................    1545-1223
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1.6001-1...................................................    1545-0058
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1.6011-1...................................................    1545-0055
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1.6011-2...................................................    1545-0055
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1.6011-3...................................................    1545-0238
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1.6011-4...................................................    1545-1685
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1.6012-2...................................................    1545-0047
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1.6012-3...................................................    1545-0047
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1.6012-6...................................................    1545-0067
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1.6013-2...................................................    1545-0091
1.6013-6...................................................    1545-0074
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1.6015-5...................................................    1545-1719
1.6015(a)-1................................................    1545-0087
1.6015(b)-1................................................    1545-0087
1.6015(d)-1................................................    1545-0087
1.6015(e)-1................................................    1545-0087
1.6015(f)-1................................................    1545-0087
1.6015(g)-1................................................    1545-0087
1.6015(h)-1................................................    1545-0087
1.6015(i)-1................................................    1545-0087
1.6017-1...................................................    1545-0074
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                                                               1545-0090
1.6031(a)-1................................................    1545-1583
1.6031(b)-1T...............................................    1545-0099
1.6031(c)-1T...............................................    1545-0099
1.6032-1...................................................    1545-0099
1.6033-2...................................................    1545-0047
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1.6033-3...................................................    1545-0052
1.6034-1...................................................    1545-0092
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1.6035-2...................................................    1545-0704
1.6037-1...................................................    1545-0130
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1.6038-2...................................................    1545-1617
                                                               1545-2020
1.6038-3...................................................    1545-1617
1.6038A-2..................................................    1545-1191
1.6038A-3..................................................    1545-1191
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1.6038B-1..................................................    1545-1617
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1.6038B-1T.................................................    1545-0026
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1.6038B-2..................................................    1545-1617
1.6039-2...................................................    1545-0820
1.6041-1...................................................    1545-0008
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1.6041-2...................................................    1545-0008
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1.6041-3...................................................    1545-1148
1.6041-4...................................................    1545-0115
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1.6041-5...................................................    1545-0295
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1.6041-6...................................................    1545-0008
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1.6041-7...................................................    1545-0112
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1.6042-1...................................................    1545-0110
1.6042-2...................................................    1545-0110
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1.6042-3...................................................    1545-0295
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1.6044-4...................................................    1545-0118
1.6044-5...................................................    1545-0118
1.6045-1...................................................    1545-0715
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1.6045-1(c)(3)(xi)(C)......................................    1545-2186
1.6045-1(n)(5).............................................    1545-2186
1.6045A-1..................................................    1545-2186
1.6045-2...................................................    1545-0115
1.6045-4...................................................    1545-1085
1.6046-1...................................................    1545-0704
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1.6046-2...................................................    1545-0704
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1.6046A....................................................    1545-1646
1.6047-1...................................................    1545-0119
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1.6047-2...................................................    1545-2234
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1.6050A-1..................................................    1545-0115
1.6050B-1..................................................    1545-0120
1.6050D-1..................................................    1545-0120
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1.6050E-1..................................................    1545-0120
1.6050H-1..................................................    1545-0901
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1.6050H-2..................................................    1545-0901
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1.6050I-2..................................................    1545-1449
1.6050J-1T.................................................    1545-0877
1.6050K-1..................................................    1545-0941
1.6050S-1..................................................    1545-1678
1.6050S-2..................................................    1545-1729
1.6050S-3..................................................    1545-1678
1.6050S-4..................................................    1545-1729
1.6052-1...................................................    1545-0008
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1.6060-1(a)(1).............................................    1545-1231
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1.6091-3...................................................    1545-0089
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1.6109-2...................................................    1545-2176
1.6115-1...................................................    1545-1464
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1.6414-1...................................................    1545-0096
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1.6425-3...................................................    1545-0170
1.6654-1...................................................    1545-0087
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1.6654-2...................................................    1545-0087
1.6654-3...................................................    1545-0087
1.6655(e)-1................................................    1545-1421
1.6662-3(c)................................................    1545-0889
1.6662-4(e) and (f)........................................    1545-0889
1.6662-6...................................................    1545-1426
1.6694-1...................................................    1545-0074
1.6694-2...................................................    1545-0074
1.6694-2(c)................................................    1545-1231
1.6694-2(c)(3).............................................    1545-1231
1.6694-3(e)................................................    1545-1231
1.6695-1...................................................    1545-0074
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1.6696-1...................................................    1545-0074
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1.6851-1...................................................    1545-0086
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1.7476-1...................................................    1545-0197
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1.7519-2T..................................................    1545-1036
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1.7520-3...................................................    1545-1343
1.7520-4...................................................    1545-1343
1.7701(l)-3................................................    1545-1642
1.7872-15..................................................    1545-1792
1.9100-1...................................................    1545-0074
1.9101-1...................................................    1545-0008
2.1-4......................................................    1545-0123
2.1-5......................................................    1545-0123
2.1-6......................................................    1545-0123
2.1-10.....................................................    1545-0123
2.1-11.....................................................    1545-0123
2.1-12.....................................................    1545-0123
2.1-13.....................................................    1545-0123
2.1-20.....................................................    1545-0123
2.1-22.....................................................    1545-0123
2.1-26.....................................................    1545-0123
3.2........................................................    1545-0123
4.954-1....................................................    1545-1068
4.954-2....................................................    1545-1068
5.6411-1...................................................    1545-0042
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5c.44F-1...................................................    1545-0619
5c.128-1...................................................    1545-0123
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6a.103A-2..................................................    1545-0123
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6a.103A-3..................................................    1545-0720
7.465-1....................................................    1545-0712
7.465-2....................................................    1545-0712
7.465-3....................................................    1545-0712
7.465-4....................................................    1545-0712
7.465-5....................................................    1545-0712
7.936-1....................................................    1545-0217
7.999-1....................................................    1545-0216
7.6039A-1..................................................    1545-0015
7.6041-1...................................................    1545-0115
11.410-1...................................................    1545-0710
11.412(c)-7................................................    1545-0710
11.412(c)-11...............................................    1545-0710
12.7.......................................................    1545-0190
12.8.......................................................    1545-0191
12.9.......................................................    1545-0195
14a.422A-1.................................................    1545-0123
15A.453-1..................................................    1545-0228
16A.126-2..................................................    1545-0074
16A.1255-1.................................................    1545-0184
16A.1255-2.................................................    1545-0184
18.1371-1..................................................    1545-0130
18.1378-1..................................................    1545-0130
18.1379-1..................................................    1545-0130
18.1379-2..................................................    1545-0130
20.2010-2..................................................    1545-0015
20.2011-1..................................................    1545-0015
20.2014-5..................................................    1545-0015
                                                               1545-0260
20.2014-6..................................................    1545-0015
20.2016-1..................................................    1545-0015
20.2031-2..................................................    1545-0015
20.2031-3..................................................    1545-0015
20.2031-4..................................................    1545-0015
20.2031-6..................................................    1545-0015
20.2031-7..................................................    1545-0020
20.2031-10.................................................    1545-0015
20.2032-1..................................................    1545-0015
20.2032A-3.................................................    1545-0015
20.2032A-4.................................................    1545-0015
20.2032A-8.................................................    1545-0015
20.2039-4..................................................    1545-0015
20.2051-1..................................................    1545-0015
20.2053-3..................................................    1545-0015
20.2053-9..................................................    1545-0015
20.2053-10.................................................    1545-0015
20.2055-1..................................................    1545-0015
20.2055-2..................................................    1545-0015
                                                               1545-0092
20.2055-3..................................................    1545-0015
20.2056(b)-4...............................................    1545-0015
20.2056(b)-7...............................................    1545-0015
                                                               1545-1612
20.2056A-2.................................................    1545-1443
20.2056A-3.................................................    1545-1360
20.2056A-4.................................................    1545-1360
20.2056A-10................................................    1545-1360
20.2106-1..................................................    1545-0015
20.2106-2..................................................    1545-0015
20.2204-1..................................................    1545-0015
20.2204-2..................................................    1545-0015
20.6001-1..................................................    1545-0015
20.6011-1..................................................    1545-0015
20.6018-1..................................................    1545-0015
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20.6018-2..................................................    1545-0015
20.6018-3..................................................    1545-0015
20.6018-4..................................................    1545-0015
                                                               1545-0022
20.6036-2..................................................    1545-0015
20.6060-1(a)(1)............................................    1545-1231
20.6061-1..................................................    1545-0015
20.6065-1..................................................    1545-0015
20.6075-1..................................................    1545-0015
20.6081-1..................................................    1545-0015
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20.6091-1..................................................    1545-0015
20.6107-1..................................................    1545-1231
20.6161-1..................................................    1545-0015
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20.6161-2..................................................    1545-0015
                                                               1545-0181
20.6163-1..................................................    1545-0015
20.6166-1..................................................    1545-0181
20.6166A-1.................................................    1545-0015
20.6166A-3.................................................    1545-0015
20.6324A-1.................................................    1545-0754
20.7520-1..................................................    1545-1343
20.7520-2..................................................    1545-1343
20.7520-3..................................................    1545-1343
20.7520-4..................................................    1545-1343
22.0.......................................................    1545-0015
25.2511-2..................................................    1545-0020
25.2512-2..................................................    1545-0020
25.2512-3..................................................    1545-0020
25.2512-5..................................................    1545-0020
25.2512-9..................................................    1545-0020
25.2513-1..................................................    1545-0020
25.2513-2..................................................    1545-0020
                                                               1545-0021
25.2513-3..................................................    1545-0020
25.2518-2..................................................    1545-0959
25.2522(a)-1...............................................    1545-0196
25.2522(c)-3...............................................    1545-0020
                                                               1545-0196
25.2523(a)-1...............................................    1545-0020
                                                               1545-0196
25.2523(f)-1...............................................    1545-0015
25.2701-2..................................................    1545-1241
25.2701-4..................................................    1545-1241
25.2701-5..................................................    1545-1273
25.2702-5..................................................    1545-1485
25.2702-6..................................................    1545-1273
25.6001-1..................................................    1545-0020
                                                               1545-0022
25.6011-1..................................................    1545-0020
25.6019-1..................................................    1545-0020
25.6019-2..................................................    1545-0020
25.6019-3..................................................    1545-0020
25.6019-4..................................................    1545-0020
25.6060-1(a)(1)............................................    1545-1231
25.6061-1..................................................    1545-0020
25.6065-1..................................................    1545-0020
25.6075-1..................................................    1545-0020
25.6081-1..................................................    1545-0020
25.6091-1..................................................    1545-0020
25.6091-2..................................................    1545-0020
25.6107-1..................................................    1545-1231
25.6151-1..................................................    1545-0020
25.6161-1..................................................    1545-0020
25.7520-1..................................................    1545-1343
25.7520-2..................................................    1545-1343
25.7520-3..................................................    1545-1343
25.7520-4..................................................    1545-1343
26.2601-1..................................................    1545-0985
26.2632-1..................................................    1545-0985
                                                               1545-1892
26.2642-1..................................................    1545-0985
26.2642-2..................................................    1545-0985
26.2642-3..................................................    1545-0985

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26.2642-4..................................................    1545-0985
26.2642-6..................................................    1545-1902
26.2652-2..................................................    1545-0985
26.2654-1..................................................    1545-1902
26.2662-1..................................................    1545-0015
                                                               1545-0985
26.2662-2..................................................    1545-0985
26.6060-1(a)(1)............................................    1545-1231
26.6107-1..................................................    1545-1231
31.3102-3..................................................    1545-0029
                                                               1545-0059
                                                               1545-0065
31.3121(b)(19)-1...........................................    1545-0029
31.3121(d)-1...............................................    1545-0004
31.3121(i)-1...............................................    1545-0034
31.3121(r)-1...............................................    1545-0029
31.3121(s)-1...............................................    1545-0029
31.3121(v)(2)-1............................................    1545-1643
31.3302(a)-2...............................................    1545-0028
31.3302(a)-3...............................................    1545-0028
31.3302(b)-2...............................................    1545-0028
31.3302(e)-1...............................................    1545-0028
31.3306(c)(18)-1...........................................    1545-0029
31.3401(a)-1...............................................    1545-0029
31.3401(a)(6)..............................................    1545-1484
31.3401(a)(6)-1............................................    1545-0029
                                                               1545-0096
                                                               1545-0795
31.3401(a)(7)-1............................................    1545-0029
31.3401(a)(8)(A)-1 ........................................    1545-0029
                                                               1545-0666
31.3401(a)(8)(C)-1 ........................................    1545-0029
31.3401(a)(15)-1...........................................    1545-0182
31.3401(c)-1...............................................    1545-0004
31.3402(b)-1...............................................    1545-0010
31.3402(c)-1...............................................    1545-0010
31.3402(f)(1)-1............................................    1545-0010
31.3402(f)(2)-1............................................    1545-0010
                                                               1545-0410
31.3402(f)(3)-1............................................    1545-0010
31.3402(f)(4)-1............................................    1545-0010
31.3402(f)(4)-2............................................    1545-0010
31.3402(f)(5)-1............................................    1545-0010
                                                               1545-1435
31.3402(h)(1)-1............................................    1545-0029
31.3402(h)(3)-1............................................    1545-0010
                                                               1545-0029
31.3402(h)(4)-1............................................    1545-0010
31.3402(i)-(1).............................................    1545-0010
31.3402(i)-(2).............................................    1545-0010
31.3402(k)-1...............................................    1545-0065
31.3402(l)-(1).............................................    1545-0010
31.3402(m)-(1).............................................    1545-0010
31.3402(n)-(1).............................................    1545-0010
31.3402(o)-2...............................................    1545-0415
31.3402(o)-3...............................................    1545-0008
                                                               1545-0010
                                                               1545-0415
                                                               1545-0717
31.3402(p)-1...............................................    1545-0415
                                                               1545-0717
31.3402(q)-1...............................................    1545-0238
                                                               1545-0239
31.3404-1..................................................    1545-0029
31.3405(c)-1...............................................    1545-1341
31.3406(a)-1...............................................    1545-0112
31.3406(a)-2...............................................    1545-0112
31.3406(a)-3...............................................    1545-0112
31.3406(a)-4...............................................    1545-0112
31.3406(b)(2)-1............................................    1545-0112
31.3406(b)(2)-2............................................    1545-0112
31.3406(b)(2)-3............................................    1545-0112
31.3406(b)(2)-4............................................    1545-0112
31.3406(b)(2)-5............................................    1545-0112
31.3406(b)(3)-1............................................    1545-0112
31.3406(b)(3)-2............................................    1545-0112
31.3406(b)(3)-3............................................    1545-0112
31.3406(b)(3)-4............................................    1545-0112
31.3406(b)(4)-1............................................    1545-0112
31.3406(c)-1...............................................    1545-0112
31.3406(d)-1...............................................    1545-0112
31.3406(d)-2...............................................    1545-0112
31.3406(d)-3...............................................    1545-0112
31.3406(d)-4...............................................    1545-0112
31.3406(d)-5...............................................    1545-0112
31.3406(e)-1...............................................    1545-0112
31.3406(f)-1...............................................    1545-0112
31.3406(g)-1...............................................    1545-0096
                                                               1545-0112
                                                               1545-1819
31.3406(g)-2...............................................    1545-0112
31.3406(g)-3...............................................    1545-0112
31.3406(h)-1...............................................    1545-0112
31.3406(h)-2...............................................    1545-0112
31.3406(h)-3...............................................    1545-0112
31.3406(i)-1...............................................    1545-0112
31.3501(a)-1T..............................................    1545-0771
31.3503-1..................................................    1545-0024
31.3504-1..................................................    1545-0029
31.6001-1..................................................    1545-0798
31.6001-2..................................................    1545-0034
                                                               1545-0798
31.6001-3..................................................    1545-0798
31.6001-4..................................................    1545-0028
31.6001-5..................................................    1545-0798
31.6001-6..................................................    1545-0029
                                                               1459-0798
31.6011(a)-1...............................................    1545-0029
                                                               1545-0034
                                                               1545-0035
                                                               1545-0059
                                                               1545-0074
                                                               1545-0256
                                                               1545-0718
                                                               1545-2097
31.6011(a)-2...............................................    1545-0001
                                                               1545-0002
31.6011(a)-3...............................................    1545-0028
31.6011(a)-3A..............................................    1545-0955
31.6011(a)-4...............................................    1545-0034
                                                               1545-0035
                                                               1545-0718
                                                               1545-1413
                                                               1545-2097
31.6011(a)-5...............................................    1545-0028
                                                               1545-0718
                                                               1545-2097
31.6011(a)-6...............................................    1545-0028
31.6011(a)-7...............................................    1545-0074
31.6011(a)-8...............................................    1545-0028
31.6011(a)-9...............................................    1545-0028
31.6011(a)-10..............................................    1545-0112
31.6011(b)-1...............................................    1545-0003
31.6011(b)-2...............................................    1545-0029
31.6051-1..................................................    1545-0008
                                                               1545-0182
                                                               1545-0458
                                                               1545-1729
31.6051-2..................................................    1545-0008
31.6051-3..................................................    1545-0008
31.6053-1..................................................    1545-0029
                                                               1545-0062
                                                               1545-0064
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                                                               1545-1603
31.6053-2..................................................    1545-0008
31.6053-3..................................................    1545-0065
                                                               1545-0714
31.6053-4..................................................    1545-0065
                                                               1545-1603
31.6060-1(a)(1)............................................    1545-1231
31.6065(a)-1...............................................    1545-0029
31.6071(a)-1...............................................    1545-0001
                                                               1545-0028
                                                               1545-0029
31.6071(a)-1A..............................................    1545-0955
31.6081(a)-1...............................................    1545-0008
                                                               1545-0028
31.6091-1..................................................    1545-0028
                                                               1545-0029
31.6107-1..................................................    1545-1231
31.6157-1..................................................    1545-0955
31.6205-1..................................................    1545-0029
                                                               1545-2097
31.6301(c)-1AT.............................................    1545-0035
                                                               1545-0112
                                                               1545-0257
31.6302-1..................................................    1545-1413
31.6302-2..................................................    1545-1413
31.6302-3..................................................    1545-1413
31.6302-4..................................................    1545-1413
31.6302(c)-2...............................................    1545-0001
                                                               1545-0257
31.6302(c)-2A..............................................    1545-0955
31.6302(c)-3...............................................    1545-0257
31.6402(a)-2...............................................    1545-0256
                                                               1545-2097
31.6413(a)-1...............................................    1545-0029
                                                               1545-2097
31.6413(a)-2...............................................    1545-0029
                                                               1545-0256
                                                               1545-2097
31.6413(c)-1...............................................    1545-0029
                                                               1545-0171
31.6414-1..................................................    1545-0029
                                                               1545-2097
32.1.......................................................    1545-0029
                                                               1545-0415
32.2.......................................................    1545-0029
35a.3406-2.................................................    1545-0112
35a.9999-5.................................................    1545-0029
36.3121(l)(1)-1............................................    1545-0137
36.3121(l)(1)-2............................................    1545-0137
36.3121(l)(3)-1............................................    1545-0123
36.3121(1)(7)-1............................................    1545-0123
36.3121(1)(10)-1...........................................    1545-0029
36.3121(1)(10)-3...........................................    1545-0029
36.3121(1)(10)-4...........................................    1545-0257
40.6060-1(a)(1)............................................    1545-1231
40.6107-1..................................................    1545-1231
40.6302(c)-3(b)(2)(ii).....................................    1545-1296
40.6302(c)-3(b)(2)(iii)....................................    1545-1296
40.6302(c)-3(e)............................................    1545-1296
40.6302(c)-3(f)(2)(ii).....................................    1545-1296
41.4481-1..................................................    1545-0143
41.4481-2..................................................    1545-0143
41.4483-3..................................................    1545-0143
41.6001-1..................................................    1545-0143
41.6001-2..................................................    1545-0143
41.6001-3..................................................    1545-0143
41.6060-1(a)(1)............................................    1545-1231
41.6071(a)-1...............................................    1545-0143
41.6081(a)-1...............................................    1545-0143
41.6091-1..................................................    1545-0143
41.6107-1..................................................    1545-1231
41.6109-1..................................................    1545-0143
41.6151(a)-1...............................................    1545-0143
41.6156-1..................................................    1545-0143
41.6161(a)(1)-1............................................    1545-0143
44.4401-1..................................................    1545-0235
44.4403-1..................................................    1545-0235
44.4412-1..................................................    1545-0236
44.4901-1..................................................    1545-0236
44.4905-1..................................................    1545-0236
44.4905-2..................................................    1545-0236
44.6001-1..................................................    1545-0235
44.6011(a)-1...............................................    1545-0235
                                                               1545-0236
44.6060-1(a)(1)............................................    1545-1231
44.6071-1..................................................    1545-0235
44.6091-1..................................................    1545-0235
44.6107-1..................................................    1545-1231
44.6151-1..................................................    1545-0235
44.6419-1..................................................    1545-0235
44.6419-2..................................................    1545-0235
46.4371-4..................................................    1545-0023
46.4374-1..................................................    1545-0023
46.4375-1..................................................    1545-2238
46.4376-1..................................................    1545-2238
46.4701-1..................................................    1545-0023
                                                               1545-0257
48.4041-4..................................................    1545-0023
48.4041-5..................................................    1545-0023
48.4041-6..................................................    1545-0023
48.4041-7..................................................    1545-0023
48.4041-9..................................................    1545-0023
48.4041-10.................................................    1545-0023
48.4041-11.................................................    1545-0023
48.4041-12.................................................    1545-0023
48.4041-13.................................................    1545-0023
48.4041-19.................................................    1545-0023
48.4041-20.................................................    1545-0023
48.4041-21.................................................    1545-1270
48.4042-2..................................................    1545-0023
48.4052-1..................................................    1545-1418
48.4061(a)-1...............................................    1545-0023
48.4061(a)-2...............................................    1545-0023
48.4061(b)-3...............................................    1545-0023
48.4064-1..................................................    1545-0014
                                                               1545-0242
48.4071-1..................................................    1545-0023
48.4073-1..................................................    1545-0023
48.4073-3..................................................    1545-0023
                                                               1545-1074
                                                               1545-1087
48.4081-2..................................................    1545-1270
                                                               1545-1418
48.4081-3..................................................    1545-1270
                                                               1545-1418
                                                               1545-1897
48.4081-4(b)(2)(ii)........................................    1545-1270
48.4081-4(b)(3)(i).........................................    1545-1270
48.4081-4(c)...............................................    1545-1270
48.4081-6(c)(1)(ii)........................................    1545-1270
48.4081-7..................................................    1545-1270
                                                               1545-1418
48.4082-1T.................................................    1545-1418
48.4082-2..................................................    1545-1418
48.4082-6..................................................    1545-1418
48.4082-7..................................................    1545-1418
48.4101-1..................................................    1545-1418
48.4101-1T.................................................    1545-1418
48.4101-2..................................................    1545-1418
48.4161(a)-1...............................................    1545-0723
48.4161(a)-2...............................................    1545-0723
48.4161(a)-3...............................................    1545-0723
48.4161(b)-1...............................................    1545-0723
48.4216(a)-2...............................................    1545-0023

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48.4216(a)-3...............................................    1545-0023
48.4216(c)-1...............................................    1545-0023
48.4221-1..................................................    1545-0023
48.4221-2..................................................    1545-0023
48.4221-3..................................................    1545-0023
48.4221-4..................................................    1545-0023
48.4221-5..................................................    1545-0023
48.4221-6..................................................    1545-0023
48.4221-7..................................................    1545-0023
48.4222(a)-1...............................................    1545-0014
                                                               1545-0023
48.4223-1..................................................    1545-0023
                                                               1545-0257
                                                               1545-0723
48.6302(c)-1...............................................    1545-0023
                                                               1545-0257
48.6412-1..................................................    1545-0723
48.6416(a)-1...............................................    1545-0023
                                                               1545-0723
48.6416(a)-2...............................................    1545-0723
48.6416(a)-3...............................................    1545-0723
48.6416(b)(1)-1............................................    1545-0723
48.6416(b)(1)-2............................................    1545-0723
48.6416(b)(1)-3............................................    1545-0723
48.6416(b)(1)-4............................................    1545-0723
48.6416(b)(2)-1............................................    1545-0723
48.6416(b)(2)-2............................................    1545-0723
48.6416(b)(2)-3............................................    1545-0723
                                                               1545-1087
48.6416(b)(2)-4............................................    1545-0723
48.6416(b)(3)-1............................................    1545-0723
48.6416(b)(3)-2............................................    1545-0723
48.6416(b)(3)-3............................................    1545-0723
48.6416(b)(4)-1............................................    1545-0723
48.6416(b)(5)-1............................................    1545-0723
48.6416(c)-1...............................................    1545-0723
48.6416(e)-1...............................................    1545-0023
                                                               1545-0723
48.6416(f)-1...............................................    1545-0023
                                                               1545-0723
48.6416(g)-1...............................................    1545-0723
48.6416(h)-1...............................................    1545-0723
48.6420(c)-2...............................................    1545-0023
48.6420(f)-1...............................................    1545-0023
48.6420-1..................................................    1545-0162
                                                               1545-0723
48.6420-2..................................................    1545-0162
                                                               1545-0723
48.6420-3..................................................    1545-0162
                                                               1545-0723
48.6420-4..................................................    1545-0162
                                                               1545-0723
48.6420-5..................................................    1545-0162
                                                               1545-0723
48.6420-6..................................................    1545-0162
                                                               1545-0723
48.6421-0..................................................    1545-0162
                                                               1545-0723
48.6421-1..................................................    1545-0162
                                                               1545-0723
48.6421-2..................................................    1545-0162
                                                               1545-0723
48.6421-3..................................................    1545-0162
                                                               1545-0723
48.6421-4..................................................    1545-0162
                                                               1545-0723
48.6421-5..................................................    1545-0162
                                                               1545-0723
48.6421-6..................................................    1545-0162
                                                               1545-0723
48.6421-7..................................................    1545-0162
                                                               1545-0723
48.6424-0..................................................    1545-0723
48.6424-1..................................................    1545-0723
48.6424-2..................................................    1545-0723
48.6424-3..................................................    1545-0723
48.6424-4..................................................    1545-0723
48.6424-5..................................................    1545-0723
48.6424-6..................................................    1545-0723
48.6427-0..................................................    1545-0723
48.6427-1..................................................    1545-0023
                                                               1545-0162
                                                               1545-0723
48.6427-2..................................................    1545-0162
                                                               1545-0723
48.6427-3..................................................    1545-0723
48.6427-4..................................................    1545-0723
48.6427-5..................................................    1545-0723
48.6427-8..................................................    1545-1418
48.6427-9..................................................    1545-1418
48.6427-10.................................................    1545-1418
48.6427-11.................................................    1545-1418
49.4251-1..................................................    1545-1075
49.4251-2..................................................    1545-1075
49.4251-4(d)(2)............................................    1545-1628
49.4253-3..................................................    1545-0023
49.4253-4..................................................    1545-0023
49.4264(b)-1...............................................    1545-0023
                                                               1545-0224
                                                               1545-0225
                                                               1545-0226
                                                               1545-0230
                                                               1545-0257
                                                               1545-0912
49.4271-1(d)...............................................    1545-0685
49.5000B-1.................................................    1545-2177
51.2(f)(2)(ii).............................................    1545-2209
51.7.......................................................    1545-2209
52.4682-1(b)(2)(iii).......................................    1545-1153
52.4682-2(b)...............................................    1545-1153
                                                               1545-1361
52.4682-2(d)...............................................    1545-1153
                                                               1545-1361
52.4682-3(c)(2)............................................    1545-1153
52.4682-3(g)...............................................    1545-1153
52.4682-4(f)...............................................    1545-0257
                                                               1545-1153
52.4682-5(d)...............................................    1545-1361
52.4682-5(f)...............................................    1545-1361
53.4940-1..................................................    1545-0052
                                                               1545-0196
53.4942(a)-1...............................................    1545-0052
53.4942(a)-2...............................................    1545-0052
53.4942(a)-3...............................................    1545-0052
53.4942(b)-3...............................................    1545-0052
53.4945-1..................................................    1545-0052
53.4945-4..................................................    1545-0052
53.4945-5..................................................    1545-0052
53.4945-6..................................................    1545-0052
53.4947-1..................................................    1545-0196
53.4947-2..................................................    1545-0196
53.4948-1..................................................    1545-0052
53.4958-6..................................................    1545-1623
53.4961-2..................................................    1545-0024
53.4963-1..................................................    1545-0024
53.6001-1..................................................    1545-0052
53.6011-1..................................................    1545-0049
                                                               1545-0052
                                                               1545-0092
                                                               1545-0196
53.6060-1(a)(1)............................................    1545-1231
53.6065-1..................................................    1545-0052
53.6071-1..................................................    1545-0049
53.6081-1..................................................    1545-0066

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                                                               1545-0148
53.6107-1..................................................    1545-1231
53.6161-1..................................................    1545-0575
54.4975-7..................................................    1545-0575
54.4977-1T.................................................    1545-0771
54.4980B-6.................................................    1545-1581
54.4980B-7.................................................    1545-1581
54.4980B-8.................................................    1545-1581
54.4980F-1.................................................    1545-1780
54.6011-1..................................................    1545-0575
54.6011-1T.................................................    1545-0575
54.6060-1(a)(1)............................................    1545-1231
54.6107-1..................................................    1545-1231
54.9801-3..................................................    1545-1537
54.9801-4..................................................    1545-1537
54.9801-5..................................................    1545-1537
54.9801-6..................................................    1545-1537
54.9812-1T.................................................    1545-2165
54.9815-1251T..............................................    1545-2178
54.9815-2711T..............................................    1545-2179
54.9815-2712T..............................................    1545-2180
54.9815-2714T..............................................    1545-2172
54.9815-2715...............................................    1545-2229
54.9815-2719AT.............................................    1545-2181
54.9815-2719T..............................................    1545-2182
55.6001-1..................................................    1545-0123
55.6011-1..................................................    1545-0123
                                                               1545-0999
                                                               1545-1016
55.6060-1(a)(1)............................................    1545-1231
55.6061-1..................................................    1545-0999
55.6071-1..................................................    1545-0999
55.6107-1..................................................    1545-1231
56.4911-6..................................................    1545-0052
56.4911-7..................................................    1545-0052
56.4911-9..................................................    1545-0052
56.4911-10.................................................    1545-0052
56.6001-1..................................................    1545-1049
56.6011-1..................................................    1545-1049
56.6060-1(a)(1)............................................    1545-1231
56.6081-1..................................................    1545-1049
56.6107-1..................................................    1545-1231
56.6161-1..................................................    1545-0257
                                                               1545-1049
57.2(e)(2)(i)..............................................    1545-2249
145.4051-1.................................................    1545-0745
145.4052-1.................................................    1545-0120
                                                               1545-0745
                                                               1545-1076
145.4061-1.................................................    1545-0224
                                                               1545-0230
                                                               1545-0257
                                                               1545-0745
156.6001-1.................................................    1545-1049
156.6011-1.................................................    1545-1049
156.6060-1(a)(1)...........................................    1545-1231
156.6081-1.................................................    1545-1049
156.6107-1.................................................    1545-1231
156.6161-1.................................................    1545-1049
157.6001-1.................................................    1545-1824
157.6011-1.................................................    1545-1824
157.6060-1(a)(1)...........................................    1545-1231
157.6081-1.................................................    1545-1824
157.6107-1.................................................    1545-1231
157.6161-1.................................................    1545-1824
301.6011-2.................................................    1545-0225
                                                               1545-0350
                                                               1545-0387
                                                               1545-0441
                                                               1545-0957
301.6011(g)-1..............................................    1545-2079
301.6017-1.................................................    1545-0090
301.6034-1.................................................    1545-0092
301.6036-1.................................................    1545-0013
                                                               1545-0773
301.6047-1.................................................    1545-0367
                                                               1545-0957
301.6056-1.................................................    1545-2251
301.6056-2.................................................    1545-2251
301.6057-1.................................................    1545-0710
301.6057-2.................................................    1545-0710
301.6058-1.................................................    1545-0710
301.6059-1.................................................    1545-0710
301.6103(c)-1..............................................    1545-1816
301.6103(n)-1..............................................    1545-1841
301.6103(p)(2)(B)-1........................................    1545-1757
301.6104(a)-1..............................................    1545-0495
301.6104(a)-5..............................................    1545-0056
301.6104(a)-6..............................................    1545-0056
301.6104(b)-1..............................................    1545-0094
                                                               1545-0742
301.6104(d)-1..............................................    1545-1655
301.6104(d)-2..............................................    1545-1655
301.6104(d)-3..............................................    1545-1655
301.6109-1.................................................    1545-0003
                                                               1545-0295
                                                               1545-0367
                                                               1545-0387
                                                               1545-0957
                                                               1545-1461
                                                               1545-2242
301.6109-3.................................................    1545-1564
301.6110-3.................................................    1545-0074
301.6110-5.................................................    1545-0074
301.6111-1T................................................    1545-0865
                                                               1545-0881
301.6111-2.................................................    1545-0865
                                                               1545-1687
301.6112-1.................................................    1545-0865
                                                               1545-1686
301.6112-1T................................................    1545-0865
                                                               1545-1686
301.6114-1.................................................    1545-1126
                                                               1545-1484
301.6222(a)-2..............................................    1545-0790
301.6222(b)-1..............................................    1545-0790
301.6222(b)-2..............................................    1545-0790
301.6222(b)-3..............................................    1545-0790
301.6223(b)-1..............................................    1545-0790
301.6223(c)-1..............................................    1545-0790
301.6223(e)-2..............................................    1545-0790
301.6223(g)-1..............................................    1545-0790
301.6223(h)-1..............................................    1545-0790
301.6224(b)-1..............................................    1545-0790
301.6224(c)-1..............................................    1545-0790
301.6224(c)-3..............................................    1545-0790
301.6227(c)-1..............................................    1545-0790
301.6227(d)-1..............................................    1545-0790
301.6229(b)-2..............................................    1545-0790
301.6230(b)-1..............................................    1545-0790
301.6230(e)-1..............................................    1545-0790
301.6231(a)(1)-1...........................................    1545-0790
301.6231(a)(7)-1...........................................    1545-0790
301.6231(c)-1..............................................    1545-0790
301.6231(c)-2..............................................    1545-0790
301.6316-4.................................................    1545-0074
301.6316-5.................................................    1545-0074
301.6316-6.................................................    1545-0074
301.6316-7.................................................    1545-0029
301.6324A-1................................................    1545-0015
301.6361-1.................................................    1545-0024
                                                               1545-0074
301.6361-2.................................................    1545-0024
301.6361-3.................................................    1545-0074

[[Page 669]]

 
301.6402-2.................................................    1545-0024
                                                               1545-0073
                                                               1545-0091
301.6402-3.................................................    1545-0055
                                                               1545-0073
                                                               1545-0091
                                                               1545-0132
                                                               1545-1484
301.6402-5.................................................    1545-0928
301.6404-1.................................................    1545-0024
301.6404-2T................................................    1545-0024
301.6404-3.................................................    1545-0024
301.6405-1.................................................    1545-0024
301.6501(c)-1..............................................    1545-1241
                                                               1545-1637
301.6501(d)-1..............................................    1545-0074
                                                               1545-0430
301.6511(d)-1..............................................    1545-0024
                                                               1545-0582
301.6511(d)-2..............................................    1545-0024
                                                               1545-0582
301.6511(d)-3..............................................    1545-0024
                                                               1545-0582
301.6652-2.................................................    1545-0092
301.6685-1.................................................    1545-0092
301.6689-1T................................................    1545-1056
301.6707-1T................................................    1545-0865
                                                               1545-0881
301.6708-1T................................................    1545-0865
301.6712-1.................................................    1545-1126
301.6903-1.................................................    1545-0013
                                                               1545-1783
301.6905-1.................................................    1545-0074
301.7001-1.................................................    1545-0123
301.7101-1.................................................    1545-1029
301.7207-1.................................................    1545-0092
301.7216-2.................................................    1545-0074
301.7216-2(o)..............................................    1545-1209
301.7425-3.................................................    1545-0854
301.7430-2(c)..............................................    1545-1356
301.7502-1.................................................    1545-1899
301.7507-8.................................................    1545-0123
301.7507-9.................................................    1545-0123
301.7513-1.................................................    1545-0429
301.7517-1.................................................    1545-0015
301.7605-1.................................................    1545-0795
301.7623-1.................................................    1545-0409
                                                               1545-1534
301.7654-1.................................................    1545-0803
301.7701-3.................................................    1545-1486
301.7701-4.................................................    1545-1465
301.7701-7.................................................    1545-1600
301.7701-16................................................    1545-0795
301.7701(b)-1..............................................    1545-0089
301.7701(b)-2..............................................    1545-0089
301.7701(b)-3..............................................    1545-0089
301.7701(b)-4..............................................    1545-0089
301.7701(b)-5..............................................    1545-0089
301.7701(b)-6..............................................    1545-0089
301.7701(b)-7..............................................    1545-0089
                                                               1545-1126
301.7701(b)-9..............................................    1545-0089
301.7705-1T................................................    1545-2266
301.7705-2T................................................    1545-2266
301.7805-1.................................................    1545-0805
301.9000-5.................................................    1545-1850
301.9001-1.................................................    1545-0220
301.9100-2.................................................    1545-1488
301.9100-3.................................................    1545-1488
301.9100-4T................................................    1545-0016
                                                               1545-0042
                                                               1545-0074
                                                               1545-0129
                                                               1545-0172
                                                               1545-0619
301.9100-6T................................................    1545-0872
301.9100-7T................................................    1545-0982
301.9100-8.................................................    1545-1112
301.9100-11T...............................................    1545-0123
301.9100-12T...............................................    1545-0026
                                                               1545-0074
                                                               1545-0172
                                                               1545-1027
301.9100-14T...............................................    1545-0046
301.9100-15T...............................................    1545-0046
301.9100-16T...............................................    1545-0152
302.1-7....................................................    1545-0024
305.7701-1.................................................    1545-0823
305.7871-1.................................................    1545-0823
420.0-1....................................................    1545-0710
Part 509...................................................    1545-0846
Part 513...................................................    1545-0834
Part 514...................................................    1545-0845
Part 521...................................................    1545-0848
601.104....................................................    1545-0233
601.105....................................................    1545-0091
601.201....................................................    1545-0019
                                                               1545-0819
601.204....................................................    1545-0152
601.401....................................................    1545-0257
601.504....................................................    1545-0150
601.601....................................................    1545-0800
601.602....................................................    1545-0295
                                                               1545-0387
                                                               1545-0957
601.702....................................................    1545-0429
------------------------------------------------------------------------


(26 U.S.C. 7805)

[T.D. 8011, 50 FR 10222, Mar. 14, 1985]

    Editorial Note: For Federal Register citations affecting Sec.  
602.101, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.

[[Page 671]]



List of CFR Sections Affected



All changes in this volume of the Code of Federal Regulations (CFR) that 
were made by documents published in the Federal Register since January 
1, 2014 are enumerated in the following list. Entries indicate the 
nature of the changes effected. Page numbers refer to Federal Register 
pages. The user should consult the entries for chapters, parts and 
subparts as well as sections for revisions.
For changes to this volume of the CFR prior to this listing, consult the 
annual edition of the monthly List of CFR Sections Affected (LSA). The 
LSA is available at www.govinfo.gov. For changes to this volume of the 
CFR prior to 2001, see the ``List of CFR Sections Affected, 1949-1963, 
1964-1972, 1973-1985, and 1986-2000'' published in 11 separate volumes. 
The ``List of CFR Sections Affected 1986-2000'' is available at 
www.govinfo.gov.

                                  2014

26 CFR
                                                                   79 FR
                                                                    Page
Chapter I
1.148-0 Amended....................................................67351
1.148-3 (i)(3) added...............................................67351
1.148-11 Heading revised; (l) added................................67351
1.162-3 (c)(4)(i), (ii), (d)(1), (2), (e)(1) and (j)(3) correctly 
        amended; (d)(3) correctly revised..........................42190
1.162-4 (a) correctly amended......................................42191
1.162-31 Added.....................................................56904
1.162-32 Added.....................................................59113
1.162(l)-1T Added..................................................43631
1.165-2 (c) amended................................................48667
1.168(i)-0 Amended.................................................48667
1.168(i)-0T Removed................................................48667
1.168(i)-1 (a) through (l)(1) and (m) revised......................48667
(c)(2)(ii)(D), (e)(3)(iii)(C)(3) and (m)(4) correctly revised; 
        (e)(3)(ii)(B) Example 2, (iii)(A), (v)(B)(1), (f)(3) and 
        (j)(3)(ii) correctly amended...............................78697
1.168(i)-1T Removed................................................48678
1.168(i)-7 (a) amended; (b), (c)(2)(ii)(H) and (e) revised.........48678
    (e)(4) correctly revised.......................................78697
1.168(i)-8 Added...................................................48678
    (f)(2)(ii), (3)(ii), (h)(2)(iv) and (3)(iv) correctly amended; 
(h)(2)(iii) and (3)(iii) correctly revised.........................78697
1.168(i)-8T Removed................................................48684

                                  2015

26 CFR
                                                                   80 FR
                                                                    Page
Chapter I
1.141-0 Amended....................................................65642
1.141-1 (e) added..................................................65643
1.141-3 (g)(2)(v) redesignated as (g)(2)(vi); new (g)(2)(v) added 
                                                                   65643
1.141-6 Revised....................................................65643
1.141-12 (d)(1) amended; (i)(1), (j) and (k) Example 8 revised; 
        (d)(3), (4), (5) and (i)(2) redesignated as (d)(4), (5), 
        (6) and (i)(3); new (d)(3) and new (i)(2) added............65644
1.141-13 (d)(1) and (g) Example 5 revised..........................65645
1.141-15 Heading, (a), (e) and (i) revised; (b)(4), (l) and (m) 
        added......................................................65645
    (l)(1) correctly revised.......................................74678
1.145-2 (b)(4) and (5) added; (c)(2) amended.......................65646
1.150-5 (a)(1) revised.............................................65646

[[Page 672]]

1.162-27 (e)(2)(vi)(A), (7) Example 9, (4)(iv) and (f)(3) revised; 
        (j)(2)(vi) added...........................................16972

                                  2016

26 CFR
                                                                   81 FR
                                                                    Page
Chapter I
1.141-0 Amended....................................................46591
1.141-1 (a) revised................................................46592
1.141-15 (l)(2) redesignated as (l)(3); new (l)(2) and (n) added; 
        new (l)(3) amended.........................................46592
1.148-0 Amended....................................................46592
    (c) amended....................................................89003
1.148-1 (c)(4)(i)(B)(1) and (ii) revised; (c)(4)(i)(B)(2) and (3) 
        amended; (c)(4)(i)(B)(4) added.............................46592
    (b) amended; (f) added.........................................89003
1.148-2 (e)(3) heading and (i) revised.............................46593
1.148-3 (d)(1)(iv) revised; (d)(4) added; (j) Example 2 amended....46593
1.148-4 (h)(3)(iv)(B) through (E) redesignated as (h)(3)(iv)(E) 
        through (H); new (h)(3)(iv)(B), (C), (D), (4)(i)(C)(1), 
        (2) and (iv) added; (a), (b)(3)(i), (h)(2)(v) heading, 
        introductory text, (viii), (3)(iv)(A), new (E) and new (G) 
        revised; (h)(2)(ii)(A), (v)(B), (vi), new (3)(iv)(F), new 
        (H) and (4)(i)(C) amended..................................46593
1.148-5 (c)(3), (d)(2), (3), (6)(iii)(A)(1) and (6) revised; 
        (d)(6)(i) and (e)(2)(ii)(B) amended........................46595
1.148-6 (d)(3)(iii)(A) amended; (d)(4)(iii) removed................46597
1.148-7 (c)(3)(v) and (i)(6)(ii) revised...........................46597
1.148-8 (d) revised................................................46597
1.148-10 (a)(4) and (e) amended; (e) heading revised...............46597
1.148-11 (d)(1)(i) through (vi) redesignated as (d)(1)(i)(A) 
        through (F); (d)(1) heading, new (i)(B), (D), (F) and (l) 
        revised; (d)(1)(i) introductory text, new (ii) and (k) 
        added......................................................46597
    (l)(2) and (3) correctly amended...............................57459
    (m) added......................................................89004
1.150-1 (a)(2)(iii) and (f) added; (b) amended; (c)(2) revised.....46598
1.150-2(d)(3) (a) amended; (d)(3) and (j)(1) revised; (j)(3) added
                                                                   46598
1.165-11 Revised...................................................70940
1.165-11T Added....................................................70940

                                  2017

26 CFR
                                                                   82 FR
                                                                    Page
Chapter I
1.148-11 (k)(1) amended............................................37817
1.162(l)-0 Added...................................................34610
1.162(l)-1 Added...................................................34610
1.162(l)-1T Removed................................................34611

                                  2018

26 CFR
                                                                   83 FR
                                                                    Page
Chapter I
1.147 (f)-1 Added..................................................67690
1.148-1 (e)(3) reinstated; CFR correction..........................24661
1.148-4 (h)(3)(iv) heading revised.................................14175

                                  2019

    Regulations published from January 1, 2019, through April 1, 2019

26 CFR
                                                                   84 FR
                                                                    Page
Chapter I
1.148-1A Removed....................................................9233
1.148-2A Removed....................................................9233
1.148-3A Removed....................................................9233
1.148-4A Removed....................................................9233
1.148-5A Removed....................................................9233
1.148-6A Removed....................................................9233
1.148-9A Removed....................................................9233

[[Page 673]]

1.148-10A Removed...................................................9233
1.149(d)-1A Removed.................................................9233
1.150-1A Removed....................................................9233
1.162-25T (c) Examples 1 and 2 redesignated as (c)(1) and (2); 
        (c)(1) and (2) amended......................................9233
1.165-13T Removed...................................................9233
1.166-4 (d)(2) and (3) removed; (d)(1) redesignated as new (d)......9233
1.168(f)(8) -1T Removed.............................................9233


                                  [all]