[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2023 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, 2022

          Containing a codification of documents of general 
          applicability and future effect

          As of April 1, 2022
                    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........................     885
      Alphabetical List of Agencies Appearing in the CFR......     905
      Table of OMB Control Numbers............................     915
      List of CFR Sections Affected...........................     933

[[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, 2022), 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 
Register since the last revision of that volume of the Code. Source 
citations for the regulations are referred to by volume number and page 
number of the Federal Register and date of publication. Publication 
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Code a note has been inserted to reflect the future effective date. In 
those instances where a regulation published in the Federal Register 
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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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requirements.

PAST PROVISIONS OF THE CODE

    Provisions of the Code that are no longer in force and effect as of 
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Code users may find the text of provisions in effect on any given date 
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the Code prior to the LSA listings at the end of the volume, consult 
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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 
``[Reserved]'' location at any time. Occasionally ``[Reserved]'' is used 
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not dropped in error.

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 
approval is based are:
    (a) The incorporation will substantially reduce the volume of 
material published in the Federal Register.
    (b) The matter incorporated is in fact available to the extent 
necessary to afford fairness and uniformity in the administrative 
process.
    (c) The incorporating document is drafted and submitted for 
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CFR INDEXES AND TABULAR GUIDES

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separate volume, revised annually as of January 1, entitled CFR Index 
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.
    An index to the text of ``Title 3--The President'' is carried within 
that volume.

[[Page vii]]

    The Federal Register Index is issued monthly in cumulative form. 
This index is based on a consolidation of the ``Contents'' entries in 
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the revision dates of the 50 CFR titles.

REPUBLICATION OF MATERIAL

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INQUIRIES

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the top of odd-numbered pages.
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or write to the Director, Office of the Federal Register, National 
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Connect to NARA's website at www.archives.gov/federal-register.
    The eCFR is a regularly updated, unofficial editorial compilation of 
CFR material and Federal Register amendments, produced by the Office 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, 2022







[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of twenty-two volumes. The 
contents of these volumes represent all current regulations codified 
under this title by the Internal Revenue Service, Department of the 
Treasury, as of April 1, 2022. 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 Denial of deduction for certain fines, penalties, and other 
          amounts.
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 not 
          deductible for taxable years beginning on or after January 1, 
          1994, and for taxable years beginning prior to January 1, 
          2018.
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.
1.162-33 Certain employee remuneration in excess of $1,000,000 not 
          deductible for taxable years beginning after December 31, 
          2017.
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.
1.163-15 Debt proceeds distributed from any taxpayer account or from 
          cash.
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.
1.163(j)-0 Table of contents.
1.163(j)-1 Definitions.
1.163(j)-2 Deduction for business interest expense limited.
1.163(j)-3 Relationship of the section 163(j) limitation to other 
          provisions affecting interest.
1.163(j)-4 General rules applicable to C corporations (including REITs, 
          RICs, and members of consolidated groups) and tax-exempt 
          corporations.
1.163(j)-5 General rules governing disallowed business interest expense 
          carryforwards for C corporations.
1.163(j)-6 Application of the section 163(j) limitation to partnerships 
          and subchapter S corporations.
1.163(j)-7 Application of the section 163(j) limitation to foreign 
          corporations and United States shareholders.
1.163(j)-8 [Reserved]
1.163(j)-9 Elections for excepted trades or businesses; safe harbor for 
          certain REITs.
1.163(j)-10 Allocation of interest expense, interest income, and other 
          items of expense and gross income to an excepted trade or 
          business.
1.163(j)-11 Transition rules.
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.

[[Page 7]]

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 to take disaster loss deduction for preceding year.
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.
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.
1.168(k)-2 Additional first year depreciation deduction for property 
          acquired and placed in service after September 27, 2017.
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.

[[Page 8]]

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 1.163(j)-1 also issued under 26 U.S.C. 163(j)(8)(B) and 26 
U.S.C. 1502.
    Section 1.163(j)-2 also issued under 26 U.S.C. 1502.
    Section 1.163(j)-3 also issued under 26 U.S.C. 1502.
    Section 1.163(j)-4 also issued under 26 U.S.C. 163(j)(8)(B) and 26 
U.S.C. 1502.
    Section 1.163(j)-5 also issued under 26 U.S.C. 1502.
    Section 1.163(j)-6 also issued under 26 U.S.C. 163(j)(8)(B) and 26 
U.S.C. 1502.
    Section 1.163(j)-7 also issued under 26 U.S.C. 163(j)(8)(B) and 26 
U.S.C. 1502.
    Section 1.163(j)-8 also issued under 26 U.S.C. 163(j)(8)(B).
    Section 1.163(j)-9 also issued under 26 U.S.C. 163(j)(7)(B) and (C) 
and 26 U.S.C. 1502.
    Section 1.163(j)-10 also issued under 26 U.S.C. 163(j)(8)(B) and 26 
U.S.C. 1502.
    Section 1.163(j)-11 also issued under 26 U.S.C. 1502.
    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).
    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.

[[Page 9]]

    (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.

               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.

[[Page 10]]

    (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.
    (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.

[[Page 11]]

    (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, 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,

[[Page 12]]

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 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

[[Page 13]]

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 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

[[Page 14]]

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:

    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

[[Page 15]]

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 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

[[Page 16]]

    (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 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.

[[Page 17]]

    (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.
    (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

[[Page 18]]

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 
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

[[Page 19]]

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 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

[[Page 20]]

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 (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.

[[Page 21]]

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 
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

[[Page 22]]

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.
    (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)

[[Page 23]]

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 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

[[Page 24]]

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 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

[[Page 25]]

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.
    (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

[[Page 26]]

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 
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

[[Page 27]]

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 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,

[[Page 28]]

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 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

[[Page 29]]

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--
    (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

[[Page 30]]

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);
    (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

[[Page 31]]

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 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

[[Page 32]]

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. 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

[[Page 33]]

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 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

[[Page 34]]

    (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 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),

[[Page 35]]

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 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

[[Page 36]]

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 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

[[Page 37]]

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 $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]

[[Page 38]]



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 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

[[Page 39]]

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 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

[[Page 40]]

    (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 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

[[Page 41]]

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.
    (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.

[[Page 42]]

    (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 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

[[Page 43]]

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 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

[[Page 44]]

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 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

[[Page 45]]

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
    (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

[[Page 46]]

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 (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.

[[Page 47]]

    (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).
    (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

[[Page 48]]

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.
    (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

[[Page 49]]

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 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

[[Page 50]]

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 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

[[Page 51]]

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 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

[[Page 52]]

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 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

[[Page 53]]

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 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

[[Page 54]]

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 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

[[Page 55]]

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 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.

[[Page 56]]

    (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 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).

[[Page 57]]

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
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

[[Page 58]]

 
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 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

[[Page 59]]

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 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

[[Page 60]]

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 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

[[Page 61]]

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 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

[[Page 62]]

(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, 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:

[[Page 63]]

    (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.
    (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

[[Page 64]]

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.
    (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

[[Page 65]]

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 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

[[Page 66]]

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 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

[[Page 67]]

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.
    (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

[[Page 68]]

(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 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

[[Page 69]]

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 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.

[[Page 70]]

    (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).
    (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

[[Page 71]]

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.
    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

[[Page 72]]

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 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.

[[Page 73]]

    (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]



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,

[[Page 74]]

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 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

[[Page 75]]

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 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]

[[Page 76]]



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 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-

[[Page 77]]

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]



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)

[[Page 78]]

(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 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.

[[Page 79]]

    (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.
    (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

[[Page 80]]

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.
    (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

[[Page 81]]

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 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

[[Page 82]]

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 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

[[Page 83]]

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 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

[[Page 84]]

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 
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

[[Page 85]]

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.
    (4) Exception for certain capital projects.
    (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.
    (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.

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    (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.
    (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.

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    (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.
    (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.

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    (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.
    (n) Investment-type property.

[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; T.D. 9854, 84 FR 14007, Apr. 9, 
2019]



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 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

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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 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--

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    (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 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

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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 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

[[Page 92]]

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 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-

[[Page 93]]

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 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. Except as otherwise 
provided in this paragraph (e), 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

[[Page 94]]

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--
    (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--

[[Page 95]]

    (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 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.
    (4) Exception for certain capital projects. Investment-type property 
does not include real property or tangible personal property (for 
example, land, buildings, and equipment) that is used in furtherance of 
the public purposes for which the tax-exempt bonds are issued. For 
example, investment-type property does not include a courthouse financed 
with governmental bonds or an eligible exempt facility under section 
142, such as a public road, financed with private activity bonds.
    (f) Definition of issue price--(1) In general. Except as otherwise 
provided in

[[Page 96]]

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 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

[[Page 97]]

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; T.D. 9854, 
84 FR 14007, Apr. 9, 2019]



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 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

[[Page 98]]

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 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)

[[Page 99]]

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 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

[[Page 100]]

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 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

[[Page 101]]

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 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

[[Page 102]]

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 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

[[Page 103]]

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 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)

[[Page 104]]

 
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:

------------------------------------------------------------------------
                                          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:

[[Page 105]]



------------------------------------------------------------------------
                                                 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, 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

[[Page 106]]

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;
    (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--

[[Page 107]]

    (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
------------------------------------------------------------------------

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

[[Page 108]]

 
                                                              30,000,000
------------------------------------------------------------------------

    (C) Because the yield on the issue computed by assuming all bonds in 
the issue subject to redemption within 5 years of the issue date are 
redeemed at maturity is more than one-eighth of one percentage point 
higher than the yield on the issue computed by assuming all bonds 
subject to optional redemption within 5 years of the issue date are 
redeemed at the earliest date for their redemption, each bond is treated 
as redeemed on the date that would produce the lowest yield for the 
issue. The lowest yield on the issue would result from a redemption of 
all the bonds on January 1, 1999. Thus, the yield on the issue is 5.9126 
percent per year compounded semiannually.

    (c) Computing yield on a variable yield issue--(1) In general. The 
yield on a variable yield issue is computed separately for each 
computation period. The yield for each computation period is the 
discount rate that, when used in computing the present value as of the 
first day of the computation period of all the payments of principal and 
interest and fees for qualified guarantees that are attributable to the 
computation period, produces an amount equal to the present value, using 
the same discount rate, of the aggregate issue price (or deemed issue 
price, as determined in paragraph (c)(2)(iv) of this section) of the 
bonds of the issue as of the first day of the computation period. The 
yield on a variable yield bond is computed in the same manner as the 
yield on a variable yield issue. Except as provided in paragraph (c)(2) 
of this section, yield on any fixed yield bond in a variable yield issue 
is computed in the same manner as the yield on a fixed yield issue as 
provided in paragraph (b) of this section.
    (2) Payments on bonds included in yield for a computation period--
(i) Payments in general. The payments on a bond that are attributable to 
a computation period include any amounts actually paid during the period 
for principal on the bond. Payments also include any amounts paid during 
the current period both for interest accruing on the bond during the 
current period and for interest accruing during the prior period that 
was included in the deemed issue price of the bond as accrued unpaid 
interest at the start of the current period under this paragraph (c)(2). 
Further, payments include any amounts properly allocable to fees for a 
qualified guarantee of the bond for the period and to any amounts 
properly allocable to a qualified hedge for the period.
    (ii) Payments at actual redemption. If a bond is actually redeemed 
during a computation period, an amount equal to the greater of its value 
on the redemption date or the actual redemption price is a payment on 
the actual redemption date.
    (iii) Payments for bonds outstanding at end of computation period. 
If a bond is outstanding at the end of a computation period, a payment 
equal to the bond's value is taken into account on the last day of that 
period.
    (iv) Issue price for bonds outstanding at beginning of next 
computation period. A bond outstanding at the end of a computation 
period is treated as if it were immediately reissued on the next day for 
a deemed issue price equal to the value from the day before as 
determined under paragraph (c)(2)(iii) of this section.
    (3) Example. The provisions of this paragraph (c) may be illustrated 
by the following example.

    Example. On January 1, 1994, City A issues an issue of identical 
plain par bonds in an aggregate principal amount of $1,000,000. The 
bonds pay interest at a variable rate on each June 1 throughout the term 
of the issue. The entire principal amount of the bonds plus accrued, 
unpaid interest is payable on the final maturity date of January 1, 
2000. No bond year is selected. On June 1, 1994, 1995, 1996, 1997, and 
1998, interest in the amounts of $30,000, $55,000, $57,000, $56,000, and 
$45,000 is paid on the bonds. From June 1, 1998, to January 1, 1999, 
$30,000 of interest accrues on the bonds. From January 1, 1999, to June 
1, 1999, another $35,000 of interest accrues. On June 1, 1999, the 
issuer actually pays $65,000 of interest. On January 1, 2000, $1,000,000 
of principal and $38,000 of accrued interest are paid. The payments for 
the computation period starting on the issue date and ending on January 
1, 1999, include all annual interest payments paid from the issue date 
to June 1, 1998. Because the issue is outstanding on January 1, 1999, it 
is treated as redeemed on that date for amount equal to its value 
($1,000,000 plus accrued, unpaid interest of $30,000 under paragraph 
(e)(1) of this section). Thus, $1,030,000 is treated as paid on January 
1, 1999. The issue is then treated as reissued

[[Page 109]]

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.
    (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

[[Page 110]]

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 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

[[Page 111]]

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 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

[[Page 112]]

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 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

[[Page 113]]

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 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

[[Page 114]]

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; 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

[[Page 115]]

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 
(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,

[[Page 116]]

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 (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

[[Page 117]]

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 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

[[Page 118]]

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 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

[[Page 119]]

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 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

[[Page 120]]

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, 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.

[[Page 121]]

    (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 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

[[Page 122]]

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 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.

[[Page 123]]

    (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 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

[[Page 124]]

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 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

[[Page 125]]

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 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

[[Page 126]]

    (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 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

[[Page 127]]

($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 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,

[[Page 128]]

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 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

[[Page 129]]

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 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.

[[Page 130]]

    (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 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,

[[Page 131]]

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 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

[[Page 132]]

debt service fund, is reasonable only if it satisfies the requirements 
of paragraphs (e)(2) through (6) of this section in addition to the 
other requirements of this section.
    (2) Investments held by a commingled fund--(i) Required ratable 
allocations. Not less frequently than as of the close of each fiscal 
period, all payments and receipts (including deemed payments and 
receipts) on investments held by a commingled fund must be allocated 
(but not necessarily distributed) among the different investors in the 
fund. This allocation must be based on a consistently applied, 
reasonable ratable allocation method.
    (ii) Safe harbors for ratable allocation methods. Reasonable ratable 
allocation methods include, without limitation, methods that allocate 
these items in proportion to either--
    (A) The average daily balances of the amounts in the commingled fund 
from different investors during a fiscal period (as described in 
paragraph (e)(4) of this section); or
    (B) The average of the beginning and ending balances of the amounts 
in the commingled fund from different investors for a fiscal period that 
does not exceed one month.
    (iii) Definition of investor. For purposes of this paragraph (e), 
the term investor means each different source of funds invested in a 
commingled fund. For example, if a city invests gross proceeds of an 
issue and tax revenues in a commingled fund, it is treated as two 
different investors.
    (3) Certain expenditures involving a commingled fund. If a ratable 
allocation method is used under paragraph (d) of this section to 
allocate expenditures from the commingled fund, the same ratable 
allocation method must be used to allocate payments and receipts on 
investments in the commingled fund under paragraph (e)(2) of this 
section.
    (4) Fiscal periods. The fiscal year of a commingled fund is the 
calendar year unless the fund adopts another fiscal year. A commingled 
fund may use any consistent fiscal period that does not exceed three 
months (e.g., a daily, weekly, monthly, or quarterly fiscal period).
    (5) Unrealized gains and losses on investments of a commingled 
fund--(i) Mark-to-market requirement for internal commingled funds with 
longer-term investment portfolios. Except as otherwise provided in this 
paragraph (e), in the case of a commingled fund in which the issuer and 
any related party own more than 25 percent of the beneficial interests 
in the fund (an internal commingled fund), the fund must treat all its 
investments as if sold at fair market value either on the last day of 
the fiscal year or the last day of each fiscal period. The net gains or 
losses from these deemed sales of investments must be allocated to all 
investors of the commingled fund during the period since the last 
allocation.
    (ii) Exception for internal commingled funds with shorter-term 
investment portfolios. If the remaining weighted average maturity of all 
investments held by a commingled fund during a particular fiscal year 
does not exceed 18 months, and the investments held by the commingled 
fund during that fiscal year consist exclusively of obligations, the 
mark-to-market requirement of paragraph (e)(5)(i) of this section does 
not apply.
    (iii) Exception for commingled reserve funds and sinking funds. The 
mark-to-market requirement of paragraph (e)(5)(i) of this section does 
not apply to a commingled fund that operates exclusively as a reserve 
fund, sinking fund, or replacement fund for two or more issues of the 
same issuer.
    (6) Allocations of commingled funds serving as common reserve funds 
or sinking funds--(i) Permitted ratable allocation methods. If a 
commingled fund serves as a common reserve fund, replacement fund, or 
sinking fund for two or more issues (a commingled reserve), after making 
reasonable adjustments to account for proceeds allocated under paragraph 
(b)(1) or (b)(2) of this section, investments held by that commingled 
fund must be allocated ratably among the issues served by the commingled 
fund in accordance with one of the following methods--
    (A) The relative values of the bonds of those issues under 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

[[Page 133]]

    (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 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

[[Page 134]]

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 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

[[Page 135]]

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 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.

[[Page 136]]

    (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 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

[[Page 137]]

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 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.

[[Page 138]]

    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 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

[[Page 139]]

date and the end of each of the first three spending periods, the amount 
of available construction proceeds is $10,800,000. To qualify as a 
construction issue, F must reasonably expect on the issue date that at 
least $8,100,000 (75 percent of $10,800,000) will be used for 
construction expenditures. In order to meet the 10 percent spending 
requirement at the end of the first spending period, F must spend at 
least $1,080,000. As of the end of the fourth spending period, F has 
received $1,100,000 in earnings. In order to meet the spending 
requirement at the end of the fourth spending period, however, F must 
spend all of the $11,100,000 of actual available construction proceeds 
(except for reasonable retainage not exceeding $555,000).
    Example 2. Treatment of investment earnings without a reserve fund. 
City G issues bonds having an issue price of $11,200,000. G does not 
elect to exclude earnings on the reserve fund from available 
construction proceeds. G uses $200,000 of proceeds to pay issuance costs 
and deposits $1,000,000 of proceeds into a reasonably required reserve 
fund. G deposits the remaining $10,000,000 of proceeds into a 
construction fund to be used for construction expenditures. On the issue 
date, G reasonably expects that, based on the reasonably expected date 
of substantial completion and rates of investment, total earnings on the 
construction fund will be $800,000, and total earnings on the reserve 
fund to the date of substantial completion will be $150,000. G 
reasonably expects that substantial completion will occur during the 
fourth spending period. As of the issue date, the amount of available 
construction proceeds is $10,950,000 ($10,000,000 originally deposited 
into the construction fund plus $800,000 expected earnings on the 
construction fund and $150,000 expected earnings on the reserve fund). 
To qualify as a construction issue, G must reasonably expect on the 
issue date that at least $8,212,500 will be used for construction 
expenditures.
    Example 3. Election to exclude earnings on a reserve fund. The facts 
are the same as Example 2, except that G elects on the issue date to 
exclude earnings on the reserve fund from available construction 
proceeds. The amount of available construction proceeds as of the issue 
date is $10,800,000.

    (j) Election to treat portion of issue used for construction as 
separate issue--(1) In general. For purposes of paragraph (e) of this 
section, if any proceeds of an issue are to be used for construction 
expenditures, the issuer may elect on or before the issue date to treat 
the portion of the issue that is not a refunding issue as two, and only 
two, separate issues, if--
    (i) One of the separate issues is a construction issue as defined in 
paragraph (f) of this section;
    (ii) The issuer reasonably expects, as of the issue date, that this 
construction issue will finance all of the construction expenditures to 
be financed by the issue; and
    (iii) The issuer makes an election to apportion the issue under this 
paragraph (j)(1) in which it identifies the amount of the issue price of 
the issue allocable to the construction issue.
    (2) Example. The operation of this paragraph (j) is illustrated by 
the following example.

    Example. City D issues bonds having an issue price of $19,000,000. 
On the issue date, D reasonably expects to use $10,800,000 of bond 
proceeds (including investment earnings) for construction expenditures 
for the project being financed. D deposits $10,000,000 in a construction 
fund to be used for construction expenditures and $9,000,000 in an 
acquisition fund to be used for acquisition of equipment not qualifying 
as construction expenditures. D estimates on the issue date, based on 
reasonably expected expenditures and rates of investment, that total 
earnings on the construction fund will be $800,000 and total earnings on 
the acquisition fund will be $200,000. Because the total construction 
expenditures to be financed by the issue are expected to be $10,800,000, 
the maximum available construction proceeds for a construction issue is 
$14,400,000 ($10,800,000 divided by 0.75). To determine the maximum 
amount of the issue price allocable to a construction issue, the 
estimated investment earnings allocable to the construction issue are 
subtracted. The entire $800,000 of earnings on the construction fund are 
allocable to the construction issue. Only a portion of the $200,000 of 
earnings on the acquisition fund, however, are allocable to the 
construction issue. The total amount of the available construction 
proceeds that is expected to be used for acquisition is $3,600,000 
($14,400,000-$10,800,000). The portion of earnings on the acquisition 
fund that is allocable to the construction issue is $78,261 ($200,000 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

[[Page 140]]

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
    (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

[[Page 141]]

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.
    (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

[[Page 142]]

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 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

[[Page 143]]

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 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

[[Page 144]]

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).
    (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.

[[Page 145]]

    (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 
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--

[[Page 146]]

    (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 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

[[Page 147]]

issue comprised of that group of purpose investments. A allocates those 
purpose investments representing those loans to that separate unrefunded 
portion of the issue. In addition, A treats the unoriginated portion of 
the 1994 issue as a separate issue and allocates the nonpurpose 
investments representing the unoriginated proceeds of the 1994 issue to 
the refunded portion of the issue. Thus, when proceeds of the 1996 issue 
are used to pay principal on the refunded portion of the 1994 issue that 
is treated as a separate issue under paragraph (h) of this section, only 
the portion of the 1994 issue representing unoriginated loan funds 
invested in nonpurpose investments transfer to become transferred 
proceeds of the 1996 issue.

    (4) Allocations of bonds of a multipurpose issue--(i) Reasonable 
allocation of bonds to portions of issue. After reasonable adjustment of 
the issue price of a multipurpose issue to account for common costs, the 
portion of the bonds of a multipurpose issue allocated to a separate 
purpose must have an issue price that bears the same ratio to the 
aggregate issue price of the multipurpose issue as the portion of the 
sale proceeds of the multipurpose issue used for that separate purpose 
bears to the aggregate sale proceeds of the multipurpose issue. For a 
refunding issue used to refund two or more prior issues, the portion of 
the sales proceeds allocated to the refunding of a separate prior issue 
is based on the present value of the refunded debt service on that prior 
issue, using the yield on investments in the refunding escrow allocable 
to the entire refunding issue as the discount rate.
    (ii) Safe harbor for pro rata allocation method for bonds. The use 
of the relative amount of sales proceeds used for each separate purpose 
to ratably allocate each bond or a ratable number of substantially 
identical whole bonds is a reasonable method for allocating bonds of a 
multipurpose issue.
    (iii) Safe harbor for allocations of bonds used to finance separate 
purpose investments. An allocation of a portion of the bonds of a 
multipurpose issue to a particular purpose investment is generally 
reasonable if that purpose investment has principal and interest 
payments that reasonably coincide in time and amount to principal and 
interest payments on the bonds allocated to that purpose investment.
    (iv) Rounding of bond allocations to next whole bond denomination 
permitted. An allocation that rounds each resulting fractional bond up 
or down to the next integral multiple of a permitted denomination of 
bonds of that issue not in excess of $100,000 does not prevent the 
allocation from satisfying this paragraph (h)(4).
    (v) Restrictions on allocations of bonds to refunding purposes. For 
each portion of a multipurpose issue that is used to refund a separate 
prior issue, a method of allocating bonds of that issue is reasonable 
under this paragraph (h) only if, in addition to the requirements of 
paragraphs (h)(1) and (h)(2) of this section, the portion of the bonds 
allocated to the refunding of that prior issue--
    (A) Results from a pro rata allocation under paragraph (h)(4)(ii) of 
this section;
    (B) Reflects aggregate principal and interest payable in each bond 
year that is less than, equal to, or proportionate to, the aggregate 
principal and interest payable on the prior issue in each bond year;
    (C) Results from an allocation of all the bonds of the entire 
multipurpose issue in proportion to the remaining weighted average 
economic life of the capital projects financed or refinanced by the 
issue, determined in the same manner as under section 147(b); or
    (D) Results from another reasonable allocation method, but only to 
the extent that the application of the allocation methods provided in 
this paragraph (h)(4)(v) is not permitted under state law restrictions 
applicable to the bonds, reasonable terms of bonds issued before, or 
subject to a master indenture that became effective prior to, July 1, 
1993, or other similar restrictions or circumstances. This paragraph 
(h)(4)(v)(D) shall be strictly construed and is available only if it 
does not result in a greater burden on the market for tax-exempt bonds 
than would occur using one of the other allocation methods provided in 
this paragraph (h)(4)(v). (See also 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

[[Page 148]]

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 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

[[Page 149]]

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 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;

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    (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 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

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of $9.5 million, the letter of credit is a materially higher yielding 
investment. Neither result would change if Developer's obligation under 
the Bank note is contingent on Bank performing its obligation under the 
letter of credit. Each characterization causes the bonds to be arbitrage 
bonds.
    Example 2. Bonds outstanding longer than necessary for yield-
blending device. (i) Longer bond maturity to create sinking fund. In 
1994, Authority issues an advance refunding issue (the refunding issue) 
to refund a 1982 prior issue (the prior issue). Under current market 
conditions, Authority will have to invest the refunding escrow at a 
yield significantly below the yield on the refunding issue. Authority 
issues its refunding issue with a longer weighted average maturity than 
otherwise necessary primarily for the purpose of creating a sinking fund 
for the refunding issue that will be invested in a guaranteed investment 
contract. The weighted average maturity of the refunding issue is less 
than 120 percent of the remaining average economic life of the 
facilities financed with the proceeds of the prior issue. The guaranteed 
investment contract has a yield that is higher than the yield on the 
refunding issue. The yield on the refunding escrow blended with the 
yield on the guaranteed investment contract does not exceed the yield on 
the issue. The refunding issue uses an abusive arbitrage device and the 
bonds of the issue are arbitrage bonds under section 148(a).
    (ii) Refunding of noncallable bonds. The facts are the same as in 
paragraph (i) of this Example 2 except that instead of structuring the 
refunding issue to enable it to take advantage of sinking fund 
investments, Authority will also refund other long-term, non-callable 
bonds in the same refunding issue. There are no savings attributable to 
the refunding of the non-callable bonds (e.g., a low-to-high refunding). 
The Authority invests the portion of the proceeds of the refunding issue 
allocable to the refunding of the non-callable bonds in the refunding 
escrow at a yield that is higher than the yield on the refunding issue, 
based on the relatively long escrow period for this portion of the 
refunding. The Authority invests the other portion of the proceeds of 
the refunding issue in the refunding escrow at a yield lower than the 
yield on the refunding issue. The blended yield on all the investments 
in the refunding escrow for the prior issues does not exceed the yield 
on the refunding issue. The portion of the refunding issue used to 
refund the noncallable bonds, however, was not otherwise necessary and 
was issued primarily to exploit the difference between taxable and tax-
exempt rates for that long portion of the refunding escrow to minimize 
the effect of lower yielding investments in the other portion of the 
escrow. The refunding issue uses an abusive arbitrage device and the 
bonds of the issue are arbitrage bonds.
    (iii) Governmental purpose. In paragraphs (i) and (ii) of this 
Example 2, the existence of a governmental purpose for the described 
financing structures would not change the conclusions unless Authority 
clearly established that the primary purpose for the use of the 
particular structure was a bona fide governmental purpose. The fact that 
each financing structure had the effect of eliminating significant 
amounts of negative arbitrage is strong evidence of a primary purpose 
that is not a bona fide governmental purpose. Moreover, in paragraph (i) 
of this Example 2, the structure of the refunding issue coupled with the 
acquisition of the guaranteed investment contract to lock in the 
investment yield associated with the structure is strong evidence of a 
primary purpose that is not a bona fide governmental purpose.
    Example 3. Window refunding. (i) Authority issues its 1994 refunding 
issue to refund a portion of the principal and interest on its 
outstanding 1985 issue. The 1994 refunding issue is structured using 
zero-coupon bonds that pay no interest or principal for the 5-year 
period following the issue date. The proceeds of the 1994 refunding 
issue are deposited in a refunding escrow to be used to pay only the 
interest requirements of the refunded portion of the 1985 issue. 
Authority enters into a guaranteed investment contract with a financial 
institution, G, under which G agrees to provide a guaranteed yield on 
revenues invested by Authority during the 5-year period following the 
issue date. The guaranteed investment contract has a yield that is no 
higher than the yield on the refunding issue. The revenues to be 
invested under this guaranteed investment contract consist of the 
amounts that Authority otherwise would have used to pay principal and 
interest on the 1994 refunding issue. The guaranteed investment contract 
is structured to generate receipts at times and in amounts sufficient to 
pay the principal and redemption requirements of the refunded portion of 
the 1985 issue. A principal purpose of these transactions is to avoid 
transferred proceeds. Authority will continue to invest the unspent 
proceeds of the 1985 issue that are on deposit in a refunding escrow for 
its 1982 issue at a yield equal to the yield on the 1985 issue and will 
not otherwise treat those unspent proceeds as transferred proceeds of 
the 1994 refunding issue. The 1994 refunding issue is an issue of 
arbitrage bonds since those bonds involve a transaction or series of 
transactions that overburdens the market by leaving bonds outstanding 
longer than is necessary to obtain a material financial advantage based 
on arbitrage. Specifically, Authority has structured the 1994 refunding 
issue to make available for the refunding of the 1985 issue replacement 
proceeds rather than proceeds so that the unspent proceeds of the 1985 
issue will not become transferred proceeds of the 1994 refunding issue.

[[Page 152]]

    (ii) The result would be the same in each of the following 
circumstances:
    (A) The facts are the same as in paragraph (i) of this Example 3 
except that Authority does not enter into the guaranteed investment 
contract but instead, as of the issue date of the 1994 refunding issue, 
reasonably expects that the released revenues will be available for 
investment until used to pay principal and interest on the 1985 issue.
    (B) The facts are the same as in paragraph (i) of this Example 3 
except that there are no unspent proceeds of the 1985 issue and 
Authority invests the released revenues at a yield materially higher 
than the yield on the 1994 issue.
    (C) The facts are the same as in paragraph (i) of this Example 3 
except that Authority uses the proceeds of the 1994 issue for capital 
projects instead of to refund a portion of the 1985 issue.
    Example 4. Sale of conduit loan. On January 1, 1994, Authority 
issues a conduit financing issue (the 1994 conduit financing issue) and 
uses the proceeds to purchase from City, an unrelated party, a tax-
exempt bond of City (the City note). The proceeds of the 1994 conduit 
financing issue are to be used to advance refund a prior conduit 
financing issue that was issued in 1988 and used to make a loan to City. 
The 1994 conduit financing issue and the City note each have a yield of 
8 percent on January 1, 1994. On June 30, 1996, interest rates have 
decreased and Authority sells the City note to D, a person unrelated to 
either City or Authority. Based on the sale price of the City note and 
treating June 30, 1996 as the issue date of the City note, the City note 
has a 6 percent yield. Authority deposits the proceeds of the sale of 
the City note into an escrow to redeem the bonds of the 1994 conduit 
financing issue on January 1, 2001. The escrow is invested in nonpurpose 
investments having a yield of 8 percent. For purposes of section 149(d), 
City and Authority are related parties and, therefore, the issue date of 
the City note is treated as being June 30, 1996. Thus, the City note is 
an advance refunding of Authority's 1994 conduit financing issue. 
Interest on the City note is not exempt from Federal income tax from the 
date it is sold to D under section 149(d), because, by investing the 
escrow investments at a yield of 8 percent instead of a yield not 
materially higher than 6 percent, the sale of the City note employs a 
device to obtain a material financial advantage, based on arbitrage, 
apart from the savings attributable to lower interest rates. In 
addition, the City note is not a tax-exempt bond because the note is the 
second advance refunding of the original bond under section 149(d)(3). 
The City note also employs an abusive arbitrage device and is an 
arbitrage bond under section 148.
    Example 5. Re-refunding. (i) On January 1, 1984, City issues a tax-
exempt issue (the 1984 issue) to finance the cost of constructing a 
prison. The 1984 issue has a 7 percent yield and a 30-year maturity. The 
1984 issue is callable at any time on or after January 1, 1994. On 
January 1, 1990, City issues a refunding issue (the 1990 issue) to 
advance refund the 1984 issue. The 1990 issue has an 8 percent yield and 
a 30-year maturity. The 1990 issue is callable at any time on or after 
January 1, 2000. The proceeds of the 1990 issue are invested at an 8 
percent yield in a refunding escrow for the 1984 issue (the original 
1984 escrow) in a manner sufficient to pay debt service on the 1984 
issue until maturity (i.e., an escrow to maturity). On January 1, 1994, 
City issues a refunding issue (the 1994 issue). The 1994 issue has a 6 
percent yield and a 30-year maturity. City does not invest the proceeds 
of the 1994 issue in a refunding escrow for the 1990 issue in a manner 
sufficient to pay a portion of the debt service until, and redeem a 
portion of that issue on, January 1, 2000. Instead, City invests those 
proceeds at a 6 percent yield in a new refunding escrow for a portion of 
the 1984 issue (the new 1984 escrow) in a manner sufficient to pay debt 
service on a portion of the 1984 issue until maturity. City also 
liquidates the investments allocable to the proceeds of the 1990 issue 
held in the original 1984 escrow and reinvests those proceeds in an 
escrow to pay a portion of the debt service on the 1990 issue itself 
until, and redeem a portion of that issue on, January 1, 2000 (the 1990 
escrow). The 1994 bonds are arbitrage bonds and employ an abusive device 
under section 149(d)(4). Although, in form, the proceeds of the 1994 
issue are used to pay principal on the 1984 issue, this accounting for 
the use of the proceeds of the 1994 issue is an unreasonable, 
inconsistent accounting method under 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

[[Page 153]]

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.
    (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

[[Page 154]]

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.
    (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

[[Page 155]]

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 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.

[[Page 156]]

    (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.
    (n) Investment-type property. Section 1.148-1(e)(1) and (4) apply to 
bonds sold on or after July 8, 2019. An issuer may apply the provisions 
of Sec.  1.148-1(e)(1) and (4) to bonds sold before July 8, 2019.

[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; T.D. 9854, 84 FR 14007, Apr. 9, 2019]



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).
    (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

[[Page 157]]

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), 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

[[Page 158]]

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;
    (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,

[[Page 159]]

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 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

[[Page 160]]

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 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).

[[Page 161]]

    (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 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

[[Page 162]]

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.
    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:

[[Page 163]]

    (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.
    (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--

[[Page 164]]

    (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).
    (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

[[Page 165]]

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--
    (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

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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 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.

[[Page 167]]

    (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 
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.

[[Page 168]]

    (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 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.

[[Page 169]]

    (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, 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]

[[Page 170]]

   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 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

[[Page 171]]

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.
    (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

[[Page 172]]

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 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

[[Page 173]]

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 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,

[[Page 174]]

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 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-

[[Page 175]]

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 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

[[Page 176]]

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)(1) A payment to a spouse (payee spouse) of alimony or separate 
maintenance is not treated as a payment by the payor spouse for the 
support of any dependent. Similarly, the distribution of income of an 
estate or trust to a divorced or legally separated payee spouse is not 
treated as a payment by the payor spouse for the support of any 
dependent. The preceding sentence will not apply, however, to the extent 
that such a distribution is in satisfaction of the amount or portion of 
income that, by the terms of a divorce decree, a written separation 
agreement, or the trust instrument is fixed as payable for the support 
of the minor children of the payor spouse.
    (2) Paragraph (b)(1) of this section applies to taxable years 
beginning on or after October 13, 2020.
    (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:

    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

[[Page 177]]

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.
    (e)(1) In defining a qualifying relative for taxable year 2018, the 
exemption amount in section 152(d)(1)(B) is $4,150. For taxable years 
2019 through 2025, the exemption amount, as adjusted for inflation, is 
set forth in annual guidance published in the Internal Revenue Bulletin. 
See Sec.  601.601(d)(2) of this chapter.
    (2) Paragraph (e)(1) of this section applies to taxable years ending 
after August 28, 2018.

[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; T.D. 9913, 85 FR 64386, Oct. 13, 2020]



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
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

[[Page 178]]

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 
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;

[[Page 179]]

    (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 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

[[Page 180]]

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 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.

[[Page 181]]

    (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 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

[[Page 182]]

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 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

[[Page 183]]

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.



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).

[[Page 184]]

    (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.
    (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.

[[Page 185]]

    (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 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.

[[Page 186]]

    (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 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.

[[Page 187]]

    (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;
    (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

[[Page 188]]

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 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

[[Page 189]]

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 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

[[Page 190]]

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 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

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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 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

[[Page 192]]

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 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

[[Page 193]]

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 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

[[Page 194]]

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 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

[[Page 195]]

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 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

[[Page 196]]

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 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

[[Page 197]]

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 not deductible. 
Whether a particular trip is primarily person or primarily to obtain 
education the expenses of which

[[Page 198]]

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 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

[[Page 199]]

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 200]]

    (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 201]]

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 202]]

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 203]]

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) Payments and transfers to entities described in section 170(c)--
(1) In general. A payment or transfer to or for the use of an entity 
described in section 170(c) that bears a direct relationship to the 
taxpayer's trade or business and that is made with a reasonable 
expectation of financial return commensurate with the amount of the 
payment or transfer may constitute an allowable deduction as a trade or 
business expense rather than a charitable contribution deduction under 
section 170. For payments or transfers in excess of the amount 
deductible under section 162(a), see Sec.  1.170A-1(h).
    (2) Examples. The following examples illustrate the rules of 
paragraph (a)(1) of this section:
    (i) Example 1. A, an individual, is a sole proprietor who 
manufactures musical instruments and sells them through a website. A 
makes a $1,000 payment to a local church (which is a charitable 
organization described in section 170(c)) for a half-page advertisement 
in the church's program for a concert. In the program, the church thanks 
its concert supporters, including A. A's advertisement includes the URL 
for the website through which A sells its instruments. A reasonably 
expects that the advertisement will attract new customers to A's website 
and will help A to sell more musical instruments. A may treat the $1,000 
payment as an expense of carrying on a trade or business under section 
162.
    (ii) Example 2. P, a partnership, operates a chain of supermarkets, 
some of

[[Page 204]]

which are located in State N. P operates a promotional program in which 
it sets aside the proceeds from one percent of its sales each year, 
which it pays to one or more charities described in section 170(c). The 
funds are earmarked for use in projects that improve conditions in State 
N. P makes the final determination on which charities receive payments. 
P advertises the program. P reasonably believes the program will 
generate a significant degree of name recognition and goodwill in the 
communities where it operates and thereby increase its revenue. As part 
of the program, P makes a $1,000 payment to a charity described in 
section 170(c). P may treat the $1,000 payment as an expense of carrying 
on a trade or business under section 162. This result is unchanged if, 
under State N's tax credit program, P expects to receive a $1,000 income 
tax credit on account of P's payment, and under State N law, the credit 
can be passed through to P's partners.
    (3) Safe harbors for C corporations and specified passthrough 
entities making payments in exchange for State or local tax credits--(i) 
Safe harbor for C corporations. If a C corporation makes a payment to or 
for the use of an entity described in section 170(c) and receives or 
expects to receive in return a State or local tax credit that reduces a 
State or local tax imposed on the C corporation, the C corporation may 
treat such payment as meeting the requirements of an ordinary and 
necessary business expense for purposes of section 162(a) to the extent 
of the amount of the credit received or expected to be received.
    (ii) Safe harbor for specified passthrough entities--(A) Definition 
of specified passthrough entity. For purposes of this paragraph 
(a)(3)(ii), an entity is a specified passthrough entity if each of the 
following requirements is satisfied--
    (1) The entity is a business entity other than a C corporation and 
is regarded for all Federal income tax purposes as separate from its 
owners under Sec.  301.7701-3 of this chapter;
    (2) The entity operates a trade or business within the meaning of 
section 162;
    (3) The entity is subject to a State or local tax incurred in 
carrying on its trade or business that is imposed directly on the 
entity; and
    (4) In return for a payment to an entity described in section 
170(c), the entity described in paragraph (a)(3)(ii)(A)(1) of this 
section receives or expects to receive a State or local tax credit that 
the entity applies or expects to apply to offset a State or local tax 
described in paragraph (a)(3)(ii)(A)(3) of this section.
    (B) Safe harbor. Except as provided in paragraph (a)(3)(ii)(C) of 
this section, if a specified passthrough entity makes a payment to or 
for the use of an entity described in section 170(c), and receives or 
expects to receive in return a State or local tax credit that reduces a 
State or local tax described in paragraph (a)(3)(ii)(A)(3) of this 
section, the specified passthrough entity may treat such payment as an 
ordinary and necessary business expense for purposes of section 162(a) 
to the extent of the amount of credit received or expected to be 
received.
    (C) Exception. The safe harbor described in this paragraph 
(a)(3)(ii) does not apply if the credit received or expected to be 
received reduces a State or local income tax.
    (iii) Definition of payment. For purposes of this paragraph (a)(3), 
payment is defined as a payment of cash or cash equivalent.
    (iv) Examples. The following examples illustrate the rules of 
paragraph (a)(3) of this section.
    (A) Example 1. C corporation that receives or expects to receive 
dollar-for-dollar State or local tax credit. A, a C corporation engaged 
in a trade or business, makes a payment of $1,000 to an entity described 
in section 170(c). In return for the payment, A expects to receive a 
dollar-for-dollar State tax credit to be applied to A's State corporate 
income tax liability. Under paragraph (a)(3)(i) of this section, A may 
treat the $1,000 payment as an expense of carrying on a trade or 
business under section 162.
    (B) Example 2. C corporation that receives or expects to receive 
percentage-based State or local tax credit. B, a C corporation engaged 
in a trade or business, makes a payment of $1,000 to an

[[Page 205]]

entity described in section 170(c). In return for the payment, B expects 
to receive a local tax credit equal to 80 percent of the amount of this 
payment ($800) to be applied to B's local real property tax liability. 
Under paragraph (a)(3)(i) of this section, B may treat $800 as an 
expense of carrying on a trade or business under section 162. The 
treatment of the remaining $200 will depend upon the facts and 
circumstances and is not affected by paragraph (a)(3)(i) of this 
section.
    (C) Example 3. Partnership that receives or expects to receive 
dollar-for-dollar State or local tax credit. P is a limited liability 
company classified as a partnership for Federal income tax purposes 
under Sec.  301.7701-3 of this chapter. P is engaged in a trade or 
business and makes a payment of $1,000 to an entity described in section 
170(c). In return for the payment, P expects to receive a dollar-for-
dollar State tax credit to be applied to P's State excise tax liability 
incurred by P in carrying on its trade or business. Under applicable 
State law, the State's excise tax is imposed at the entity level (not 
the owner level). Under paragraph (a)(3)(ii) of this section, P may 
treat the $1,000 as an expense of carrying on a trade or business under 
section 162.
    (D) Example 4. S corporation that receives or expects to receive 
percentage-based State or local tax credit. S is an S corporation 
engaged in a trade or business and is owned by individuals C and D. S 
makes a payment of $1,000 to an entity described in section 170(c). In 
return for the payment, S expects to receive a local tax credit equal to 
80 percent of the amount of this payment ($800) to be applied to S's 
local real property tax liability incurred by S in carrying on its trade 
or business. Under applicable local law, the real property tax is 
imposed at the entity level (not the owner level). Under paragraph 
(a)(3)(ii) of this section, S may treat $800 of the payment as an 
expense of carrying on a trade or business under section 162. The 
treatment of the remaining $200 will depend upon the facts and 
circumstances and is not affected by paragraph (a)(3)(ii) of this 
section.
    (v) Applicability of section 170 to payments in exchange for State 
or local tax benefits. For rules regarding the availability of a 
charitable contribution deduction under section 170 where a taxpayer 
makes a payment or transfers property to or for the use of an entity 
described in section 170(c) and receives or expects to receive a State 
or local tax benefit in return for such payment, see Sec.  1.170A-
1(h)(3).
    (4) Applicability dates. Paragraphs (a)(1) and (2) of this section, 
regarding the application of section 162 to taxpayers making payments or 
transfers to entities described in section 170(c), apply to payments or 
transfers made on or after December 17, 2019. Section 1.162-15(a), as it 
appeared in the April 1, 2020 edition of 26 CFR part 1, generally 
applies to payments or transfers made prior to December 17, 2019. 
However, taxpayers may choose to apply paragraphs (a)(1) and (2) of this 
section to payments and transfers made on or after January 1, 2018. 
Paragraph (a)(3) of this section, regarding the safe harbors for C 
corporations and specified passthrough entities making payments to 
section 170(c) entities in exchange for State or local tax credits, 
applies to payments made by these entities on or after December 17, 
2019. However, taxpayers may choose to apply the safe harbors of 
paragraph (a)(3) to payments made on or after January 1, 2018.
    (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 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

[[Page 206]]

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(a)(2).

[T.D. 6819, 30 FR 5580, Apr. 20, 1965, as amended by T.D. 9907, 85 FR 
48472, Aug. 11, 2020]



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 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

[[Page 207]]

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 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

[[Page 208]]

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 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.

[[Page 209]]

    (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 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

[[Page 210]]

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 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

[[Page 211]]

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]



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

[[Page 212]]

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 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

[[Page 213]]

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 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

[[Page 214]]

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 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

[[Page 215]]

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 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.

[[Page 216]]

    (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  Denial of deduction for certain fines, penalties, 
and other amounts.

    (a) Deduction Disallowed. Except as otherwise provided in this 
section, no deduction is allowed under chapter 1 of the Internal Revenue 
Code (Code) for any amount that is paid or incurred--
    (1) By suit, settlement agreement (agreement), or otherwise, as 
defined in paragraph (e)(5) of this section;
    (2) To, or at the direction of, a government, as defined in 
paragraph (e)(1) of this section, or a governmental entity, as defined 
in paragraph (e)(2) of this section; and
    (3) In relation to the violation, or investigation or inquiry by 
such government or governmental entity into the potential violation, of 
any civil or criminal law.
    (i) An amount that is paid or incurred in relation to the violation 
of any civil or criminal law includes a fine or penalty.
    (ii) An investigation or inquiry into the potential violation of any 
law does not include routine investigations or inquiries, such as audits 
or inspections, of regulated businesses that are not related to any 
evidence of wrongdoing or suspected wrongdoing, but are conducted to 
ensure compliance with the rules and regulations applicable to those 
businesses.
    (b) Exception for restitution, remediation, and amounts paid to come 
into compliance with a law--(1) In general. Paragraph (a) of this 
section does not apply to amounts paid or incurred for restitution 
(including remediation) or to come into compliance with a law, as 
defined in paragraphs (e)(4) of this section, provided that both the 
identification and the establishment requirements of paragraphs (b)(2) 
and (b)(3) of this section are met.
    (2) Identification requirement--(i) In general. A court order 
(order) or an agreement, as defined in paragraph (e)(5) of this section, 
identifies a payment by stating the nature of, or purpose for, each 
payment each taxpayer is obligated to pay and the amount of each payment 
identified.
    (ii) Meeting the identification requirement. The identification 
requirement is met if an order or agreement specifically states the 
amount of the payment described in paragraph (b)(2)(i) of this section 
and that the payment constitutes restitution, remediation, or an amount 
paid to come into compliance with a law. If the order or agreement uses 
a different form of the required words (such as ``remediate'' or 
``comply with a law'') and describes the purpose for which restitution 
or remediation will be paid or the law with which the taxpayer must 
comply, the order or agreement will be treated as stating that the 
payment constitutes restitution, remediation, or an amount paid to come 
into compliance with a law. Similarly, if an order or agreement 
specifically describes the damage done, harm suffered, or manner of 
noncompliance with a law and describes the action required of the 
taxpayer to provide restitution, remediation, or to come into compliance 
with any law, as defined in paragraph (e)(4) of this section, the order 
or agreement will be treated as stating that the payment

[[Page 217]]

constitutes restitution, remediation, or an amount paid to come into 
compliance with any law. Meeting the establishment requirement of 
paragraph (b)(3) of this section alone is not sufficient to meet the 
identification requirement of paragraph (b)(2) of this section.
    (iii) Payment amount not identified. (A) If the order or agreement 
identifies a payment as restitution, remediation, or to come into 
compliance with a law but does not identify some or all of the amount 
the taxpayer must pay or incur, the identification requirement may be 
met for any payment amount not identified if the order or agreement 
describes the damage done, harm suffered, or manner of noncompliance 
with a law, and describes the action required of the taxpayer, such as 
paying or incurring costs to provide services or to provide property.
    (B) If the order or agreement identifies a lump-sum payment or 
multiple damages award as restitution, remediation, or to come into 
compliance with a law but does not allocate some or all of the amount 
the taxpayer must pay or incur among restitution, remediation, or to 
come into compliance with a law, or does not allocate the total payment 
amount among multiple taxpayers, the identification requirement may be 
met for any payment amount not specifically allocated if the order or 
agreement describes the damage done, harm suffered, or manner of 
noncompliance with a law, and describes the action required of the 
taxpayer, such as paying or incurring costs to provide services or to 
provide property.
    (3) Establishment requirement--(i) Meeting the establishment 
requirement. The establishment requirement is met if the taxpayer, using 
documentary evidence, proves the taxpayer's legal obligation, pursuant 
to the order or agreement, to pay the amount identified as restitution, 
remediation, or to come into compliance with a law; the amount paid or 
incurred; the date the amount was paid or incurred; and that, based on 
the origin of the liability and the nature and purpose of the amount 
paid or incurred, the amount the taxpayer paid or incurred was for 
restitution or remediation, as defined in paragraph (e)(4)(i) of this 
section or to come into compliance with any law, as defined in paragraph 
(e)(4)(ii) of this section. If the amount is paid or incurred to a 
segregated fund or account, as described in paragraphs (e)(4)(i)(A)(2) 
and (3), (e)(4)(i)(B), or (e)(4)(i)(C) of this section, the taxpayer may 
meet the establishment requirement even if each ultimate recipient, or 
each ultimate use, of the payment is not designated or is unknown. A 
taxpayer will not meet the establishment requirement if the taxpayer 
fails to prove that the taxpayer paid or incurred the amount identified 
as restitution, remediation, or to come into compliance with a law; the 
amount paid; the date the amount was paid or incurred; or that the 
amount the taxpayer paid or incurred was for the nature and purpose 
identified in the order or agreement as required by paragraph (b)(2)(i) 
of this section, or was made for the damage done, harm suffered, 
noncompliance, or to provide property or services as described in 
(b)(2)(iii) of this section. Meeting the identification requirement of 
paragraph (b)(2) of this section is not sufficient to meet the 
establishment requirement of paragraph (b)(3) of this section.
    (ii) Substantiating the establishment requirement. The documentary 
evidence described in paragraph (b)(3)(i) of this section includes, but 
is not limited to, receipts; the legal or regulatory provision related 
to the violation or potential violation of any law; documents issued by 
the government or governmental entity relating to the investigation or 
inquiry, including court pleadings filed by the government or 
governmental entity requesting restitution, remediation, or demanding 
that defendant take action to come into compliance with the law; 
judgment; decree; documents describing how the amount to be paid was 
determined; and correspondence exchanged between the taxpayer and the 
government or governmental entity before the order or agreement became 
binding under applicable law, determined without regard to whether all 
appeals have been exhausted or the time for filing an appeal has 
expired.
    (c) Other exceptions--(1) Suits between private parties. Paragraph 
(a) of this section does not apply to any amount

[[Page 218]]

paid or incurred by reason of any order or agreement in a suit in which 
no government or governmental entity is a party or any order or 
agreement in a suit pursuant to which a government or governmental 
entity enforces its rights as a private party.
    (2) Taxes and related interest. Paragraph (a) of this section does 
not apply to amounts paid or incurred as otherwise deductible taxes or 
related interest. However, if penalties are imposed relating to such 
taxes, paragraph (a) of this section applies to disallow a deduction for 
such penalties and interest payments related to such penalties.
    (3) Failure to pay title 26 tax. In the case of any amount paid or 
incurred as restitution for failure to pay tax imposed under title 26 of 
the United States Code, paragraph (a) of this section does not disallow 
a deduction for title 26 taxes, such as excise and employment taxes, 
which are equal to or less than the deduction otherwise allowed under 
chapter 1 of the Code if the tax had been timely paid.
    (d) Application of general principles of Federal income tax law--(1) 
Taxable year of deduction. If, under paragraph (b) or (c) of this 
section, the taxpayer is allowed a deduction for the amount paid or 
incurred pursuant to an order or agreement, the deduction is taken into 
account under the rules of section 461 and the related regulations, or 
under a provision specifically applicable to the allowed deduction, such 
as Sec.  1.468B-3(c).
    (2) Tax benefit rule applies. If the deduction allowed under 
paragraphs (b) or (c) of this section results in a tax benefit to the 
taxpayer, the taxpayer must include in income, under sections 61 and 
111, the recovery of any amount deducted in a prior taxable year to the 
extent the prior year's deduction reduced the taxpayer's tax liability.
    (i) A tax benefit to the taxpayer includes a reduction in the 
taxpayer's tax liability for a prior taxable year or the creation of a 
net operating loss carryback or carryover.
    (ii) A taxpayer's recovery of any amount deducted in a prior taxable 
year includes, but is not limited to--
    (A) Receiving a refund, recoupment, rebate, reimbursement, or 
otherwise recovering some or all of the amount the taxpayer paid or 
incurred, or
    (B) Being relieved of some or all of the payment liability under the 
order or agreement.
    (e) Definitions. For section 162(f) and Sec.  1.162-21, the 
following definitions apply:
    (1) Government. A government means--
    (i) The government of the United States, a State, or the District of 
Columbia;
    (ii) The government of a territory of the United States, including 
American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, or the 
U.S. Virgin Islands;
    (iii) The government of a foreign country;
    (iv) An Indian tribal government, as defined in section 7701(a)(40), 
or a subdivision of an Indian tribal government, as determined in 
accordance with section 7871(d); or
    (v) A political subdivision (such as a local government unit) of a 
government described in paragraph (e)(1)(i), (ii), or (iii) of this 
section.
    (2) Governmental entity. A governmental entity means--
    (i) A corporation or other entity serving as an agency or 
instrumentality of a government (as defined in paragraph (e)(1) of this 
section), or
    (ii) A nongovernmental entity treated as a governmental entity as 
described in paragraph (e)(3) of this section.
    (3) Nongovernmental entity treated as a governmental entity. A 
nongovernmental entity treated as a governmental entity is an entity 
that--
    (i) Exercises self-regulatory powers (including imposing sanctions) 
in connection with a qualified board or exchange, as defined in section 
1256(g)(7); or
    (ii) Exercises self-regulatory powers, including adopting, 
administering, or enforcing rules and imposing sanctions, as part of 
performing an essential governmental function.
    (4) Restitution, remediation of property, and amounts paid to come 
into compliance with a law--(i) Amounts for restitution or remediation. 
An amount is paid or incurred for restitution or remediation pursuant to 
paragraph (b)(1) of this section if it is paid or incurred to restore, 
in whole or in part, the person,

[[Page 219]]

as defined in section 7701(a)(1); government; governmental entity; 
property; environment; wildlife; or natural resources harmed, injured, 
or damaged by the violation or potential violation of any law described 
in paragraph (a)(3) of this section to the same or substantially similar 
position or condition as existed prior to such harm, injury or damage.
    (A) Environment, wildlife, or natural resources. Restitution or 
remediation of the environment, wildlife, or natural resources includes 
amounts paid or incurred for the purpose of conserving soil, air, or 
water resources, protecting or restoring the environment or an 
ecosystem, improving forests, or providing a habitat for fish, wildlife, 
or plants. The amounts must be paid or incurred--
    (1) To, or at the direction of, a government or governmental entity 
to be used exclusively for the restitution or remediation of a harm to 
the environment, wildlife, or natural resources;
    (2) To a segregated fund or account established by a government or 
governmental entity and, pursuant to the order or agreement, the amounts 
are not disbursed to the general account of the government or 
governmental entity for general enforcement efforts or other 
discretionary purposes; or
    (3) To a segregated fund or account established at the direction of 
a government or governmental entity.
    (4) Paragraph (e)(4)(i)(A) of this section applies only if there is 
a strong nexus or connection between the purpose of the payment and the 
harm to the environment, natural resources, or wildlife that the 
taxpayer has caused or is alleged to have caused.
    (B) Disgorgement or forfeiture. Provided the identification and 
establishment requirements of paragraphs (b)(2) and (b)(3) of this 
section are met, restitution may include amounts paid or incurred as 
disgorgement or forfeiture, if paid or incurred at the direction of a 
government or governmental entity directly to the person, as defined in 
section 7701(a)(1), harmed by the violation or potential violation of 
any law or to, or at the direction of, the government or governmental 
entity, to establish a segregated fund or account for the benefit of 
such harmed person. This paragraph (e)(4)(i)(B) does not apply if the 
order or agreement identifies the payment amount as in excess of the 
taxpayer's net profits or, pursuant to the order or agreement, the 
amounts are disbursed to the general account of the government or 
governmental entity for general enforcement efforts or other 
discretionary purposes.
    (C) Segregated funds or accounts. Provided the identification and 
establishment requirements of paragraphs (b)(2) and (b)(3) of this 
section are met, restitution or remediation may include amounts paid or 
incurred, pursuant to an order or agreement, to a segregated fund or 
account to restore, in whole or in part, the person, as defined in 
section 7701(a)(1); government; governmental entity; property; 
environment; wildlife; or natural resources harmed, injured, or damaged 
by the violation or potential violation of any law described in 
paragraph (a)(3) of this section. This paragraph (e)(4)(i)(C) does not 
apply if, pursuant to the order or agreement, the amounts are disbursed 
to the general account of the government or governmental entity for 
general enforcement efforts or other discretionary purposes.
    (ii) Amounts to come into compliance with a law. An amount is paid 
or incurred to come into compliance with a law that the taxpayer has 
violated, or is alleged to have violated, by performing services; taking 
action, such as modifying equipment; providing property; or doing any 
combination thereof to come into compliance with that law.
    (iii) Amounts not included. Regardless of whether the order or 
agreement identifies them as such, restitution, remediation, and amounts 
paid to come into compliance with a law do not include any amount paid 
or incurred--
    (A) As reimbursement to a government or governmental entity for 
investigation costs or litigation costs incurred in such government or 
governmental entity's investigation into, or litigation concerning, the 
violation or potential violation of any law; or
    (B) At the taxpayer's election, in lieu of a fine or penalty.
    (5) Suit, agreement, or otherwise. A suit, agreement, or otherwise 
includes, but is not limited to, suits; settlement

[[Page 220]]

agreements; orders; non-prosecution agreements; deferred prosecution 
agreements; judicial proceedings; administrative adjudications; 
decisions issued by officials, committees, commissions, or boards of a 
government or governmental entity; and any legal actions or hearings 
which impose a liability on the taxpayer or pursuant to which the 
taxpayer assumes liability.
    (f) Examples. The application of this section is illustrated by the 
following examples.
    (1) Example 1. (i) Facts. Corp. A enters into an agreement with 
State Y's environmental enforcement agency (Agency) for violating state 
environmental laws. Pursuant to the agreement, Corp. A pays $40X to the 
Agency in civil penalties, $80X in restitution for the environmental 
harm that the taxpayer has caused, $50X for remediation of contaminated 
sites, and $60X to conduct comprehensive upgrades to Corp. A's 
operations to come into compliance with the state environmental laws.
    (ii) Analysis. The identification requirement is satisfied for those 
amounts the agreement identifies as restitution, remediation, or to come 
into compliance with a law. If Corp. A meets the establishment 
requirement, as provided in paragraph (b)(3), paragraph (a) of this 
section will not disallow Corp. A's deduction for $80X in restitution 
and $50X for remediation. Under paragraph (a) of this section, Corp. A 
may not deduct the $40X in civil penalties. Paragraph (a) of this 
section will not disallow Corp. A's deduction for the $60X paid to come 
into compliance with the state environmental laws. See section 161, 
concerning items allowed as deductions, and section 261, concerning 
items for which no deduction is allowed, and the regulations related to 
sections 161 and 261.
    (2) Example 2. (i) Facts. Corp. A enters into an agreement with 
State T's securities agency (Agency) for violating a securities law by 
inducing B to make a $100X investment in Corp. C stock, which B lost 
when the Corp. C stock became worthless. As part of the agreement, Corp. 
A agrees to pay $100X to B as restitution for B's investment loss, 
incurred as a result of Corp. A's actions. The agreement specifically 
states that the $100X payment by Corp. A to B is restitution. The 
agreement also requires Corp. A to pay a $40X penalty for violating 
Agency law. Corp. A pays the $140X.
    (ii) Analysis. Corp. A's $100X payment to B is identified in the 
agreement as restitution. If Corp. A establishes, as provided in 
paragraph (b)(3) of this section, that the amount paid was for that 
purpose, paragraph (a) of this section will not disallow Corp. A's 
deduction for the $100X payment. Under paragraph (a) of this section, 
Corp. A may not deduct its $40X payment to the Agency because it was 
paid for Corp. A's violation of Agency law.
    (3) Example 3. (i) Facts. Corp. B is under investigation by State 
X's environmental enforcement agency for a potential violation of State 
X's law governing emissions standards. Corp. B enters into an agreement 
with State X under which it agrees to upgrade the engines in a fleet of 
vehicles that Corp. B operates to come into compliance with State X's 
law. Although the agreement does not provide the specific amount Corp. B 
will incur to upgrade the engines to come into compliance with State X's 
law, it identifies that Corp. B must upgrade existing engines to lower 
certain emissions. Under the agreement, Corp. B also agrees to construct 
a nature center in a local park for the benefit of the community. 
Instead of paying $12X, to come into compliance with State X's law, 
Corp. B pays $15X to upgrade the engines to a standard higher than that 
which the law requires. Corp. B presents evidence to establish that it 
would cost $12X to upgrade the engines to come into compliance with 
State X's law.
    (ii) Analysis. Because the agreement describes the specific action 
Corp. B must take to come into compliance with State X's law, and Corp. 
B provides evidence, as described in paragraph (b)(3)(ii) of this 
section, to establish that the agreement obligates it to incur costs to 
come into compliance with a law, paragraph (a) of this section will not 
disallow Corp. B's deduction for the $12X Corp. B incurs to come into 
compliance. Corp. B may also deduct the $3X if it is otherwise 
deductible under chapter 1 of the Code. However, Corp. B may not deduct 
the

[[Page 221]]

amounts paid to construct the nature center because no facts exist to 
establish that the amount was paid either to come into compliance with a 
law or as restitution or remediation.
    (4) Example 4. (i) Facts. Corp. D enters into an agreement with 
governmental entity, Trade Agency, for engaging in unfair trade 
practices in violation of Trade Agency laws. The agreement requires 
Corp. D to pay $80X to a Trade Agency fund, through disgorgement of net 
profits, to be used exclusively to pay restitution to the consumers 
harmed by Corp. D's violation of Trade Agency law. Corp. D pays $80X to 
Trade Agency fund and Trade Agency disburses all amounts in the 
restitution fund to the harmed consumers.
    (ii) Analysis. The agreement identifies the $80X payment to the fund 
as restitution. Trade Agency uses the funds exclusively to provide 
restitution to the harmed consumers and does not use it for 
discretionary or general enforcement purposes. If Corp. D establishes, 
as provided in paragraph (b)(3) of this section, that the $80X 
constitutes restitution under paragraph (e)(4)(i)(B) of this section, 
paragraph (a) of this section does not apply.
    (5) Example 5. (i) Facts. B, a regulated banking institution, is 
subject to the supervision of, and annual examinations by governmental 
entity, R. In the ordinary course of its business, B is required to pay 
annual assessment fees to R, which fees are used to support R in 
supervising and examining banking institutions to ensure a safe and 
sound banking system. Following an annual examination conducted in the 
ordinary course of B's business, R issues a letter to B identifying 
concerns with B's internal compliance functions. B takes corrective 
action to address R's concerns by investing in its internal compliance 
functions. R does not conduct an investigation or inquiry into B's 
potential violation of any law.
    (ii) Analysis. The payment of annual assessment fees by B to R in 
the ordinary course of business is not related to the violation of any 
law or the investigation or inquiry into the potential violation of any 
law. In addition, B's costs of taking the corrective action are not 
related to the violation of any law or the investigation or inquiry into 
the potential violation of any law as described in section 162(f)(1). 
Paragraph (a) of this section will not disallow the deduction of the 
annual assessment fees and the cost of the corrective actions.
    (6) Example 6. (i) Facts. B, a regulated banking institution, is 
subject to the supervision of, and annual examinations by governmental 
entity, R. Following an annual examination conducted in the ordinary 
course of B's business, R pursues an enforcement action against B for 
violation of banking laws. B and R enter a settlement agreement, 
pursuant to which B agrees to undertake certain improvements to come 
into compliance with banking laws and to pay R $20X for violation of 
banking laws. B pays the $20X.
    (ii) Analysis. If the agreement meets the identification requirement 
of paragraph (b)(2) of this section and B meets the establishment 
requirement of paragraph (b)(3) of this section, paragraph (a) of this 
section will not disallow the deduction of the costs of the corrective 
actions to come into compliance with banking laws. However, B may not 
deduct the $20X paid to R because the amount was not paid to come into 
compliance with a law or as restitution or remediation.
    (7) Example 7. (i) Facts. Corp. C contracts with governmental 
entity, Q, to design and build a rail project within five years. Corp. C 
does not complete the project. Q sues Corp. C for breach of contract and 
damages of $10X. A jury finds Corp. C breached the contract and Corp. C 
pays $10X to Q.
    (ii) Analysis. The suit arose out of a proprietary contract, wherein 
Q enforced its rights as a private party. Paragraph (a) of this section 
will not disallow Corp. C's deduction of the payment of $10X pursuant to 
this suit.
    (8) Example 8. (i) Facts. Corp. C contracts with governmental 
entity, Q, to design and build a rail project within five years. Site 
conditions cause construction delays and Corp. C asks Q to pay $50X in 
excess of the contracted amount to complete the project. After Q pays 
for the work, it learns that, at the time it entered the contract with 
Corp. C, Corp. C knew that certain conditions at the project site would 
make it challenging to complete the project

[[Page 222]]

within five years. Q sues Corp. C for withholding critical information 
during contract negotiations in violation of the False Claims Act (FCA). 
The court enters a judgment in favor of Q pursuant to which Corp. C will 
pay Q $50X in restitution and $150X in treble damages. Corp. C pays the 
$200X.
    (ii) Analysis. The suit pertains to Corp. C's violation of the FCA. 
The order identifies the $50X Corp. C is required to pay as restitution, 
as described in paragraph (b)(2) of this section. If Corp. C 
establishes, as provided in paragraph (b)(3) of this section, that the 
amount paid was for restitution, paragraph (a) of this section will not 
disallow Corp. C's deduction for the $50X payment. Under paragraph (a) 
of this section, Corp. C may not deduct the $150X paid for the treble 
damages imposed for violation of the FCA because the order did not 
identify all or part of the payment as restitution.
    (9) Example 9. (i) Facts. Corp. T operates a truck fleet company 
incorporated in State A. State A requires that all vehicles registered 
in State A have a vehicle emissions test every two years. Corp. T's 40 
trucks take the emissions test on March 1 for which it pays the $15 per 
vehicle. Under State A law, if a vehicle fails the emissions test, the 
vehicle owner has 30 days to certify to State A that the vehicle has 
been repaired and has passed the emissions test. State A imposes a $1X 
penalty per vehicle for failure to comply with this 30-day rule. Twenty 
trucks pass; twenty trucks fail. Corp. T does not submit the required 
certification to State A for the twenty trucks that failed the emissions 
test. State A imposes a $40X penalty against Corp. T. Corp. T pays the 
$40X.
    (ii) Analysis. Emissions tests are conducted in the ordinary course 
of operating a truck fleet company and, therefore, paragraph (a) of this 
section does not apply to the $600 Corp. T pays for the emissions tests. 
However, Corp. T may not deduct the $40X penalty for failure to comply 
with State A requirements because the amount is required to be paid to a 
government in relation to the violation of a law.
    (10) Example 10. (i) Facts. Corp. G operates a chain of 20 grocery 
stores in County X. Under County X health and food safety code and 
regulations, Corp. G is subject to annual inspections for which Corp. G 
is required to pay an inspection fee of $40 per store. Pursuant to the 
annual inspection, the County X health inspector finds violations of 
County X's health and food safety code and regulations in three of Corp. 
G's 20 stores. County X bills Corp. G $800 for the annual inspection 
fees for the 20 stores and a $1,000 fine for each of the three stores, 
for a total fine of $3,000, for violations of the health and food safety 
code. Corp. G pays the fees and fines.
    (ii) Analysis. Paragraph (a) of this section will not disallow Corp. 
G's deduction for the $800 inspection fees paid in the ordinary course 
of a regulated business. Under paragraph (a) of this section, Corp. G 
may not deduct the $3,000 fine for violation of the County X health code 
and food safety ordinances because it was paid to a government in 
relation to the violation of a law.
    (11) Example 11. (i) Facts. Corp. G operates a chain of grocery 
stores in County X. Under County X health and food safety code and 
regulations, Corp. G is subject to annual inspections. Pursuant to an 
annual inspection, the County X health inspector finds that the 
refrigeration system in one of Corp. G's stores does not keep food at 
the temperature required by the health and food safety code and 
regulations. The County X health inspector issues a warning letter 
instructing Corp. G to correct the violation and bring the refrigeration 
system into compliance with the law before a reinspection in 60 days or 
face the imposition of fines if it fails to comply. Corp. G pays $10,000 
to bring its refrigeration system into compliance with the law.
    (ii) Analysis. Provided the identification and establishment 
requirements of paragraphs (b)(2) and (b)(3), respectively, of this 
section are met, paragraph (a) of this section will not disallow Corp. 
G's deduction for the $10,000 it pays to bring its refrigeration system 
into compliance with the law.
    (12) Example 12. (i) Facts. Corp. G operates a chain of grocery 
stores in County X. Under County X health and food safety code and 
regulations, Corp. G is subject to annual inspections. Pursuant to an 
annual inspection, the

[[Page 223]]

County X health inspector finds that the refrigeration system in one of 
Corp. G's stores does not keep food at the temperature required by the 
health and food safety code and regulations. The County X health 
inspector issues a warning letter instructing Corp. G to correct the 
violation and bring the refrigeration system into compliance with the 
law before a reinspection in 60 days or face the imposition of fines if 
it fails to comply. The County X health inspector later reinspects the 
refrigeration system. Corp. G pays a reinspection fee of $80. During the 
reinspection, the health inspector finds that Corp. G did not bring its 
refrigeration system into compliance with the law. The health inspector 
issues a citation imposing a $250 fine on Corp. G. Corp. G pays the $250 
fine.
    (ii) Analysis. Paragraph (a) of this section will disallow Corp. G's 
deduction for the $80 inspection fee because it is paid in relation to 
the investigation or inquiry by County X into the potential violation of 
a law. Paragraph (a) of this section will also disallow Corp. G's 
deduction for the $250 fine paid for violation of the law.
    (13) Example 13. (i) Facts. Accounting Firm was convicted of 
embezzling $500X from Bank in violation of State X law. The court issued 
an order requiring Accounting Firm to pay $100X in restitution to Bank. 
The court also issued an order of forfeiture and restitution for $400X, 
which was seized by the State X officials. Accounting Firm paid $100X to 
Bank. The $400X seized was deposited with Fund within the State X 
treasury and, at the discretion of the State X Attorney General, was 
used to support law enforcement programs.
    (ii) Analysis. Although the order identified the amount forfeited as 
restitution, paragraph (a) of this section will disallow Accounting 
Firm's deduction for the $400X forfeited because, under paragraph 
(e)(4)(i)(B)(I) of this section, it does not constitute restitution. If 
Accounting Firm establishes, as provided in paragraph (b)(3) of this 
section, that the $100X constitutes restitution under paragraph 
(e)(4)(i), paragraph (a) of this section will not disallow Accounting 
Firm's deduction for the $100X paid, provided the $100X is otherwise 
deductible under chapter 1.
    (g) Applicability date. The rules of this section apply to taxable 
years beginning on or after January 19, 2021, except that such rules do 
not apply to amounts paid or incurred under any order or agreement 
pursuant to a suit, agreement, or otherwise, which became binding under 
applicable law before such date, determined without regard to whether 
all appeals have been exhausted or the time for filing appeals has 
expired.

[T.D. 9946, 86 FR 4984, Jan. 19, 2021]



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

[[Page 224]]

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 
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).

[[Page 225]]

    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]



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.

[[Page 226]]

    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 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

[[Page 227]]

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 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.

[[Page 228]]

    (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 
$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 
not deductible for taxable years beginning on or after January 1, 1994, 
and for taxable years beginning prior to January 1, 2018.

    (a) Scope. This section provides rules for the application of the $1 
million deduction limitation under section 162(m)(1) for taxable years 
beginning on or after January 1, 1994, and beginning prior to January 1, 
2018, and, as provided in paragraph (j) of this section, for taxable 
years beginning after December 31, 2017. For rules concerning the 
applicability of section 162(m)(1) to taxable years beginning after 
December 31, 2017, see Sec.  1.162-33. Paragraph (b) of this section 
provides the general rule limiting deductions under section 162(m)(1). 
Paragraph (c) of this section provides definitions of generally 
applicable terms. Paragraph (d) of this section provides an exception 
from the deduction limitation 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)(1). Paragraph (j) of this section contains the 
effective date provisions, which also specify when these rules apply to 
the deduction for compensation otherwise deductible in a taxable year 
beginning after December 31, 2017. For rules concerning the 
deductibility of compensation for services that are not covered by 
section 162(m)(1) 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). For rules concerning the 
deduction limitation under section 162(m)(6) applicable to certain 
health insurance providers, see Sec.  1.162-31.
    (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

[[Page 229]]

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 
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

[[Page 230]]

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. 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

[[Page 231]]

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 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),

[[Page 232]]

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 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

[[Page 233]]

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 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

[[Page 234]]

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. 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

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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 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

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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 
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.

[[Page 237]]

    (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. 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

[[Page 238]]

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 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.

[[Page 239]]

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.
    (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

[[Page 240]]

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 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

[[Page 241]]

    (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. 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

[[Page 242]]

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 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

[[Page 243]]

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, 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

[[Page 244]]

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).
    (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 the deduction for compensation that is otherwise deductible by 
the corporation in taxable years beginning on or after January 1, 1994, 
and beginning prior to January 1, 2018. Section 162(m)

[[Page 245]]

and this section also apply to compensation that is a grandfathered 
amount (as defined in Sec.  1.162-33(g)) at the time it is paid to the 
covered employee or otherwise deductible. For examples of the 
application of the rules of this section to grandfathered amounts paid 
during or otherwise deductible for taxable years beginning after 
December 31, 2017, see Sec.  1.162-33(g).
    (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 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

[[Page 246]]

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; T.D. 9932, 85 FR 86492, 
Dec. 30, 2020]



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.
    (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:

[[Page 247]]

[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).
    (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

[[Page 248]]

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:
[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

[[Page 249]]

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

                                                                                                  [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

[[Page 250]]

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--
    (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.

[[Page 251]]

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.
    (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

[[Page 252]]

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 (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

[[Page 253]]

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 
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

[[Page 254]]

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 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]

[[Page 255]]



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 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

[[Page 256]]

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.
    (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

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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 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

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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 
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

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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 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

[[Page 260]]

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 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)

[[Page 261]]

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 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).

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    (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 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-

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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 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

[[Page 264]]

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 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

[[Page 265]]

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 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

[[Page 266]]

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 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.

[[Page 267]]

    (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. 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

[[Page 268]]

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.
    (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

[[Page 269]]

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 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

[[Page 270]]

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 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

[[Page 271]]

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 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

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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 
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

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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 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

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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 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

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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 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.

[[Page 276]]

    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 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

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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 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

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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 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

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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 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

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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 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

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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 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

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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 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

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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) 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

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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 
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

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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 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

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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 (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

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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 
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

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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 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

[[Page 289]]

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. 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

[[Page 290]]

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 
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.

[[Page 291]]

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 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

[[Page 292]]

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 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

[[Page 293]]

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).

    (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.  1.162-33  Certain employee remuneration in excess of $1,000,000 
not deductible for taxable years beginning after December 31, 2017.

    (a) Scope. This section provides rules for the application of the $1 
million deduction limitation under section 162(m)(1) for taxable years 
beginning after December 31, 2017. For rules concerning the 
applicability of section 162(m)(1) to taxable years beginning on or 
after January 1, 1994, and prior to January 1, 2018, see Sec.  1.162-27. 
Paragraph (b) of this section provides the general rule limiting 
deductions under section 162(m)(1). Paragraph (c) of this section 
provides definitions of generally applicable terms. Paragraph (d) of 
this section provides rules for determining when a corporation becomes a 
publicly held corporation. Paragraph (e) of this section provides rules 
for payments that are subject to section 280G (golden parachute 
payments). Paragraph (f) of this section provides a special rule for 
coordination with section 4985 (stock compensation of insiders in 
expatriated corporations). Paragraph (g) of this section provides 
transition rules addressing the amendments made by Public Law 115-97, 
including the rules for contracts that are grandfathered. Paragraph (h) 
of this section sets forth the effective date provisions. For rules 
concerning the deductibility of compensation for services that are not 
covered by section 162(m)(1) 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). For rules 
concerning the deduction limitation under section 162(m)(6) applicable 
to certain health insurance providers, see Sec.  1.162-31. For purposes 
of this section, references to an amount being paid to an employee refer 
to the event that otherwise would result in the availability of a 
deduction to the employer with respect to such amount, whether that 
results from an actual payment in cash, transfer of property, or other 
event.
    (b) Limitation on deduction. Section 162(m)(1) 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 that issues securities 
required to be registered under section 12 of the Exchange Act or that 
is required to file reports under section 15(d) of the Exchange Act. In 
addition, a publicly held corporation means any S corporation (as 
defined in section 1361(a)(1)) that issues securities that are required 
to be registered under section 12(b) of the Exchange Act, or that is 
required to file reports under section 15(d) of the

[[Page 294]]

Exchange Act. 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 securities issued by the corporation are 
required to be registered under section 12 of the Exchange Act or the 
corporation is required to file reports under section 15(d) of the 
Exchange Act. Whether registration under the Exchange Act is required by 
rules other than those of the Exchange Act is irrelevant to this 
determination. A publicly traded partnership that is treated as a 
corporation under section 7704 (or otherwise) is a publicly held 
corporation if, as of the last day of its taxable year, its securities 
are required to be registered under section 12 of the Exchange Act or it 
is required to file reports under section 15(d) of the Exchange Act.
    (ii) Affiliated groups--(A) In general. A publicly held corporation 
includes an affiliated group of corporations (affiliated group), as 
defined in section 1504 (determined without regard to section 1504(b)), 
that includes one or more publicly held corporations (as defined in 
paragraph (c)(1)(i) of this section). In the case of an affiliated group 
that includes two or more publicly held corporations as defined in 
paragraph (c)(1)(i) of this section, each member of the affiliated group 
that is a publicly held corporation as defined in paragraph (c)(1)(i) of 
this section is separately subject to this section, and, due to having 
at least one member that is a publicly held corporation, the affiliated 
group as a whole is subject to this section. Thus, for example, assume 
that a publicly held corporation (as defined in paragraph (c)(1)(i) of 
this section) is a wholly-owned subsidiary of another publicly held 
corporation (as defined in paragraph (c)(1)(i) of this section), which 
is a wholly-owned subsidiary of a privately held corporation. In this 
case, the two subsidiaries are separately subject to this section, and 
all three corporations are members of an affiliated group that is 
subject to this section. If an individual is a covered employee of both 
subsidiaries, each subsidiary has its own $1 million deduction 
limitation with respect to that covered employee. Furthermore, each 
subsidiary has its own set of covered employees as defined in paragraphs 
(c)(2)(i) through (iv) of this section (although the same individual may 
be a covered employee of both subsidiaries).
    (B) Proration of amount disallowed as a deduction. If, in a taxable 
year, a covered employee (as defined in paragraphs (c)(2)(i) through (v) 
of this section) of one member of an affiliated group is paid 
compensation by more than one member of the 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 affiliated group (excluding compensation paid by any other publicly 
held corporation in the affiliated group, as defined in paragraph 
(c)(1)(i) of this section, of which the individual is also a covered 
employee as defined in paragraphs (c)(2)(i) through (v) of this 
section). In the event that, in a taxable year, a covered employee (as 
defined in paragraphs (c)(2)(i) through (v) of this section) is paid 
compensation by more than one publicly held corporation in an affiliated 
group and is also a covered employee of more than one publicly held 
payor corporation (as defined in paragraph (c)(1)(i) of this section) in 
the affiliated group, the amount disallowed as a deduction is determined 
separately with respect to each publicly held corporation of which the 
individual is a covered employee. Any amount disallowed as a deduction 
by this section must be prorated among the payor corporations (excluding 
any other publicly held payor corporation of which the individual is 
also a covered employee) in proportion to the amount of compensation 
paid to the covered employee (as defined in paragraphs (c)(2)(i) through 
(v) of this section) by each such corporation in the taxable year. For 
purposes of this paragraph (c)(1)(ii)(B), the amount of compensation 
treated as paid by a payor corporation that is not a publicly held 
corporation (as defined in paragraph (c)(1)(i) of this section) is 
determined by prorating the amount actually paid by that payor 
corporation in proportion to the total amount paid by all of the 
publicly held corporations of which the individual is a covered employee 
(as defined in paragraph

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(c)(2)(i) through (v) of this section). This process is repeated for 
each publicly held payor corporation of which the individual is a 
covered employee.
    (iii) Disregarded entities. For purposes of paragraph (c)(1) of this 
section, a publicly held corporation includes a corporation that owns an 
entity that is disregarded as an entity separate from its owner within 
the meaning of Sec.  301.7701-2(c)(2)(i) of this chapter if the 
disregarded entity issues securities required to be registered under 
section 12(b) of the Exchange Act, or is required to file reports under 
section 15(d) of the Exchange Act.
    (iv) Qualified subchapter S subsidiaries. For purposes of paragraph 
(c)(1) of this section, a publicly held corporation includes an S 
corporation that owns a qualified subchapter S subsidiary as defined in 
section 1361(b)(3)(B) (QSub) if the QSub issues securities required to 
be registered under section 12(b) of the Exchange Act, or is required to 
file reports under section 15(d) of the Exchange Act.
    (v) Qualified real estate investment trust subsidiaries. For 
purposes of paragraph (c)(1) of this section, a publicly held 
corporation includes a real estate investment trust as defined in 
section 856(a) that owns a qualified real estate investment trust 
subsidiary as defined in section 856(i)(2) (QRS), if the QRS issues 
securities required to be registered under section 12(b) of the Exchange 
Act or is required to file reports under section 15(d) of the Exchange 
Act.
    (vi) Examples. The following examples illustrate the provisions of 
this paragraph (c)(1). For each example, assume that no corporation is a 
predecessor of a publicly held corporation within the meaning of 
paragraph (c)(2)(ii) of this section. Furthermore, for each example, 
unless provided otherwise, a reference to a publicly held corporation 
means a publicly held corporation as defined in paragraph (c)(1)(i) of 
this section. Additionally, for each example, assume that the 
corporation is a calendar-year taxpayer and has a fiscal year ending 
December 31 for reporting purposes under the Exchange Act. The examples 
in this paragraph (c)(1)(vi) are not intended to provide guidance on the 
legal requirements of the Securities Act and Exchange Act and the rules 
thereunder (17 CFR part 240).
    (A) Example 1 (Corporation required to file reports under section 
15(d) of the Exchange Act)--(1) Facts. Corporation Z plans to issue debt 
securities in a public offering registered under the Securities Act. 
Corporation Z is not required to file reports under section 15(d) of the 
Exchange Act for any other class of securities and does not have another 
class of securities required to be registered under section 12 of the 
Exchange Act. On April 1, 2021, the SEC declares effective the 
Securities Act registration statement for Corporation Z's debt 
securities. As a result, Corporation Z is required to file reports under 
section 15(d) of the Exchange Act, and this requirement continues to 
apply as of December 31, 2021.
    (2) Conclusion. Corporation Z is a publicly held corporation for its 
2021 taxable year because it is required to file reports under section 
15(d) of the Exchange Act as of the last day of its taxable year.
    (B) Example 2 (Corporation not required to file reports under 
section 15(d) of the Exchange Act)--(1) Facts. The facts are the same as 
in paragraph (c)(1)(vi)(A) of this section (Example 1), except that, on 
January 1, 2022, pursuant to section 15(d) of the Exchange Act, 
Corporation Z's obligation to file reports under section 15(d) is 
automatically suspended for the fiscal year ending December 31, 2022, 
because Corporation Z meets the statutory requirements for an automatic 
suspension. As of December 31, 2022, Corporation Z is not required to 
file reports under section 15(d) of the Exchange Act.
    (2) Conclusion. Corporation Z is not a publicly held corporation for 
its 2022 taxable year because it is not required to file reports under 
section 15(d) of the Exchange Act as of as of the last day of its 
taxable year.
    (C) Example 3 (Corporation not required to file reports under 
section 15(d) of the Exchange Act)--(1) Facts. The facts are the same as 
in paragraph (c)(1)(vi)(B) of this section (Example 2), except that, on 
January 1, 2022, pursuant to section 15(d) of the Exchange Act, 
Corporation

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Z's obligation to file reports under section 15(d) is not automatically 
suspended for the fiscal year ending December 31, 2022. Instead, on May 
2, 2022, Corporation Z is eligible to suspend its section 15(d) 
reporting obligation under 17 CFR 240.12h-3 (Rule 12h-3 under the 
Exchange Act) and files Form 15, Certification and Notice of Termination 
of Registration under Section 12(g) of the Securities Exchange Act of 
1934 or Suspension of Duty to File Reports under Sections 13 and 15(d) 
of the Securities Exchange Act of 1934, (or its successor) to suspend 
its section 15(d) reporting obligation for its fiscal year ending 
December 31, 2022. As of December 31, 2022, Corporation Z is not 
required to file reports under section 15(d) of the Exchange Act.
    (2) Conclusion. Corporation Z is not a publicly held corporation for 
its 2022 taxable year because it is not required to file reports under 
section 15(d) of the Exchange Act as of the last day of its taxable 
year. If Corporation Z had not utilized Rule 12h-3 to suspend its 
section 15(d) reporting obligation, Corporation Z would be a publicly 
held corporation for its 2022 taxable year because it would have been 
required to file reports under section 15(d) of the Exchange Act as of 
the last day of its taxable year.
    (D) Example 4 (Corporation required to file reports under section 
15(d) of the Exchange Act)--(1) Facts. Corporation Y is a wholly-owned 
subsidiary of Corporation X, which is required to file reports under the 
Exchange Act. Corporation Y issued a class of debt securities in a 
public offering registered under the Securities Act, and therefore is 
required to file reports under section 15(d) of the Exchange Act for its 
fiscal year ending December 31, 2020. Corporation Y has no other class 
of securities registered under the Exchange Act. In its Form 10-K, 
Annual Report Pursuant to section 13 or section 15(d) of the Securities 
Exchange Act of 1934, (or its successor) for the 2020 fiscal year, 
Corporation Y may omit Item 11, Executive Compensation (required by Part 
III of Form 10-K), which requires disclosure of compensation of certain 
executive officers, because it is wholly-owned by Corporation X and the 
other conditions of General Instruction I to Form 10-K are satisfied.
    (2) Conclusion. Corporation Y is a publicly held corporation for its 
2020 taxable year because it is required to file reports under section 
15(d) of the Exchange Act as of the last day of its taxable year.
    (E) Example 5 (Corporation not required to file reports under 
section 15(d) of the Exchange Act and not required to register 
securities under section 12 of the Exchange Act)--(1) Facts. Corporation 
A has a class of securities registered under section 12(g) of the 
Exchange Act. For its 2020 taxable year, Corporation A is a publicly 
held corporation. On September 30, 2021, Corporation A is eligible to 
terminate the registration of its securities under section 12(g) of the 
Exchange Act pursuant to 17 CFR 240.12g-4(a)(2) (Rule 12g-4(a)(2) under 
the Exchange Act), but does not terminate the registration of its 
securities prior to December 31, 2021. Because Corporation A did not 
issue securities in a public offering registered under the Securities 
Act, Corporation A is not required to file reports under section 15(d) 
of the Exchange Act.
    (2) Conclusion. Corporation A is not a publicly held corporation for 
its 2021 taxable year because, as of the last day of its taxable year, 
the securities issued by Corporation A are not required to be registered 
under section 12 of the Exchange Act and Corporation A is not required 
to file reports under section 15(d) of the Exchange Act.
    (F) Example 6 (Corporation required to file reports under section 
15(d) of the Exchange Act)--(1) Facts. The facts are the same as in 
paragraph (c)(1)(vi)(E) of this section (Example 5), except that 
Corporation A previously issued a class of securities in a public 
offering registered under the Securities Act. Furthermore, on October 1, 
2021, Corporation A terminates the registration of its securities under 
section 12(g) of the Exchange Act. Because Corporation A issued a class 
of securities in a public offering registered under the Securities Act 
and is not eligible to suspend its reporting obligation under section 
15(d) of the Exchange Act, as of December 31, 2021, Corporation A is 
required to file reports under section 15(d) of the Exchange Act.

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    (2) Conclusion. Corporation A is a publicly held corporation for its 
2021 taxable year because it is required to file reports under section 
15(d) of the Exchange Act as of the last day of its taxable year.
    (G) Example 7 (Corporation not required to file reports under 
section 15(d) of the Exchange Act and not required to register 
securities under section 12 of the Exchange Act)--(1) Facts. On November 
1, 2021, Corporation B is an issuer with only one class of equity 
securities. On November 5, 2021, Corporation B files a registration 
statement for its equity securities under section 12(g) of the Exchange 
Act. Corporation B's filing of its registration statement is voluntary 
because the Exchange Act does not require Corporation B to register its 
class of securities under section 12(g) of the Exchange Act based on the 
number and composition of its record holders. On December 1, 2021, the 
SEC declares effective the Exchange Act registration statement for 
Corporation B's securities. As of December 31, 2021, Corporation B 
continues to have its class of equity securities registered voluntarily 
under section 12 of the Exchange Act. Corporation B is not required to 
file reports under section 15(d) of the Exchange Act because it did not 
register any class of securities in a public offering under the 
Securities Act.
    (2) Conclusion. Corporation B is not a publicly held corporation for 
its 2021 taxable year because, as of the last day of that taxable year, 
the securities issued by Corporation B are not required to be registered 
under section 12 of the Exchange Act and Corporation B is not required 
to file reports under section 15(d) of the Exchange Act.
    (H) Example 8 (Corporation not required to file reports under 
section 15(d) of the Exchange Act and not required to register 
securities under section 12 of the Exchange Act)--(1) Facts. The facts 
are the same as in paragraph (c)(1)(vi)(G) of this section (Example 7), 
except that, on December 31, 2022, because of a change in circumstances, 
Corporation B must register its class of equity securities under section 
12(g) of the Exchange Act within 120 days of December 31, 2022. On 
February 1, 2023, the SEC declares effective the Exchange Act 
registration statement for Corporation B's securities.
    (2) Conclusion. Corporation B is not a publicly held corporation for 
its 2022 taxable year because, as of the last day of that taxable year, 
Corporation B is not required to file reports under section 15(d) of the 
Exchange Act and the class of equity securities issued by Corporation B 
is not yet required to be registered under section 12 of the Exchange 
Act.
    (I) Example 9 (Securities of foreign private issuer in the form of 
ADRs traded in the over-the-counter market)--(1) Facts. For its fiscal 
and taxable years ending December 31, 2021, Corporation W is a foreign 
private issuer. Because Corporation W has not registered an offer or 
sale of securities under the Securities Act, it is not required to file 
reports under section 15(d) of the Exchange Act. Corporation W qualifies 
for an exemption from registration of its securities under section 12(g) 
of the Exchange Act pursuant to 17 CFR 240.12g3-2(b) (Rule 12g3-2(b) 
under the Exchange Act). Corporation W wishes to have its securities 
traded in the U.S. in the over-the-counter market in the form of ADRs. 
Because Corporation W qualifies for an exemption pursuant to Rule 12g3-
2(b), Corporation W is not required to register its securities 
underlying the ADRs under section 12 of the Exchange Act; however, the 
depositary bank is required to register the ADRs under the Securities 
Act. Even though the depositary bank is required to register the ADRs 
under the Securities Act, the registration of the ADRs does not result 
in either the depositary bank or Corporation W being required to file 
reports under section 15(d) of the Exchange Act. On February 3, 2021, 
the SEC declares effective the Securities Act registration statement for 
the ADRs. On February 4, 2021, Corporation W's ADRs begin trading in the 
over-the-counter market. On December 31, 2021, the securities of 
Corporation W are not required to be registered under section 12 of the 
Exchange Act because Corporation W qualifies for an exemption pursuant 
to Rule 240.12g3-2(b). Furthermore, on December 31, 2021, Corporation W 
is not required to file reports under section 15(d) of the Exchange Act.

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    (2) Conclusion. Corporation W is not a publicly held corporation for 
its 2021 taxable year because, as of the last day of that taxable year, 
the securities underlying the ADRs are not required to be registered 
under section 12 of the Exchange Act and Corporation W is not required 
to file reports under section 15(d) of the Exchange Act. The result 
would be the same if Corporation W had its securities traded in the 
over-the-counter market other than in the form of ADRs.
    (J) Example 10 (Securities of foreign private issuer in the form of 
ADRs quoted on Over the Counter Bulletin Board)--(1) Facts. The facts 
are the same as in paragraph (c)(1)(vi)(I) of this section (Example 9), 
except that Corporation W has its securities quoted on the Over the 
Counter Bulletin Board (OTCBB) in the form of ADRs. Because Corporation 
W qualifies for an exemption pursuant to 17 CFR 240.12g3-2(b) (Rule 
12g3-2(b) under the Exchange Act), Corporation W is not required to 
register its securities underlying the ADRs under section 12 of the 
Exchange Act. However, the depositary bank is required to register the 
ADRs under the Securities Act. In addition, section 6530(b)(1) of the 
OTCBB Rules requires that a foreign equity security may be quoted on the 
OTCBB only if the security is registered with the SEC pursuant to 
section 12 of the Exchange Act and the issuer of the security is current 
in its reporting obligations. To comply with the OTCBB Rules, on 
February 5, 2021, Corporation W files a registration statement for its 
class of securities underlying the ADRs under section 12(g) of the 
Exchange Act. On February 26, 2021, the SEC declares effective the 
Exchange Act registration statement for Corporation W's securities. As 
of December 31, 2021, Corporation W is subject to the reporting 
obligations under section 12 of the Exchange Act as a result of the 
section 12 registration.
    (2) Conclusion. Corporation W is not a publicly held corporation for 
its 2021 taxable year because, as of the last day of that taxable year, 
its ADRs and the securities underlying the ADRs are not required by the 
Exchange Act to be registered under section 12 and Corporation W is not 
required to file reports under section 15(d) of the Exchange Act. The 
Securities Act requirement applicable to the bank pursuant to the OTCBB 
rules is irrelevant. The result would be the same if Corporation W had 
its securities traded on the OTCBB other than in the form of ADRs.
    (K) Example 11 (Securities of foreign private issuer in the form of 
ADRs listed on a national securities exchange without a capital raising 
transaction)--(1) Facts. For its fiscal and taxable years ending 
December 31, 2021, Corporation V is a foreign private issuer. 
Corporation V wishes to list its securities on the New York Stock 
Exchange (NYSE) in the form of ADRs without a capital raising 
transaction. Under the Exchange Act, Corporation V is required to 
register its securities underlying the ADRs under section 12(b) of the 
Exchange Act. Because the ADRs and the deposited securities are separate 
securities, the depositary bank is required to register the ADRs under 
the Securities Act. On February 2, 2021, the SEC declares effective 
Corporation V's registration statement under section 12(b) of the 
Exchange Act in connection with the underlying securities, and the 
depositary bank's registration statement under the Securities Act in 
connection with the ADRs. On March 1, 2021, Corporation V's securities 
begin trading on the NYSE in the form of ADRs. As of December 31, 2021, 
Corporation V is not required to file reports under section 15(d) of the 
Exchange Act; however, the securities underlying the ADRs are required 
to be registered under section 12(b) of the Exchange Act.
    (2) Conclusion. Corporation V is a publicly held corporation for its 
2021 taxable year because, as of the last day of that taxable year, the 
securities underlying the ADRs are required to be registered under 
section 12 of the Exchange Act. The result would be the same if 
Corporation V had its securities listed on the NYSE other than in the 
form of ADRs. The result also would be the same if Corporation V had 
wished to raised capital during its 2021 taxable year and been required 
to register the offer of securities underlying the ADRs under the 
Securities Act and to register the class of those securities under 
section 12(b) of the Exchange

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Act, and the depositary bank was required to register the ADRs under the 
Securities Act.
    (L) Example 12 (Foreign private issuer incorporates subsidiary in 
the United States to issue debt securities and subsequently issues a 
guarantee)--(1) Facts. For its fiscal and taxable years ending December 
31, 2021, Corporation T is a foreign private issuer. Corporation T 
wishes to access the U.S. capital markets. Corporation T incorporates 
Corporation U, a wholly-owned subsidiary, in the U.S. to issue debt 
securities. On January 15, 2021, the SEC declares effective Corporation 
U's Securities Act registration statement. To enhance Corporation U's 
credit and the marketability of Corporation U's debt securities, 
Corporation T issues a guarantee of Corporation U's securities and, as 
required, registers the guarantee under the Securities Act on 
Corporation U's registration statement. On December 31, 2021, 
Corporations T and U are required to file reports under section 15(d) of 
the Exchange Act.
    (2) Conclusion. Corporations T and U are publicly held corporations 
for their 2021 taxable years because they are required to file reports 
under section 15(d) of the Exchange Act as of the last day of their 
taxable years.
    (M) Example 13 (Affiliated group comprised of two corporations, one 
of which is a publicly held corporation)--(1) Facts. Employee D, a 
covered employee of Corporation N, receives compensation from, 
Corporations N and O, members of an affiliated group. Corporation N, the 
parent corporation, is a publicly held corporation. Corporation O is a 
direct subsidiary of Corporation N and is a privately held corporation. 
The total compensation paid to Employee D from the affiliated group 
members is $3,000,000 for the taxable year, of which Corporation N pays 
$2,100,000 and Corporation O pays $900,000.
    (2) Conclusion. Because the compensation paid by all affiliated 
group members is aggregated for purposes of section 162(m)(1), 
$2,000,000 of the aggregate compensation paid is nondeductible. 
Corporations N and O each are treated as paying a ratable portion of the 
nondeductible compensation. Thus, two thirds of each corporation's 
payment will be nondeductible. Corporation N has a nondeductible 
compensation expense of $1,400,000 ($2,100,000 x $2,000,000/$3,000,000). 
Corporation O has a nondeductible compensation expense of $600,000 
($900,000 x $2,000,000/$3,000,000).
    (N) Example 14 (Affiliated group comprised of two corporations, one 
of which is a publicly held corporation)--(1) Facts. The facts are the 
same as in paragraph (c)(1)(vi)(M) of this section (Example 13), except 
that Corporation O is a publicly held corporation, Corporation N is a 
privately held corporation, and Employee D is a covered employee of 
Corporation O (instead of Corporation N).
    (2) Conclusion. The result is the same as in paragraph (c)(1)(vi)(M) 
of this section (Example 13). Even though subsidiary Corporation O is 
the publicly held corporation, Corporations N and O still comprise an 
affiliated group. Accordingly, $2,000,000 of the aggregate compensation 
paid is nondeductible, and Corporations N and O each are treated as 
paying a ratable portion of the nondeductible compensation.
    (O) Example 15 (Affiliated group comprised of two publicly held 
corporations)--(1) Facts. The facts are the same as in paragraph 
(c)(1)(vi)(M) of this section (Example 13), except that Corporation O is 
a publicly held corporation. As in paragraph (c)(1)(vi)(M) of this 
section (Example 13), Employee D is not a covered employee of 
Corporation O.
    (2) Conclusion. The result is the same as in paragraph (c)(1)(vi)(M) 
of this section (Example 13). Even though Corporations N and O each are 
publicly held corporations, Corporations N and O comprise an affiliated 
group for purposes of prorating the amount disallowed as a deduction. 
Accordingly, $2,000,000 of the aggregate compensation paid is 
nondeductible, and Corporations N and O each are treated as paying a 
ratable portion of the nondeductible compensation.
    (P) Example 16 (Affiliated group comprised of two publicly held 
corporations)--(1) Facts. The facts are the same as in paragraph 
(c)(1)(vi)(O) of this section (Example 15), except that Employee D also 
is a covered employee of Corporation O.
    (2) Conclusion. Corporations N and O each are publicly held 
corporations and separately subject to this section, but

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also comprise an affiliated group. Because Employee D is a covered 
employee of both Corporations N and O, each of which is a separate 
publicly held corporation, the determination of the amount disallowed as 
a deduction is made separately for each publicly held corporation. 
Corporation N has a nondeductible compensation expense of $1,100,000 
(the excess of $2,100,000 over $1,000,000), and Corporation O has no 
nondeductible compensation expense because the amount it paid to 
Employee D did not exceed $1,000,000.
    (Q) Example 17 (Affiliated group comprised of three corporations, 
one of which is a publicly held corporation)--(1) Facts. Employee C, a 
covered employee of publicly held parent Corporation P, receives 
compensation from Corporations P, Q, and R, members of an affiliated 
group. Corporation Q is a direct subsidiary of Corporation P, and 
Corporation R is a direct subsidiary of Corporation Q. Corporations Q 
and R both are privately held. The total compensation paid to Employee C 
from the affiliated group members is $3,000,000 for the taxable year, of 
which Corporation P pays $1,500,000, Corporation Q pays $900,000, and 
Corporation R pays $600,000.
    (2) Conclusion. Because the compensation paid by affiliated group 
members is aggregated for purposes of section 162(m)(1), $2,000,000 of 
the aggregate compensation paid is nondeductible. Corporations P, Q, and 
R each are treated as paying a ratable portion of the nondeductible 
compensation. Thus, two thirds of each corporation's payment will be 
nondeductible. The nondeductible compensation expense for Corporation P 
is $1,000,000 ($1,500,000 x $2,000,000/$3,000,000); for Corporation Q is 
$600,000 ($900,000 x $2,000,000/$3,000,000); and for Corporation R is 
$400,000 ($600,000 x $2,000,000/$3,000,000).
    (R) Example 18 (Affiliated group comprised of three corporations, 
one of which is a publicly held corporation)--(1) Facts. The facts are 
the same as in paragraph (c)(1)(vi)(Q) of this section (Example 17), 
except that Corporation Q is a publicly held corporation and Corporation 
P is a privately held corporation, and Employee C is a covered employee 
of Corporation Q (instead of Corporation P).
    (2) Conclusion. The result is the same as in paragraph (c)(1)(vi)(Q) 
of this section (Example 17). Even though Corporation Q, the subsidiary, 
is the publicly held corporation, Corporations P, Q, and R comprise an 
affiliated group. Accordingly, $2,000,000 of the aggregate compensation 
paid is nondeductible, and Corporations P, Q, and R each are treated as 
paying a ratable portion of the nondeductible compensation.
    (S) Example 19 (Affiliated group comprised of three corporations, 
two of which are publicly held corporations)--(1) Facts. The facts are 
the same as in paragraph (c)(1)(vi)(R) of this section (Example 18), 
except that Corporation R also is a publicly held corporation. As in 
paragraph (c)(1)(vi)(R) of this section (Example 18), Corporation Q is a 
publicly held corporation, Corporation P is a privately held 
corporation, and Employee C is a covered employee of Corporation Q but 
not a covered employee of Corporation R.
    (2) Conclusion. The result is the same as in paragraph (c)(1)(vi)(R) 
of this section (Example 18). Even though Corporation R also is a 
publicly held corporation, Corporations P, Q, and R comprise an 
affiliated group. Accordingly, $2,000,000 of the aggregate compensation 
paid is nondeductible, and Corporations P, Q, and R each are treated as 
paying a ratable portion of the nondeductible compensation.
    (T) Example 20 (Affiliated group comprised of three publicly held 
corporations)--(1) Facts. The facts are the same as in paragraph 
(c)(1)(vi)(Q) of this section (Example 17), except that Corporations Q 
and R also are publicly held corporations, and Employee C is a covered 
employee of both Corporations P and Q but is not a covered employee of 
Corporation R.
    (2) Conclusion. Even though Corporations P, Q, and R each are 
publicly held corporations, they comprise an affiliated group. Because 
Employee C is a covered employee of both Corporations P and Q, the 
determination of the amount disallowed as a deduction is separately 
prorated among Corporations P and R and among Corporations Q and R. For 
each separate calculation of the total amount of the disallowed 
deduction and the proration of the disallowed deduction, the amount paid 
by

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Corporation R is taken into account in proportion to the total 
compensation paid by Corporations P and Q. With respect to Corporations 
P and R, $875,000 of the aggregate compensation is nondeductible (the 
excess of $1,875,000 (the sum of the compensation paid by Corporation P 
($1,500,000) and the portion of compensation paid by Corporation R that 
is treated as allocable to Employee C being a covered employee of 
Corporation P ($600,000 x $1,500,000/($1,500,000 + $900,000) = $375,000) 
over the $1,000,000 deduction limitation). Corporations P and R each are 
treated as paying a ratable portion of the nondeductible compensation. 
Corporation P has a nondeductible compensation expense of $700,000 
($1,500,000 x $875,000/$1,875,000), and Corporation R has a 
nondeductible compensation expense of $175,000 ($375,000 x $875,000/
$1,875,000). For Corporations Q and R, $125,000 of the aggregate 
compensation is nondeductible (the excess of $1,125,000 (the sum of the 
compensation paid by Corporation Q ($900,000) and the portion of 
compensation paid by Corporation R that is treated as allocable to 
Employee C being a covered employee of Corporation Q ($600,000 x 
$900,000/($1,500,000 + $900,000) = $225,000) over the $1,000,000 
deduction limitation). Corporation Q has a nondeductible compensation 
expense of $100,000 ($900,000 x $125,000/$1,125,000), and Corporation R 
has a nondeductible compensation expense of $25,000 ($225,000 x 
$125,000/$1,125,000). The total nondeductible compensation expense for 
Corporation R is $200,000.
    (U) Example 21 (Affiliated group comprised of three publicly held 
corporations)--(1) Facts. The facts are the same as in paragraph 
(c)(1)(vi)(T) of this section (Example 20), except that Employee C does 
not receive any compensation from Corporation R.
    (2) Conclusion. Even though Corporations P, Q, and R each are 
publicly held corporations and separately subject to this section, they 
comprise an affiliated group. Because Employee C is a covered employee 
of, and receives compensation from, both Corporations P and Q, each of 
which is a separate publicly held corporation, the determination of the 
amount disallowed as a deduction is made separately for Corporations P 
and Q. Corporation P has a nondeductible compensation expense of 
$500,000 (the excess of $1,500,000 over $1,000,000), and Corporation Q 
has no nondeductible compensation expense because the amount it paid to 
Employee C was below $1,000,000.
    (V) Example 22 (Affiliated group comprised of three corporations, 
one of which is a publicly held corporation)--(1) Facts. The facts are 
the same as in paragraph (c)(1)(vi)(Q) of this section (Example 17), 
except that Corporation R is a direct subsidiary of Corporation P (and 
not a direct subsidiary of Corporation Q).
    (2) Conclusion. The result is the same as in paragraph (c)(1)(vi)(Q) 
of this section (Example 17). Corporations P, Q, and R comprise an 
affiliated group. Accordingly, $2,000,000 of the aggregate compensation 
paid is nondeductible, and Corporations P, Q, and R each are treated as 
paying a ratable portion of the nondeductible compensation.
    (W) Example 23 (Affiliated group comprised of three publicly held 
corporations)--(1) Facts. The facts are the same as in paragraph 
(c)(1)(vi)(V) of this section (Example 22), except that Corporations Q 
and R also are publicly held corporations, and Employee C is a covered 
employee of both Corporations P and Q but not of Corporation R.
    (2) Conclusion. The result is the same as in paragraph (c)(1)(vi)(V) 
of this section (Example 22). Even though Corporations P, Q, and R each 
are publicly held corporations, they comprise an affiliated group. 
Because Employee C is a covered employee of both Corporations P and Q, 
the amount disallowed as a deduction is prorated separately among 
Corporations P and R and among Corporations Q and R.
    (X) Example 24 (Disregarded entity)--(1) Facts. Corporation G is 
privately held for its 2020 taxable year. Entity H, a limited liability 
company, is wholly-owned by Corporation G and is disregarded as an 
entity separate from its owner under Sec.  301.7701-2(c)(2)(i) of this 
chapter. As of December 31, 2020, Entity H is required to file reports 
under section 15(d) of the Exchange Act.
    (2) Conclusion. Because Entity H is required to file reports under 
section 15(d) of the Exchange Act and is disregarded as an entity 
separate from its owner, Corporation G is a publicly held

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corporation for its 2020 taxable year. The result would be the same if 
Corporation G was a REIT under section 856(a) and Entity H was a QRS 
under section 856(i)(2).
    (2) Covered employee--(i) General rule. Except as provided in 
paragraph (c)(2)(vi) of this section, with respect to a publicly held 
corporation as defined in paragraph (c)(1) of this section (without 
regard to paragraph (c)(1)(ii) of this section), for the publicly held 
corporation's taxable year, a covered employee means any of the 
following--
    (A) The principal executive officer (PEO) or principal financial 
officer (PFO) of the publicly held corporation serving at any time 
during the taxable year, including individuals acting in either such 
capacity.
    (B) The three highest compensated executive officers of the publicly 
held corporation for the taxable year (other than the principal 
executive officer or principal financial officer, or an individual 
acting in such capacity), regardless of whether the executive officer is 
serving at the end of the publicly held corporation's taxable year, and 
regardless of whether the executive officer's compensation is subject to 
disclosure for the last completed fiscal year under the executive 
compensation disclosure rules under the Exchange Act. For purposes of 
this paragraph (c)(2)(i)(B), the term ``executive officer'' means an 
executive officer as defined in 17 CFR 240.3b-7. The amount of 
compensation used to identify the three most highly compensated 
executive officers for the taxable year is determined pursuant to the 
executive compensation disclosure rules under the Exchange Act (using 
the taxable year as the fiscal year for purposes of making the 
determination), regardless of whether the corporation's fiscal year and 
taxable year end on the same date.
    (C) Any individual who was a covered employee of the publicly held 
corporation (or any predecessor of a publicly held corporation, within 
the meaning of paragraph (c)(2)(ii) of this section) for any preceding 
taxable year beginning after December 31, 2016. For taxable years 
beginning prior to January 1, 2018, covered employees are identified in 
accordance with the rules in Sec.  1.162-27(c)(2).
    (ii) Predecessor of a publicly held corporation--(A) Publicly held 
corporations that become privately held. For purposes of this paragraph 
(c)(2)(ii), a predecessor of a publicly held corporation includes a 
publicly held corporation that, after becoming a privately held 
corporation, again becomes a publicly held corporation for a taxable 
year ending before the 36-month anniversary of the due date for the 
corporation's U.S. Federal income tax return (disregarding any 
extensions) for the last taxable year for which the corporation was 
previously publicly held.
    (B) Corporate reorganizations. A predecessor of a publicly held 
corporation includes a publicly held corporation the stock or assets of 
which are acquired in a corporate reorganization (as defined in section 
368(a)(1)).
    (C) Corporate divisions. A predecessor of a publicly held 
corporation includes a publicly held corporation that is a distributing 
corporation (within the meaning of section 355(a)(1)(A)) that 
distributes the stock of a controlled corporation (within the meaning of 
section 355(a)(1)(A)) to its shareholders in a distribution or exchange 
qualifying under section 355(a)(1) (corporate division). The rule of 
this paragraph (c)(2)(ii)(C) applies only with respect to covered 
employees of the distributing corporation who begin performing services 
for the controlled corporation (or for a corporation affiliated with the 
controlled corporation that receives stock of the controlled corporation 
in the corporate division) within the period beginning 12 months before 
and ending 12 months after the distribution.
    (D) Affiliated groups. A predecessor of a publicly held corporation 
includes any other publicly held corporation that becomes a member of 
its affiliated group (as defined in paragraph (c)(1)(ii) of this 
section).
    (E) Asset acquisitions. If a publicly held corporation, including 
one or more members of an affiliated group as defined in paragraph 
(c)(1)(ii) of this section (acquiror), acquires at least 80% of the 
gross operating assets (determined by fair market value on the date of 
acquisition) of another publicly held corporation (target), then the 
target is a predecessor of the acquiror.

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For an acquisition of assets that occurs over time, only assets acquired 
within a 12-month period are taken into account to determine whether at 
least 80% of the target's gross operating assets were acquired. However, 
this 12-month period is extended to include any continuous period that 
ends on, or begins on, any day during which the acquiror has an 
arrangement to purchase, directly or indirectly, assets of the target. A 
shareholder's additions to the assets of target made as part of a plan 
or arrangement to avoid the application of this subsection to acquiror's 
purchase of target's assets are disregarded in applying this paragraph 
(c)(2)(ii)(E). This paragraph (c)(2)(ii)(E) applies only with respect to 
the target's covered employees who begin performing services for the 
acquiror (or a corporation affiliated with the acquiror) within the 
period beginning 12 months before and ending 12 months after the date of 
the transaction as defined in paragraph (c)(2)(ii)(I) of this section 
(incorporating any extensions to the 12-month period made pursuant to 
this paragraph).
    (F) Predecessor of a predecessor. For purposes of this paragraph 
(c)(2)(ii), a predecessor of a corporation includes each predecessor of 
the corporation and the predecessor or predecessors of any prior 
predecessor or predecessors.
    (G) Corporations that are not publicly held at the time of the 
transaction and sequential transactions--(1) Predecessor corporation is 
not publicly held at the time of the transaction. This paragraph 
(c)(2)(ii)(G)(1) applies if a corporation that was previously publicly 
held (the first corporation) would be a predecessor to another 
corporation (the second corporation) under the rules of this paragraph 
(c)(2)(ii) but for the fact that the first corporation is not a publicly 
held corporation at the time of the relevant transaction (or 
transactions). If this paragraph (c)(2)(ii)(G)(1) applies, the first 
corporation is a predecessor of a publicly held corporation if the 
second corporation is a publicly held corporation at the time of the 
relevant transaction (or transactions) and the relevant transaction (or 
transactions) take place during a taxable year ending before the 36-
month anniversary of the due date for the first corporation's U.S. 
Federal income tax return (excluding any extensions) for the last 
taxable year for which the first corporation was previously publicly 
held.
    (2) Second corporation is not publicly held at the time of the 
transaction. This paragraph (c)(2)(ii)(G)(2) applies if a corporation 
that is publicly held (the first corporation) at the time of the 
relevant transaction (or transactions) would be a predecessor to another 
corporation (the second corporation) under the rules of this paragraph 
(c)(2)(ii) but for the fact that the second corporation is not a 
publicly held corporation at the time of the relevant transaction (or 
transactions). If this paragraph (c)(2)(ii)(G)(2) applies, the first 
corporation is a predecessor of a publicly held corporation if the 
second corporation becomes a publicly held corporation for a taxable 
year ending before the 36-month anniversary of the due date for the 
first corporation's U.S. Federal income tax return (excluding any 
extensions) for the first corporation's last taxable year in which the 
transaction is taken into account.
    (3) Neither corporation is publicly held at the time of the 
transaction. This paragraph (c)(2)(ii)(G)(3) applies if a corporation 
that was previously publicly held (the first corporation) would be a 
predecessor to another corporation (the second corporation) under the 
rules of this paragraph (c)(2)(ii) but for the fact that neither the 
first corporation nor the second corporation is a publicly held 
corporation at the time of the relevant transaction (or transactions). 
If this paragraph (c)(2)(ii)(G)(3) applies, the first corporation is a 
predecessor of a publicly held corporation if the second corporation 
becomes a publicly held corporation for a taxable year ending before the 
36-month anniversary of the due date for the first corporation's U.S. 
Federal income tax return (excluding any extensions) for the last 
taxable year for which the first corporation was previously publicly 
held.
    (4) Sequential transactions. If a corporation that was previously 
publicly held (the first corporation) would be a predecessor to another 
corporation (the second corporation) under the rules of this paragraph 
(c)(2)(ii) but for the fact

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that the first corporation is (or its assets are) transferred to one or 
more intervening corporations prior to being transferred to the second 
corporation, and if each intervening corporation would be a predecessor 
of a publicly held corporation with respect to the second corporation if 
the intervening corporation or corporations were publicly held 
corporations, then paragraphs (c)(2)(ii)(G)(1) through (3) of this 
section also apply without regard to the intervening corporations.
    (H) Elections under sections 336(e) and 338. For purposes of this 
paragraph (c)(2), if a corporation makes an election to treat as an 
asset purchase either the sale, exchange, or distribution of stock 
pursuant to regulations under section 336(e) (Sec. Sec.  1.336-1 through 
1.336-5) or the purchase of stock pursuant to regulations under section 
338 (Sec. Sec.  1.338-1 through 1.338-11, 1.338(h)(10)-1, and 1.338(i)-
1), the corporation that issued the stock is treated as the same 
corporation both before and after such transaction.
    (I) Date of transaction. For purposes of this paragraph (c)(2)(ii), 
the date that a transaction is treated as having occurred is the date on 
which all events necessary for the transaction to be described in the 
relevant provision in this paragraph (c)(2)(ii) have occurred.
    (J) Publicly traded partnership. For purposes of applying this 
paragraph (c)(2)(ii), a publicly traded partnership is a predecessor of 
a publicly held corporation if under the same facts and circumstances a 
corporation substituted for the publicly traded partnership would be a 
predecessor of the publicly held corporation, and at the time of the 
transaction the publicly traded partnership is treated as a publicly 
held corporation as defined in paragraph (c)(1)(i) of this section. In 
making this determination, the rules in paragraphs (c)(2)(ii)(A) through 
(I) of this section apply by analogy to publicly traded partnerships.
    (iii) Disregarded entities. If a publicly held corporation under 
paragraph (c)(1) of this section owns an entity that is disregarded as 
an entity separate from its owner under Sec.  301.7701-2(c)(2)(i) of 
this chapter, then the covered employees of the publicly held 
corporation are determined pursuant to paragraphs (c)(2)(i) and (ii) of 
this section. The executive officers of the entity that is disregarded 
as an entity separate from its corporate owner under Sec.  301.7701-
2(c)(2)(i) of this chapter are neither covered employees of the entity 
nor of the publicly held corporation unless they meet the definition of 
covered employee in paragraphs (c)(2)(i) and (ii) of this section with 
respect to the publicly held corporation, in which case they are covered 
employees for its taxable year.
    (iv) Qualified subchapter S subsidiaries. If a publicly held 
corporation under paragraph (c)(1) of this section owns an entity that 
is a QSub under section 1361(b)(3)(B), then the covered employees of the 
publicly held corporation are determined pursuant to paragraphs 
(c)(2)(i) and (ii) of this section. The executive officers of the QSub 
are neither covered employees of the QSub nor of the publicly held 
corporation unless they meet the definition of covered employee in 
paragraphs (c)(2)(i) and (ii) of this section with respect to the 
publicly held corporation, in which case they are covered employees for 
the taxable year of the publicly held corporation.
    (v) Qualified real estate investment trust subsidiaries. If a 
publicly held corporation under paragraph (c)(1) of this section owns an 
entity that is a QRS under section 856(i)(2), then the covered employees 
of the publicly held corporation are determined pursuant to paragraphs 
(c)(2)(i) and (ii) of this section. The executive officers of the QRS 
are neither covered employees of the QRS nor of the publicly held 
corporation unless they meet the definition of covered employee in 
paragraphs (c)(2)(i) and (ii) of this section with respect to the 
publicly held corporation, in which case they are covered employees for 
the taxable year of the publicly held corporation.
    (vi) Covered employee of an affiliated group. A person who is 
identified as a covered employee in paragraphs (c)(2)(i) through (v) of 
this section for a publicly held corporation's taxable year is also a 
covered employee for the taxable year of an affiliated group treated as 
a publicly held corporation pursuant to paragraph (c)(1)(ii) of this

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section (treatment of an affiliated group).
    (vii) Examples. The following examples illustrate the provisions of 
this paragraph (c)(2). For each example, assume that the corporation has 
a taxable year that is a calendar year and has a fiscal year ending 
December 31 for reporting purposes under the Exchange Act. Also, for 
each example, unless provided otherwise, assume that none of the 
employees were covered employees for any taxable year preceding the 
first taxable year set forth in that example (since being a covered 
employee for a preceding taxable year would provide a separate, 
independent basis for classifying that employee as a covered employee 
for a subsequent taxable year).
    (A) Example 1 (Covered employees of members of an affiliated 
group)--(1) Facts. Corporations A, B, and C are direct wholly-owned 
subsidiaries of Corporation D. Corporations D and A are each publicly 
held corporations as of December 31, 2020. Corporations B and C are not 
publicly held corporations for their 2020 taxable years. Employee E 
served as the PEO of Corporation D from January 1, 2020, to March 31, 
2020. Employee F served as the PEO of Corporation D from April 1, 2020, 
to December 31, 2020. Employee G served as the PEO of Corporation A for 
its entire 2020 taxable year. Employee H served as the PEO of 
Corporation B for its entire 2020 taxable year. Employee I served as the 
PEO of Corporation C for its entire 2020 taxable year. From April 1, 
2020, through September 30, 2020, Employee E served as an advisor (not 
as a PEO) to Employee I and received compensation from Corporation C for 
these services. In 2020, all four corporations paid compensation to 
their respective PEOs.
    (2) Conclusion (Employees E and F). Because both Employees E and F 
served as the PEO of Corporation D during its 2020 taxable year, both 
Employees E and F are covered employees of Corporation D for its 2020 
and subsequent taxable years.
    (3) Conclusion (Employee G). Because Employee G served as the PEO of 
Corporation A, Employee G is a covered employee of Corporation A for its 
2020 and subsequent taxable years.
    (4) Conclusion (Employee H). Even though Employee H served as the 
PEO of Corporation B, Employee H is not a covered employee of 
Corporation B for its 2020 taxable year, because Corporation B is 
considered a publicly held corporation solely by reason of being a 
member of an affiliated group as defined in paragraph (c)(1)(ii) of this 
section.
    (5) Conclusion (Employee I). Even though Employee I served as the 
PEO of Corporation C, Employee I is not a covered employee of 
Corporation C for its 2020 taxable year, because Corporation C is 
considered a publicly held corporation solely by reason of being a 
member of an affiliated group as defined in paragraph (c)(1)(ii) of this 
section.
    (B) Example 2 (Covered employees of a publicly held corporation)--
(1) Facts. Corporation J is a publicly held corporation. Corporation J 
is not a smaller reporting company or emerging growth company for 
purposes of reporting under the Exchange Act. For 2020, Employee K 
served as the sole PEO of Corporation J and Employees L and M both 
served as the PFO of Corporation J at separate times during the year. 
Employees N, O, and P were, respectively, the first, second, and third 
highest compensated executive officers of Corporation J for 2020 other 
than the PEO and PFO, and all three retired before December 31, 2020. 
Employees Q, R, and S were, respectively, Corporation J's fourth, fifth, 
and sixth highest compensated executive officers other than the PEO and 
PFO for 2020, and all three were serving as of December 31, 2020. On 
March 1, 2021, Corporation J filed its Form 10-K, Annual Report Pursuant 
to Section 13 or 15(d) of the Securities Exchange Act of 1934 with the 
SEC. With respect to Item 11, Executive Compensation (as required by 
Part III of Form 10-K, or its successor), Corporation J disclosed the 
compensation of Employee K for serving as the PEO, Employees L and M for 
serving as the PFO, and Employees Q, R, and S pursuant to 17 CFR 
229.402(a)(3)(iii) (Item 402 of Regulation S-K). Corporation J also 
disclosed the compensation of Employees N and O pursuant to 17 CFR 
229.402(a)(3)(iv) (Item 402 of Regulation S-K).

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    (2) Conclusion (Employee K). Because Employee K served as the PEO 
during 2020, Employee K is a covered employee for Corporation J's 2020 
taxable year.
    (3) Conclusion (Employees L and M). Because Employees L and M served 
as the PFO during 2020, Employees L and M are covered employees for 
Corporation J's 2020 taxable year.
    (4) Conclusion (Employees N, O, P, Q, R, and S). Even though the 
executive compensation disclosure rules under the Exchange Act require 
Corporation J to disclose the compensation of Employees N, O, Q, R, and 
S for 2020, Corporation J's three highest compensated executive officers 
who are covered employees for its 2020 taxable year are Employees N, O, 
and P, because these are the three highest compensated executive 
officers other than the PEO and PFO for 2020.
    (C) Example 3 (Covered employees of a smaller reporting company)--
(1) Facts. The facts are the same as in paragraph (c)(2)(vii)(B) of this 
section (Example 2), except that Corporation J is a smaller reporting 
company or emerging growth company for purposes of reporting under the 
Exchange Act. With respect to Item 11, Executive Compensation, 
Corporation J disclosed the compensation of Employee K for serving as 
the PEO, Employees Q and R pursuant to 17 CFR 229.402(m)(2)(ii) (Item 
402(m) of Regulation S-K), and Employees N and O pursuant to 17 CFR 
229.402(m)(2)(iii) (Item 402(m) of Regulation S-K).
    (2) Conclusion. The result is the same as in paragraph 
(c)(2)(vii)(L) of this section (Example 2). For purposes of identifying 
a corporation's covered employees, it is irrelevant whether the 
reporting obligation under the Exchange Act for smaller reporting 
companies and emerging growth companies apply to the corporation, and it 
is irrelevant whether the specific executive officers' compensation must 
be disclosed pursuant to the disclosure rules under the Exchange Act 
applicable to the corporation.
    (D) Example 4 (Covered employees of a publicly held corporation that 
is not required to file a Form 10-K)--(1) Facts. The facts are the same 
as in paragraph (c)(2)(vii)(B) of this section (Example 2), except that 
on February 4, 2021, Corporation J files Form 15, Certification and 
Notice of Termination of Registration under Section 12(g) of the 
Securities Exchange Act of 1934 or Suspension of Duty to File Reports 
under Sections 13 and 15(d) of the Securities Exchange Act of 1934, (or 
its successor) to terminate the registration of its securities. 
Corporation J's duty to file reports under Section 13(a) of the Exchange 
Act is suspended upon the filing of the Form 15 and, as a result, 
Corporation J is not required to file a Form 10-K and disclose the 
compensation of its executive officers for 2020.
    (2) Conclusion. The result is the same as in paragraph 
(c)(2)(vii)(B) of this section (Example 2). Covered employees include 
executive officers of a publicly held corporation even if the 
corporation is not required to disclose the compensation of its 
executive officers under the Exchange Act. Therefore, Employees K, L, M, 
N, O, and P are covered employees for 2020. The result would be 
different if Corporation J filed Form 15 to terminate the registration 
of its securities prior to December 31, 2020. In that case, Corporation 
J would not be a publicly held corporation for its 2020 taxable year, 
and, therefore, Employees K, L, M, N, O, and P would not be covered 
employees for Corporation J's 2020 taxable year.
    (E) Example 5 (Covered employees of two publicly held corporations 
after a corporate transaction)--(1) Facts. Corporation T is a publicly 
held corporation for its 2019 taxable year. Corporation U is a privately 
held corporation for its 2019 and 2020 taxable years. On July 31, 2020, 
Corporation U acquires for cash 80% of the only class of outstanding 
stock of Corporation T. The affiliated group (comprised of Corporations 
U and T) elects to file a consolidated Federal income tax return. As a 
result of this election, Corporation T has a short taxable year ending 
on July 31, 2020. Corporation T does not change its fiscal year for 
reporting purposes under the Exchange Act to correspond to the short 
taxable year. Corporation T remains a publicly held corporation for its 
short taxable year ending on July 31, 2020, and its subsequent taxable 
year ending on December 31, 2020, for which it files a consolidated 
Federal income tax return with Corporation U.

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For Corporation T's taxable year ending July 31, 2020, Employee V serves 
as the only PEO, and Employee W serves as the only PFO. Employees X, Y, 
and Z are the three most highly compensated executive officers of 
Corporation T for the taxable year ending July 31, 2020, other than the 
PEO and PFO. As a result of the acquisition, effective July 31, 2020, 
Employee V ceases to serve as the PEO of Corporation T. Instead, 
Employee AA starts serving as the PEO of Corporation T on August 1, 
2020. Employee V continues to provide services for Corporation T but 
never serves as PEO again (or as an individual acting in such capacity). 
For Corporation T's taxable year ending December 31, 2020, Employee AA 
serves as the only PEO, and Employee W serves as the only PFO. Employees 
X, Y, and Z continue to serve as executive officers of Corporation T 
during the taxable year ending December 31, 2020. Employees BB, CC, and 
DD are the three most highly compensated executive officers of 
Corporation T, other than the PEO and PFO, for the taxable year ending 
December 31, 2020.
    (2) Conclusion (Employee V). Because Employee V served as the PEO 
during Corporation T's short taxable year ending July 31, 2020, Employee 
V is a covered employee for Corporation T's short taxable year ending 
July 31, 2020, even though Employee V's compensation is required to be 
disclosed pursuant to the executive compensation disclosure rules under 
the Exchange Act only for the fiscal year ending December 31, 2020. 
Because Employee V was a covered employee for Corporation T's short 
taxable year ending July 31, 2020, Employee V is also a covered employee 
for Corporation T's short taxable year ending December 31, 2020.
    (3) Conclusion (Employee W). Because Employee W served as the PFO 
during Corporation T's short taxable years ending July 31, 2020, and 
December 31, 2020, Employee W is a covered employee for both taxable 
years, even though Employee W's compensation is required to be disclosed 
pursuant to the executive compensation disclosure rules under the 
Exchange Act only for the fiscal year ending December 31, 2020. Because 
Employee W was a covered employee for Corporation T's short taxable year 
ending July 31, 2020, Employee W would be a covered employee for 
Corporation T's short taxable year ending December 31, 2020, even if 
Employee W did not serve as the PFO during this taxable year.
    (4) Conclusion (Employee AA). Because Employee AA served as the PEO 
during Corporation T's short taxable year ending December 31, 2020, 
Employee AA is a covered employee for that short taxable year.
    (5) Conclusion (Employees X, Y, and Z). Employees X, Y, and Z are 
covered employees for Corporation T's short taxable years ending July 
31, 2020, and December 31, 2020. Employees X, Y, and Z are covered 
employees for Corporation T's short taxable year ending July 31, 2020, 
because those employees are the three highest compensated executive 
officers for that short taxable year. Because they were covered 
employees for Corporation T's short taxable year ending July 31, 2020, 
Employees X, Y, and Z are covered employees for Corporation T's short 
taxable year ending December 31, 2020 and would be covered employees for 
that later short taxable year even if their compensation would not be 
required to be disclosed pursuant to the executive compensation 
disclosure rules under the Exchange Act.
    (6) Conclusion (Employees BB, CC, and DD). Employees BB, CC, and DD 
are covered employees for Corporation T's short taxable year ending 
December 31, 2020, because those employees are the three highest 
compensated executive officers for that short taxable year.
    (F) Example 6 (Predecessor of a publicly held corporation)--(1) 
Facts. Corporation EE is a publicly held corporation for its 2021 
taxable year. Corporation EE is a privately held corporation for its 
2022 and 2023 taxable years. For its 2024 taxable year, Corporation EE 
is a publicly held corporation.
    (2) Conclusion. For its 2024 taxable year, Corporation EE is a 
predecessor of a publicly held corporation within the meaning of 
paragraph (c)(2)(ii)(A) of this section because, after ceasing to be a 
publicly held corporation, it again became a publicly held corporation 
for a taxable year ending prior to April 15, 2025. Therefore, for 
Corporation EE's

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2024 taxable year, the covered employees of Corporation EE include the 
covered employees of Corporation EE for its 2021 taxable year and any 
additional covered employees determined pursuant to this paragraph 
(c)(2).
    (G) Example 7 (Predecessor of a publicly held corporation)--(1) 
Facts. The facts are the same as in paragraph (c)(2)(vii)(F) of this 
section (Example 6), except that Corporation EE remains a privately held 
corporation until it becomes a publicly held corporation for its 2027 
taxable year.
    (2) Conclusion. Corporation EE is not a predecessor of a publicly 
held corporation within the meaning of paragraph (c)(2)(ii)(A) of this 
section because it became a publicly held corporation for a taxable year 
ending after April 15, 2025. Therefore, any covered employee of 
Corporation EE for its 2021 taxable year is not a covered employee of 
Corporation EE for its 2027 taxable year due to that individual's status 
as a covered employee of Corporation EE for a preceding taxable year 
(beginning after December 31, 2016) but may be a covered employee due to 
that individual's status during the 2027 taxable year.
    (H) Example 8 (Predecessor of a publicly held corporation that is 
party to a merger)--(1) Facts. On June 30, 2021, Corporation FF (a 
publicly held corporation) merged into Corporation GG (a publicly held 
corporation) in a transaction that qualifies as a reorganization under 
section 368(a)(1)(A), with Corporation GG as the surviving corporation. 
As a result of the merger, Corporation FF has a short taxable year 
ending June 30, 2021. Corporation FF is a publicly held corporation for 
this short taxable year. Corporation GG does not have a short taxable 
year and is a publicly held corporation for its 2021 taxable year.
    (2) Conclusion. Corporation FF is a predecessor of a publicly held 
corporation within the meaning of paragraph (c)(2)(ii)(B) of this 
section. Therefore, any covered employee of Corporation FF for its short 
taxable year ending June 30, 2021, is a covered employee of Corporation 
GG for its 2021 taxable year. For Corporation GG's 2021 and subsequent 
taxable years, the covered employees of Corporation GG include the 
covered employees of Corporation FF (for a preceding taxable year 
beginning after December 31, 2016) and any additional covered employees 
determined pursuant to this paragraph (c)(2).
    (I) Example 9 (Predecessor of a publicly held corporation that is 
party to a merger)--(1) Facts. The facts are the same as in paragraph 
(c)(2)(vii)(H) of this section (Example 8), except that, after the 
merger, Corporation GG is a privately held corporation for its 2021 
taxable year.
    (2) Conclusion. Because Corporation GG is a privately held 
corporation for its 2021 taxable year, it is not subject to section 
162(m)(1) for this taxable year.
    (J) Example 10 (Predecessor of a publicly held corporation that is 
party to a merger)--(1) Facts. The facts are the same as in paragraph 
(c)(2)(vii)(I) of this section (Example 9), except that Corporation GG, 
becomes a publicly held corporation (as defined in paragraph (c)(1)(i) 
of this section) on June 30, 2023, and is a publicly held corporation 
for its 2023 taxable year.
    (2) Conclusion. Because Corporation GG became a publicly held 
corporation for a taxable year ending prior to April 15, 2025, 
Corporation FF is a predecessor of a publicly held corporation within 
the meaning of paragraph (c)(2)(ii)(G) of this section. For Corporation 
GG's 2023 and subsequent taxable years, the covered employees of 
Corporation GG include the covered employees of Corporation FF (for a 
preceding taxable year beginning after December 31, 2016) and any 
additional covered employees determined pursuant to this paragraph 
(c)(2).
    (K) Example 11 (Predecessor of a publicly held corporation that is 
party to a merger)--(1) Facts. The facts are the same as in paragraph 
(c)(2)(vii)(J) of this section (Example 10), except that Corporation FF 
is a privately held corporation for its taxable year ending June 30, 
2021, but was a publicly held corporation for its 2020 taxable year.
    (2) Conclusion. Even though Corporation FF was a privately held 
corporation when it merged with Corporation GG on June 30, 2021, 
Corporation FF will be a predecessor corporation if Corporation GG 
becomes a publicly

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held corporation within a taxable year ending prior to April 15, 2024. 
Because Corporation GG became a publicly held corporation for its 
taxable year ending December 31, 2023, Corporation FF is a predecessor 
of a publicly held corporation within the meaning of paragraph 
(c)(2)(ii)(G) of this section. For Corporation GG's 2023 and subsequent 
taxable years, the covered employees of Corporation GG include the 
covered employees of Corporation FF (for a preceding taxable year 
beginning after December 31, 2016) and any additional covered employees 
determined pursuant to this paragraph (c)(2).
    (L) Example 12 (Predecessor of a publicly held corporation that is 
party to a merger and subsequently becomes member of an affiliated 
group)--(1) Facts. The facts are the same as in paragraph (c)(2)(vii)(J) 
of this section (Example 10), except that, on June 30, 2022, Corporation 
GG becomes a publicly held corporation by becoming a member of an 
affiliated group (as defined in paragraph (c)(1)(ii) of this section). 
Corporation II is the parent corporation of the group and is a publicly 
held corporation. Employee HH was a covered employee of Corporation FF 
for its taxable year ending June 30, 2021. On July 1, 2022, Employee HH 
becomes an employee of Corporation II.
    (2) Conclusion. By becoming a member of an affiliated group (as 
defined in paragraph (c)(1)(ii) of this section) on June 30, 2022, 
Corporation GG became a publicly held corporation for a taxable year 
ending prior to April 15, 2025. Therefore, Corporation FF is a 
predecessor of a publicly held corporation (Corporation GG) within the 
meaning of paragraph (c)(2)(ii)(G) of this section. Furthermore, 
Corporation FF is also a predecessor of Corporation II, a publicly held 
corporation within the meaning of paragraph (c)(2)(ii)(G) of this 
section. For Corporation II's 2022 and subsequent taxable years, 
Employee HH is a covered employee of the affiliated group that includes 
Corporation II because Employee HH was a covered employee of Corporation 
FF for its taxable year ending June 30, 2021.
    (M) Example 13 (Predecessor of a publicly held corporation that is 
party to a merger and subsequently becomes member of an affiliated 
group)--(1) Facts. The facts are the same as in paragraph (c)(2)(vii)(L) 
of this section (Example 12), except that Corporation FF was a privately 
held corporation for its taxable year ending June 30, 2021, and Employee 
HH was a covered employee of Corporation FF for its taxable year ending 
December 31, 2020.
    (2) Conclusion. Even though Corporation FF was a privately held 
corporation when it merged with Corporation GG on June 30, 2021, 
Corporation FF will be a predecessor corporation if Corporation GG 
becomes a publicly held corporation for a taxable year ending prior to 
April 15, 2024. Because Corporation GG became a publicly held 
corporation for its 2022 taxable year by becoming a member of an 
affiliated group (as defined in paragraph (c)(1)(ii) of this section), 
Corporation FF is a predecessor of a publicly held corporation 
(Corporation GG) within the meaning of paragraph (c)(2)(ii)(G) of this 
section. Furthermore, Corporation FF is also a predecessor of 
Corporation II, a publicly held corporation within the meaning of 
paragraph (c)(2)(ii)(G) of this section. Therefore, any covered employee 
of Corporation FF for its 2020 taxable year is a covered employee of the 
affiliated group that includes Corporation II for its 2022 and 
subsequent taxable years. For Corporation II's 2022 taxable year, 
Employee HH is a covered employee of the affiliated group that includes 
Corporation II because Employee HH was a covered employee of Corporation 
FF for its 2020 taxable year.
    (N) Example 14 (Predecessor of a publicly held corporation that is a 
party to a merger)--(1) Facts. Corporation JJ is a publicly held 
corporation for its 2019 taxable year and is incorporated in State KK. 
On June 1, 2019, Corporation JJ formed a wholly-owned subsidiary, 
Corporation LL. Corporation LL is a publicly held corporation 
incorporated in State MM. On June 30, 2021, Corporation JJ merged into 
Corporation LL under State MM law in a transaction that qualifies as a 
reorganization under section 368(a)(1)(A), with Corporation LL as the 
surviving corporation. As a result of the merger, Corporation JJ has a 
short taxable year ending June 30, 2021. Corporation JJ is a publicly

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held corporation for this short taxable year.
    (2) Conclusion. Corporation JJ is a predecessor of a publicly held 
corporation within the meaning of paragraph (c)(2)(ii)(B) of this 
section. For Corporation LL's taxable years ending after June 30, 2021, 
the covered employees of Corporation LL include the covered employees of 
Corporation JJ for its short taxable year ending June 30, 2021 (as well 
as preceding taxable years beginning after December 31, 2016) and any 
additional covered employees determined pursuant to this paragraph 
(c)(2).
    (O) Example 15 (Predecessor of a publicly held corporation becomes 
member of an affiliated group)--(1) Facts. On June 30, 2021, Corporation 
OO acquires for cash 100% of the only class of outstanding stock of 
Corporation NN. The affiliated group (comprised of Corporations NN and 
OO) elects to file a consolidated Federal income tax return. As a result 
of this election, Corporation NN has a short taxable year ending on June 
30, 2021. Corporation NN is a publicly held corporation for its taxable 
year ending June 30, 2021, and a privately held corporation for 
subsequent taxable years. On June 30, 2022, Corporation OO completely 
liquidates Corporation NN. Corporation OO is a publicly held corporation 
for its 2021 and 2022 taxable years.
    (2) Conclusion. After Corporation OO acquired Corporation NN, 
Corporations NN and OO comprise an affiliated group as defined in 
paragraph (c)(1)(ii) of this section. Thus, Corporation NN is a 
predecessor of a publicly held corporation within the meaning of 
paragraph (c)(2)(ii)(D) of this section. For Corporation OO's taxable 
years ending after June 30, 2021, the covered employees of Corporation 
OO include the covered employees of Corporation NN for its short taxable 
year ending June 30, 2021 (as well as preceding taxable years beginning 
after December 31, 2016) and any additional covered employees determined 
pursuant to this paragraph (c)(2).
    (P) Example 16 (Predecessor of a publicly held corporation becomes 
member of an affiliated group)--(1) Facts. The facts are the same as in 
paragraph (c)(2)(vii)(O) of this section (Example 15), except that 
Corporation OO is a privately held corporation on June 30, 2021, and for 
its 2021 and 2022 taxable years.
    (2) Conclusion. Because Corporation OO is a privately held 
corporation for its 2021 and 2022 taxable years, it is not subject to 
section 162(m)(1) for these taxable years.
    (Q) Example 17 (Predecessor of a publicly held corporation becomes 
member of an affiliated group)--(1) Facts. The facts are the same as in 
paragraph (c)(2)(vii)(P) of this section (Example 16), except that, on 
October 1, 2022, the SEC declares effective Corporation OO's Securities 
Act registration statement in connection with its initial public 
offering, and Corporation OO is a publicly held corporation for its 2022 
taxable year.
    (2) Conclusion (Taxable Year Ending December 31, 2021). Because 
Corporation OO is a privately held corporation for its 2021 taxable 
year, it is not subject to section 162(m)(1) for this taxable year.
    (3) Conclusion (Taxable Year Ending December 31, 2022). For the 2022 
taxable year, Corporations NN and OO comprise an affiliated group as 
defined in paragraph (c)(1)(ii) of this section. Corporation NN is a 
predecessor of a publicly held corporation within the meaning of 
paragraph (c)(2)(ii)(D) and (G) of this section because Corporation OO 
became a publicly held corporation for a taxable year ending prior to 
April 15, 2025. For Corporation OO's 2022 and subsequent taxable years, 
the covered employees of Corporation OO include the covered employees of 
Corporation NN for its short taxable year ending June 30, 2021 (as well 
as preceding taxable years beginning after December 31, 2016) and any 
additional covered employees determined pursuant to this paragraph 
(c)(2).
    (R) Example 18 (Predecessor of a publicly held corporation and asset 
acquisition)--(1) Facts. Corporations VV, WW, and XX are publicly held 
corporations for their 2020 and 2021 taxable years. Corporations VV and 
WW are members of an affiliated group. Corporation WW is a direct 
subsidiary of Corporation VV. On June 30, 2021, Corporation VV

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acquires for cash 40% of the gross operating assets (determined by fair 
market value as of January 31, 2022) of Corporation XX. On January 31, 
2022, Corporation WW acquires an additional 40% of the gross operating 
assets (determined by fair market value as of January 31, 2022) of 
Corporation XX. Employees EB, EC, and EA are covered employees for 
Corporation XX's 2020 taxable year. Employees ED and EF are also covered 
employees for Corporation XX's 2021 taxable year. On January 15, 2021, 
Employee EA started performing services as an employee of Corporation 
WW. On July 1, 2021, Employee EB started performing services as an 
employee of Corporation WW. On February 1, 2022, Employees EC and ED 
started performing services as employees of Corporation WW. On June 30, 
2023, Employee EF started performing services as an employee of 
Corporation WW.
    (2) Conclusion. Because an affiliated group, comprised of 
Corporations VV and WW, acquired 80% of Corporation XX's gross operating 
assets (determined by fair market value) within a twelve-month period, 
Corporation XX is a predecessor of a publicly held corporation within 
the meaning of paragraph (c)(2)(ii)(E) of this section. Therefore, any 
covered employee of Corporation XX for its 2020 and 2021 taxable years 
(who started performing services as an employee of Corporation WW within 
the period beginning 12 months before and ending 12 months after the 
date of the January 31, 2022, acquisition (determined under paragraph 
(c)(2)(ii)(I) of this section) is a covered employee of Corporation WW 
for its 2021, 2022, and subsequent taxable years. For Corporation WW's 
2021 and subsequent taxable years, the covered employees of Corporation 
WW include Employee EB and any additional covered employees determined 
pursuant to paragraph (c)(2)(i) of this section. For Corporation WW's 
2022 and subsequent taxable years, the covered employees of Corporation 
WW include Employees EB, EC, and ED, and any additional covered 
employees determined pursuant to this paragraph (c)(2). Because Employee 
EA started performing services as an employee of Corporation WW before 
January 31, 2021, Employee EA is not a covered employee of Corporation 
WW for its 2021 taxable year and subsequent taxable years by reason of 
paragraph (c)(2)(ii)(E) of this section, but may be a covered employee 
of Corporation WW by application of other rules in this paragraph 
(c)(2). Because Employee EF started performing services as an employee 
of Corporation WW after January 31, 2023, Employee EF is not a covered 
employee of Corporation WW for its 2023 taxable year by reason of 
paragraph (c)(2)(ii)(E) of this section, but may be a covered employee 
of Corporation WW by application of other rules in this paragraph 
(c)(2).
    (S) Example 19 (Predecessor of a publicly held corporation and asset 
acquisition)--(1) Facts. The facts are the same as in paragraph 
(c)(2)(vii)(R) of this section (Example 18), except that Corporations VV 
and WW are not publicly held corporations on June 30, 2021, or for their 
2021 taxable years.
    (2) Conclusion. Because Corporations VV and WW are not publicly held 
corporations for their 2021 taxable years, they are not subject to 
section 162(m)(1) for their 2021 taxable years.
    (T) Example 20 (Predecessor of a publicly held corporation and asset 
acquisition)--(1) Facts. The facts are the same as in paragraph 
(c)(2)(vii)(R) of this section (Example 18), except that, on October 1, 
2022, the SEC declares effective Corporation VV's Securities Act 
registration statement in connection with its initial public offering, 
and Corporation VV is a publicly held corporation for its 2022 taxable 
year.
    (2) Conclusion (2021 taxable year). Because Corporations VV and WW 
are not publicly held corporations for their 2021 taxable years, they 
are not subject to section 162(m)(1) for their 2021 taxable years.
    (3) Conclusion (2022 taxable year). Corporation XX is a predecessor 
of a publicly held corporation within the meaning of paragraphs 
(c)(2)(ii)(E) and (G) of this section because a member of the affiliated 
group comprised of Corporations VV and WW acquired 80% of Corporation 
XX's gross operating assets (determined by fair market value) within a 
twelve-month period ending on January 31, 2022, and the parent of the 
affiliated group, Corporation VV,

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subsequently became a publicly held corporation for a taxable year 
ending prior to April 15, 2024. Therefore, any covered employee of 
Corporation XX for its 2020 and 2021 taxable years (who started 
performing services as an employee of Corporation WW within the period 
beginning 12 months before and ending 12 months after the acquisition) 
is a covered employee of the affiliated group comprised of Corporations 
VV and WW for its 2022 and subsequent taxable years. For Corporation 
WW's 2022 and subsequent taxable years, the covered employees of 
Corporation WW include Employees EB, EC, and ED, and any additional 
covered employees determined pursuant to this paragraph (c)(2).
    (U) Example 21 (Predecessor of a publicly held corporation and a 
division)--(1) Facts. Corporation CA is a publicly held corporation for 
its 2021 and 2022 taxable years. On March 2, 2021, Corporation DDD forms 
a wholly-owned subsidiary, Corporation CB, and transfers assets to it. 
On April 1, 2022, Corporation CA distributes all shares of Corporation 
CB to its shareholders in a transaction described in section 355(a)(1). 
On April 1, 2022, the SEC declares effective Corporation CB's Securities 
Act registration statement in connection with its initial public 
offering. Corporation CB is a publicly held corporation for its 2022 
taxable year. Employee EG serves as the PFO of Corporation CA from 
January 1, 2022, to March 31, 2022. On April 2, 2022, Employee EG starts 
performing services as an employee of Corporation CB advising the PFO of 
Corporation CB. After March 31, 2022, Employee EG ceases to provide 
services for Corporation CA.
    (2) Conclusion. Because the distribution of the stock of Corporation 
CB is a transaction described under section 355(a)(1), Corporation CA is 
a predecessor of Corporation CB within the meaning of paragraph 
(c)(2)(ii)(C) of this section. Because Employee EG was a covered 
employee of Corporation CA for its 2022 taxable year, Employee ED is a 
covered employee of Corporation CB for its 2022 taxable year. The result 
is the same whether Employee EG performs services as an advisor for 
Corporation CB as an employee or an independent contractor.
    (V) Example 22 (Predecessor of a publicly held corporation and a 
division)--(1) Facts. The facts are the same as in paragraph 
(c)(2)(vii)(U) of this section (Example 21), except that Corporation CA 
distributes 100% of the shares of Corporation CB to Corporation CD in 
exchange for all of Corporation CD's stock in Corporation CA in a 
transaction described in section 355(a)(1) and Corporation CB does not 
register any class of securities with the SEC. Also, Employee EG 
performs services as an employee of Corporation CD instead of as an 
employee of Corporation CB. Corporation CD is a privately held 
corporation for its 2022 taxable year. On October 1, 2023, the SEC 
declares effective Corporation CD's Securities Act registration 
statement in connection with its initial public offering. Corporation CD 
is a publicly held corporation for its 2023 taxable year. On January 1, 
2028, Employee EG starts performing services as an employee of 
Corporation CA. Corporation CA is a publicly held corporation for its 
2028 taxable year.
    (2) Conclusion (2022 taxable year). Because Corporation CD is a 
privately held corporation for its 2022 taxable year, it is not subject 
to section 162(m)(1) for this taxable year.
    (3) Conclusion (2023 taxable year). Because the exchange of the 
stock of Corporation CB for the stock of Corporation CA is a transaction 
described in section 355(a)(1), Corporations CB and CD are an affiliated 
group, and Corporation CD became a publicly held corporation for a 
taxable year ending prior to April 15, 2026, Corporation CA is a 
predecessor of Corporation CD within the meaning of paragraphs 
(c)(2)(ii)(D) and (G) of this section. Employee EG was a covered 
employee of Corporation CA for its 2022 taxable year, and started 
performing services as an employee of Corporation CD following April 1, 
2021, and before April 1, 2023. Therefore, Employee ED is a covered 
employee of Corporation CD for its 2023 taxable year.
    (4) Conclusion (2028 taxable year). Because Employee EG served as 
the PFO of Corporation CA from January 1, 2022, to March 31, 2022, 
Employee EG was a covered employee of Corporation CA

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for its 2022 taxable year. Because an individual who is a covered 
employee for a taxable year remains a covered employee for all 
subsequent taxable years (even after the individual has separated from 
service), Employee EG is a covered employee of Corporation CA for its 
2028 taxable year.
    (W) Example 23 (Predecessor of a publicly held corporation and a 
division)--(1) Facts. The facts are the same as in paragraph 
(c)(2)(vii)(V) of this section (Example 22), except that Employee EG 
starts performing services as an employee of Corporation CD on June 30, 
2023, instead of on April 2, 2022, and never performs services for 
Corporation CA after June 30, 2023. Furthermore, on June 30, 2023, 
Employee EH, a covered employee of Corporation CB for all of its taxable 
years, starts performing services for Corporation EF as an independent 
contractor advising its PEO but not serving as a PEO.
    (2) Conclusion (2023 taxable year). Because the exchange of the 
stock of Corporation CB for the stock of Corporation CA is a transaction 
described in section 355(a)(1) and Corporation CD became a publicly held 
corporation for a taxable year ending before April 15, 2026, Corporation 
CA is a predecessor of Corporation CD within the meaning of paragraphs 
(c)(2)(ii)(D) and (G) of this section. Even though Employee EG was a 
covered employee of Corporation CA for its 2022 taxable year, because 
Employee EG started performing services as an employee of Corporation CD 
after April 1, 2023, Employee EG is not a covered employee of 
Corporation CD for its 2023 taxable year under paragraph (c)(2)(ii)(C) 
of this section. However, Employee EG may be a covered employee of 
Corporation CD by application of other rules in this paragraph (c)(2). 
Because Employee EH was a covered employee of Corporation CB for its 
2022 taxable year, Employee EH is a covered employee of Corporation CD 
for its 2023 taxable year.
    (X) Example 24 (Predecessor of a publicly held corporation and 
election under section 338(h)(10))--(1) Facts. Corporation CE is the 
common parent of a group of corporations filing consolidated returns 
that includes Corporation CF as a member. Corporation CE wholly-owns 
Corporation CF, a publicly held corporation within the meaning of 
paragraph (c)(1)(i) of this section. On June 30, 2021, Corporation CG 
purchases Corporation CF from Corporation CE. Corporation CE and 
Corporation CG make a timely election under section 338(h)(10) with 
respect to the purchase of Corporation CF stock. For its taxable year 
ending December 31, 2021, Corporation CF continues to be a publicly held 
corporation within the meaning of paragraph (c)(1)(i) of this section.
    (2) Conclusion. As provided in paragraph (c)(2)(ii)(H) of this 
section, Corporation CF is treated as the same corporation after the 
section 338(h)(10) transaction as before the transaction for purposes 
for purposes of this paragraph (c)(2). Any covered employee of 
Corporation CF for its short taxable year ending June 30, 2021, is a 
covered employee of Corporation CF for its short taxable year ending on 
December 31, 2021, and subsequent taxable years.
    (Y) Example 25 (Disregarded entity)--(1) Facts. Corporation CH is a 
privately held corporation for its 2020 taxable year. Entity CI is a 
wholly-owned limited liability company and is disregarded as an entity 
separate from its owner, Corporation CH, under Sec.  301.7701-2(c)(2)(i) 
of this chapter. As of December 31, 2020, Entity CI is required to file 
reports under section 15(d) of the Exchange Act. For the 2020 taxable 
year, Employee EI is the PEO and Employee EJ is the PFO of Corporation 
CH. Employees EK, EL, and EM, are the three most highly compensated 
executive officers of Corporation CH (other than Employees EI and EJ). 
Employee EN is the PFO of Entity CI and does not perform any policy 
making functions for Corporation CH. Entity CI has no other executive 
officers.
    (2) Conclusion. Because Entity CI is disregarded as an entity 
separate from its owner, Corporation CH, and is required to file reports 
under section 15(d) of the Exchange Act, Corporation CH is a publicly 
held corporation under paragraph (c)(1)(iii) of this section for its 
2020 taxable year. Even though Employee EN is a PFO of Entity CI, 
Employee EN is not considered a PFO of Corporation CH under paragraph 
(c)(2)(iii) of this section. As PEO and PFO, Employees EI and EJ are 
covered

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employees of Corporation CH under paragraph (c)(2)(i) of this section. 
Additionally, as the three most highly compensated executive officers of 
Corporation CH (other than Employees EI and EJ), Employees EK, EL, and 
EM also are covered employees of Corporation CH under paragraph 
(c)(2)(i) of this section for Corporation CH's 2020 taxable year. The 
result would be the same if Entity CI was not required to file reports 
under section 15(d) of the Exchange Act and Corporation CH was a 
publicly held corporation pursuant to paragraph (c)(1)(i) instead of 
paragraph (c)(1)(iii) of this section.
    (Z) Example 26 (Disregarded entity)--(1) Facts. The facts are the 
same as in paragraph (c)(2)(vii)(Y) of this section (Example 25), except 
that Employee EN performs a policy making function for Corporation CH. 
If Corporation CH were subject to the SEC executive compensation 
disclosure rules, then Employee EN would be treated as an executive 
officer of Corporation CH pursuant to 17 CFR 240.3b-7 for purposes of 
determining the three highest compensated executive officers for 
Corporation CH's 2020 taxable year. Employee EN is compensated more than 
Employee EK, but less than Employees EL and EM.
    (2) Conclusion. Because Entity CI is disregarded as an entity 
separate from its owner, Corporation CH, and is required to file reports 
under section 15(d) of the Exchange Act, Corporation CH is a publicly 
held corporation under paragraph (c)(1)(iii) of this section for its 
2020 taxable year. As PEO and PFO, Employees EI and EJ are covered 
employees of Corporation CH under paragraph (c)(2)(i) of this section. 
Employee EN is one of the three highest compensated executive officers 
for Corporation CH's taxable year. Because Employees EN, EL, and EM are 
the three most highly compensated executive officers of Corporation CH 
(other than Employees EI and EJ), they are covered employees of 
Corporation CH under paragraph (c)(2)(i) of this section for Corporation 
CH's 2020 taxable year. The result would be the same if Entity CI was 
not required to file reports under section 15(d) of the Exchange Act and 
Corporation CH was a publicly held corporation pursuant to paragraph 
(c)(1)(i) instead of paragraph (c)(1)(iii) of this section.
    (AA) Example 27 (Individual as covered employee of a publicly held 
corporation that includes the affiliated group)--(1) Facts. Corporations 
CJ and CK are publicly held corporations for their 2020, 2021, and 2022 
taxable years. Corporation CK is a direct subsidiary of Corporation CJ. 
Employee EO is an employee, but not a covered employee (as defined in 
paragraph (c)(2)(i) of this section), of Corporation CJ for its 2020, 
2021, and 2022 taxable years. From April 1, 2020, to September 30, 2020, 
Employee EO serves as the PFO of Corporation CK. Employee EO does not 
perform any services for Corporation CK for its 2021 and 2022 taxable 
years, however, employee EO is a covered employee (as defined in 
paragraph (c)(2)(i) of this section) of Corporation CK for its 2020, 
2021, and 2022 taxable years. For the 2020 taxable year, Employee EO 
receives compensation of $1,500,000 for services provided to 
Corporations CJ and CK. Employee EO receives $2,000,000 from Corporation 
CJ for performing services for Corporation CJ during each of its 2021 
and 2022 taxable years. On June 30, 2022, Corporation CK pays $500,000 
to Employee EO from a nonqualified deferred compensation plan that 
complies with section 409A.
    (2) Conclusion (2020 taxable year). Because Employee EO is a covered 
employee of Corporation CK and because the affiliated group (comprised 
of Corporations CJ and CK) is a publicly held corporation, Employee EO 
is a covered employee of the publicly held corporation that is the 
affiliated group pursuant to paragraph (c)(2)(vi) of this section. 
Compensation paid by Corporations CJ and CK is aggregated for purposes 
of section 162(m)(1) and, as a result, $500,000 of the aggregate 
compensation paid is nondeductible. The result would be the same if 
Corporation CJ was a privately held corporation for its 2020 taxable 
year.
    (3) Conclusion (2021 taxable year). Because Employee EO is a covered 
employee of Corporation CK pursuant to paragraph (c)(2)(i)(C) of this 
section and because the affiliated group (comprised of Corporations CJ 
and CK) is a publicly held corporation, Employee

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EO is a covered employee of the publicly held corporation that is the 
affiliated group pursuant to paragraph (c)(2)(vi) of this section. 
Compensation paid by Corporations CJ and CK is aggregated for purposes 
of section 162(m)(1) and, as a result, $1,000,000 of the aggregate 
compensation paid is nondeductible. The result would be the same if 
Corporation CJ was a privately held corporation for its 2021 taxable 
year.
    (4) Conclusion (2022 taxable year). Because Employee EO is a covered 
employee of Corporation CK pursuant to paragraph (c)(2)(i)(C) of this 
section and because the affiliated group (comprised of Corporations CJ 
and CK) is a publicly held corporation, Employee EO is a covered 
employee of the publicly held corporation that is the affiliated group 
pursuant to paragraph (c)(2)(vi) of this section. Compensation paid by 
Corporations CJ and CK is aggregated for purposes of section 162(m)(1) 
and, as a result, $1,500,000 of the aggregate compensation paid is 
nondeductible. The result would be the same if Corporation CJ was a 
privately held corporation for its 2022 taxable year.
    (BB) Example 28 (Individual as covered employee of a publicly held 
corporation that includes the affiliated group)--(1) Facts. Corporation 
CL is a publicly held corporation for its 2020 through 2023 taxable 
years. Corporations CM and CN are direct subsidiaries of Corporation CL 
and are privately held corporations for their 2020 through 2022 taxable 
years. Employee EP serves as the PFO of Corporation CL from January 1, 
2020 to December 31, 2020, when Employee EP terminates employment from 
Corporation CL. On January 1, 2021, Employee EP starts performing 
services as an employee of Corporation CM. In 2021, Employee EP receives 
compensation from Corporation CM in excess of $1,000,000. On April 1, 
2022, Employee EP starts performing services as an employee of 
Corporation CN. On September 30, 2022, Employee EP terminates employment 
from Corporations CM and CN. In 2022, Employee EP receives compensation 
from Corporations CM and CN in excess of $1,000,000. For the 2021 and 
2022 taxable years, Employee EP does not serve as either the PEO or PFO 
of Corporations CM and CN, and is not one of the three highest 
compensated executive officers (other than the PEO or PFO) of 
Corporations CM and CN. On April 1, 2023, Corporation CL distributes all 
the shares of Corporation CM to its shareholders in a transaction 
described in section 355(a)(1). On April 1, 2023, the SEC declares 
effective Corporation CM's Securities Act registration statement in 
connection with its initial public offering. Corporation CM is a 
publicly held corporation for its 2023 taxable year. On April 2, 2023, 
Employee EP starts performing services as an employee of Corporation CM 
but is not an executive officer of Corporation CM.
    (2) Conclusion (2021 taxable year). Employee EP is a covered 
employee of Corporation CL for the 2020 and subsequent taxable years. 
Because Employee EP is a covered employee of Corporation CL and because 
the affiliated group (comprised of Corporations CL, CM, and CN) is a 
publicly held corporation, Employee EP is a covered employee of the 
publicly held corporation that is the affiliated group pursuant to 
paragraph (c)(2)(vi) of this section for the 2020 and subsequent taxable 
years. Therefore, Corporation CM's deduction for compensation paid to 
Employee EP for the 2021 taxable year is subject to section 162(m)(1). 
The result would be the same if Corporation CM was a publicly held 
corporation as defined in paragraph (c)(1)(i) of this section.
    (3) Conclusion (2022 taxable year). Because Employee EP is a covered 
employee of Corporation CL and because the affiliated group (comprised 
of Corporations CL, CM, and CN) is a publicly held corporation, Employee 
EP is a covered employee of the publicly held corporation that is the 
affiliated group pursuant to paragraph (c)(2)(vi) of this section. 
Therefore, Corporation CM's and CN's deduction for compensation paid to 
Employee EP for the 2022 taxable year is subject to section 162(m)(1). 
Because the compensation paid by all affiliated group members is 
aggregated for purposes of section 162(m)(1), $1,000,000 of the 
aggregate compensation paid is nondeductible. Corporations CM and CN are 
each treated as paying a ratable portion of the nondeductible 
compensation. The

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result would be the same if either Corporation CM or CN (or both) was a 
publicly held corporation as defined in paragraph (c)(1)(i) of this 
section.
    (4) Conclusion (2023 taxable year). Because the distribution of the 
stock of Corporation CM is a transaction described in section 355(a)(1), 
Corporation CL is a predecessor of Corporation CM within the meaning of 
paragraph (c)(2)(ii)(C) of this section. However, because Employee EP 
started performing services as an employee of Corporation CM on January 
1, 2021, and the distribution of stock of Corporation CM did not occur 
until April 1, 2023, Employee EP is not a covered employee of 
Corporation CM for its 2023 taxable year.
    (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 to the publicly held 
corporation under chapter 1 of the Internal Revenue Code for the taxable 
year (determined without regard to section 162(m)(1)) for remuneration 
for services performed by a covered employee in any capacity, whether or 
not the services were performed during the taxable year. Compensation 
includes an amount that is includible in the income of, or paid to, a 
person other than the covered employee (including a beneficiary after 
the death of the covered employee) for services performed by the covered 
employee.
    (ii) Compensation paid by a partnership. For purposes of paragraph 
(c)(3)(i) of this section, compensation includes an amount equal to a 
publicly held corporation's distributive share of a partnership's 
deduction for compensation expense attributable to the remuneration paid 
by the partnership to a covered employee of the publicly held 
corporation for services performed by the covered employee, including a 
payment for services under section 707(a) or under section 707(c).
    (iii) Exceptions. Compensation does not include--
    (A) Remuneration covered in section 3121(a)(5)(A) through (D) 
(concerning remuneration that is not treated as wages for purposes of 
the Federal Insurance Contributions Act);
    (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; or
    (C) Salary reduction contributions described in section 3121(v)(1).
    (iv) Examples. The following examples illustrate the provisions of 
this paragraph (c)(3). For each example, assume that the corporation is 
a calendar year taxpayer.
    (A) Example 1--(1) Facts. Corporation Z is a publicly held 
corporation for its 2020 taxable year, during which Employee A serves as 
the PEO of Corporation Z and also serves on the board of directors of 
Corporation Z. In 2020, Corporation Z paid $1,200,000 to Employee A plus 
a $50,000 fee for serving as a director of Corporation Z. These amounts 
are otherwise deductible for Corporation Z's 2020 taxable year.
    (2) Conclusion. The $1,200,000 paid to Employee A in 2020 plus the 
$50,000 director's fee paid to Employee A in 2020 are compensation 
within the meaning of this paragraph (c)(3). Therefore, Corporation Z's 
$1,250,000 deduction for the 2020 taxable year is subject to the section 
162(m)(1) limit.
    (B) Example 2--(1) Facts. Corporation X is a publicly held 
corporation for its 2020 and all subsequent taxable years. Employee B 
serves as the PEO of Corporation X for its 2020 taxable year and is a 
participant in the Corporation X nonqualified retirement plan that meets 
the requirements of section 409A. The plan provides for the distribution 
of benefits over a three-year period beginning after a participant 
separates from service. Employee B terminates employment in 2021. In 
2022, Employee B receives a $75,000 fee for services as a director and 
$1,500,000 as the first payment under the retirement plan. Employee B 
continues to serve on the board of directors until 2023 when Employee B 
dies before receiving the retirement benefit for 2023 and before 
becoming entitled to any director's fees for 2023. In 2023 and 2024, 
Corporation X pays the $1,500,000 annual retirement benefits to Person 
C, a beneficiary of Employee B.
    (2) Conclusion (2022 Taxable Year). In 2022, Corporation X paid 
Employee B

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$1,575,000, including $1,500,000 under the retirement plan and $75,000 
in director's fees. The retirement benefit and the director's fees are 
compensation within the meaning of this paragraph (c)(3). Therefore, 
Corporation X's $1,575,000 deduction for the 2022 taxable year is 
subject to the section 162(m)(1) limit.
    (3) Conclusion (2023 and 2024 Taxable Years). In 2023 and 2024, 
Corporation X made payments to Person C of $1,500,000 under the 
retirement plan. The retirement benefits are compensation within the 
meaning of this paragraph (c)(3). Therefore, Corporation X's deduction 
for each annual payment of $1,500,000 for the 2023 and 2024 taxable 
years is subject to the section 162(m)(1) limit.
    (C) Example 3--(1) Facts. Corporation T is a publicly held 
corporation for its 2021 taxable year. Corporation S is a privately held 
corporation for its 2021 taxable year. On January 2, 2021, Corporations 
S and T form a general partnership. Under the partnership agreement, 
Corporations S and T each have a 50% distributive share of the 
partnership's income, gain, loss, and deductions. For the taxable year 
ending December 31, 2021, Employee D, a covered employee of Corporation 
T, performs services for the partnership, and the partnership pays 
$800,000 to Employee D for these services, the deduction of $400,000 of 
which is allocated to Corporation T. Corporation T's $400,000 
distributive share of the partnership's deduction is reported separately 
to Corporation T pursuant to Sec.  1.702-1(a)(8)(iii).
    (2) Conclusion. Because Corporation T's $400,000 distributive share 
of the partnership's deduction is attributable to the compensation paid 
by the partnership for services performed by Employee D, a covered 
employee of Corporation T, the $400,000 is compensation within the 
meaning of this paragraph (c)(3) and Corporation T's deduction for this 
expense for its 2021 taxable year is subject to the section 162(m)(1) 
limit. Corporation T's $400,000 allocation of the partnership's 
deduction is aggregated with Corporation T's deduction for compensation 
paid to Employee D, if any, in determining the amount allowable as a 
deduction to Corporation T for compensation paid to Employee D for 
Corporation T's 2021 taxable year. The result is the same whether 
Employee D performs services for the partnership as a common law 
employee, an independent contractor, or a partner, and whether the 
payment to Employee D is a payment under section 707(a) or section 
707(c).
    (4) Securities Act. The Securities Act means the Securities Act of 
1933.
    (5) Exchange Act. The Exchange Act means the Securities Exchange Act 
of 1934.
    (6) SEC. The SEC means the United States Securities and Exchange 
Commission.
    (7) Foreign Private Issuer. A foreign private issuer means an issuer 
as defined in 17 CFR 240.3b-4(c).
    (8) American Depositary Receipt (ADR). An American Depositary 
Receipt or ADR means a negotiable certificate that evidences ownership 
of a specified number (or fraction) of a foreign private issuer's 
securities held by a depositary (typically, a U.S. bank).
    (9) Privately held corporation. A privately held corporation is a 
corporation that is not a publicly held corporation as defined in 
paragraph (c)(1) of this section (without regard to paragraph (c)(1)(ii) 
of this section).
    (d) Corporations that become publicly held--(1) In general. In the 
case of a corporation that was a privately held corporation and then 
becomes a publicly held corporation, the deduction limitation of 
paragraph (b) of this section applies to any compensation that is 
otherwise deductible for the taxable year ending on or after the date 
that the corporation becomes a publicly held corporation. A corporation 
is considered to become publicly held on the date that its registration 
statement becomes effective either under the Securities Act or the 
Exchange Act. The rules in this section apply to a partnership that 
becomes a publicly traded partnership that is a publicly held 
corporation within the meaning of paragraph (c)(1)(i) of this section.
    (2) Example. The following example illustrates the provision of this 
paragraph (d).
    (i) Facts. In 2021, Corporation E plans to issue debt securities in 
a public offering registered under the Securities

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Act. Corporation E is not required to file reports under section 15(d) 
of the Exchange Act with respect to any other class of securities and 
does not have another class of securities required to be registered 
under section 12 of the Exchange Act. On December 18, 2021, the SEC 
declares effective the Securities Act registration statement for 
Corporation E's debt securities.
    (ii) Conclusion. Corporation E becomes a publicly held corporation 
on December 18, 2021 because it is then required to file reports under 
section 15(d) of the Exchange Act. The deduction limitation of paragraph 
(b) of this section applies to any compensation that is otherwise 
deductible for Corporation E's taxable year ending on or after December 
18, 2021.
    (e) Coordination with disallowed excess parachute payments under 
section 280G. 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 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, of which $600,000 is an excess parachute payment, 
as defined in section 280G(b)(1), and a deduction for that excess 
parachute payment is disallowed by reason of section 280G(a). Because 
the $1,000,000 limitation in paragraph (b) of this section is reduced by 
the amount of the excess parachute payment, the corporation may deduct 
$400,000 ($1,000,000-$600,000), and $500,000 of the otherwise deductible 
amount is nondeductible by reason of section 162(m)(1). Thus $1,100,000 
(of the total $1,500,000 payment) is non-deductible, reflecting the 
disallowance related to the excess parachute payment under section 280G 
and the application of section 162(m)(1).
    (f) Coordination with excise tax on specified stock compensation. 
The $1,000,000 limitation in paragraph (b) of this section is reduced 
(but not below zero) by the amount (if any) of any payment (with respect 
to such employee) of the tax imposed by section 4985 directly or 
indirectly by the expatriated corporation (as defined in section 
4985(e)(2)) or by any member of the expanded affiliated group (as 
defined in section 4985(e)(4)) that includes such corporation.
    (g) Transition rules--(1) Amount of compensation payable under a 
written binding contract that was in effect on November 2, 2017--(i) 
General rule. This section does not apply to the deduction for 
compensation payable under a written binding contract that was in effect 
on November 2, 2017, and that is not modified in any material respect on 
or after that date (a grandfathered amount). Instead, section 162(m), as 
in effect prior to its amendment by Public Law 115-97, applies to limit 
the deduction for that compensation. Because Sec.  1.162-27 implemented 
section 162(m) as in effect prior to its amendment by Public Law 115-97, 
the rules of Sec.  1.162-27 determine the applicability of the deduction 
limitation under section 162(m) with respect to the payment of a 
grandfathered amount (including the potential application of the 
separate grandfathering rules contained in Sec.  1.162-27(h)). 
Compensation is a grandfathered amount only to the extent that as of 
November 2, 2017, the corporation was and remains obligated under 
applicable law (for example, state contract law) to pay the compensation 
under the contract if the employee performs services or satisfies the 
applicable vesting conditions. This section applies to the deduction for 
any amount of compensation that exceeds the grandfathered amount. If a 
grandfathered amount and non-grandfathered amount are otherwise 
deductible for the same taxable year and, under the rules of Sec.  
1.162-27, the deduction of some or all of the grandfathered amount may 
be limited (for example, the grandfathered amount does not satisfy the 
requirements of Sec.  1.162-27(e)(2) through (5) as qualified 
performance-based compensation), then the grandfathered amount is 
aggregated with the non-grandfathered amount to determine the deduction 
disallowance for the taxable year under section 162(m)(1) (so that the 
deduction limit applies to the excess of the aggregated amount over $1 
million).
    (ii) Contracts that are terminable or cancelable. If a written 
binding contract is renewed after November 2, 2017,

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this section (and not Sec.  1.162-27) applies to any payments made after 
the renewal. A written binding contract that is terminable or cancelable 
by the corporation without the employee's consent after November 2, 
2017, is treated as renewed as of the earliest 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 or extended as of a certain date unless either the 
corporation or the employee provides notice of termination of the 
contract at least 30 days before that date, the contract is treated as 
renewed 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 (unless the contract is renewed before that 
date, in which case, it is treated as renewed on the earlier 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 renewed 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. A contract is not treated as renewed if 
upon termination or cancellation of the contract the employment 
relationship continues but would no longer be covered by the contract. 
However, if the employment continues after the termination or 
cancellation, payments with respect to the post-termination or post-
cancellation employment are not made pursuant to the contract (and, 
therefore, are not grandfathered amounts).
    (iii) Compensation payable under a plan or arrangement. If a 
compensation plan or arrangement is a written binding contract in effect 
on November 2, 2017, the deduction for the amount that the corporation 
is obligated to pay to an employee pursuant to the plan or arrangement 
is not subject to this section solely because the employee was not 
eligible to participate in the plan or arrangement as of November 2, 
2017, provided the employee was employed on November 2, 2017, 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.
    (iv) Compensation subject to recovery by corporation. If the 
corporation is obligated or has discretion to recover compensation paid 
in a taxable year only upon the future occurrence of a condition that is 
objectively outside of the corporation's control, then the corporation's 
right to recovery is disregarded for purposes of determining the 
grandfathered amount for the taxable year. Whether or not the 
corporation exercises its discretion to recover any compensation does 
not affect the amount of compensation that the corporation remains 
obligated to pay under applicable law.
    (v) Compensation payable from an account balance plan--(A) In 
general. Except as otherwise provided in this paragraph (g), the 
grandfathered amount of payments from an account balance plan (as 
defined in Sec.  1.409A-1(c)(2)(i)(A)) that is a written binding 
contract in effect as of November 2, 2017, is the amount that the 
corporation is obligated to pay pursuant to the terms of the account 
balance plan in effect as of that date, as determined under applicable 
law. If under the terms of the plan, the corporation is obligated to pay 
the employee the account balance that is credited with earnings and 
losses and has no right to terminate or materially amend the plan, then 
the grandfathered amount would be the account balance as of November 2, 
2017, plus any additional contributions and earnings and losses that the 
corporation is obligated to credit to the account balance in accordance 
with the terms of the plan as of November 2, 2017, through the date of 
payment.
    (B) Account balance plan providing right to terminate. If under the 
terms of the account balance plan in effect as of November 2, 2017, the 
corporation may terminate the contract and distribute the account 
balance to the employee,

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then the grandfathered amount would be the account balance determined as 
if the corporation had terminated the plan on November 2, 2017 or, if 
later, the earliest possible date the plan could be terminated in 
accordance with the terms of the plan (termination date). Whether 
additional contributions and earnings and losses credited to the account 
balance after the termination date, through the earliest possible date 
the account balance could have been distributed to the employee in 
accordance with the terms of the plan, are grandfathered depends on 
whether the terms of the plan require the corporation to make those 
contributions or credit those earnings and losses through that 
distribution date. Notwithstanding the foregoing, the corporation may 
treat the account balance as of the termination date as the 
grandfathered amount regardless of when the amount is paid and 
regardless of whether it has been credited with additional contributions 
or earnings or losses prior to payment.
    (C) Account balance plan providing right to discontinue future 
contributions. If under the terms of the account balance plan in effect 
as of November 2, 2017, the corporation has no right to terminate the 
plan, but may discontinue future contributions and distribute the 
account balance in accordance with the terms of the plan, then the 
grandfathered amount would be the account balance determined as if the 
corporation had exercised the right to discontinue contributions on 
November 2, 2017, or, if later, the earliest permissible date the 
corporation could exercise that right in accordance with the terms of 
the plan (the freeze date). If, after the freeze date, the plan requires 
the crediting of earnings and losses on the account balance through the 
payment date, then the earnings and losses credited to the grandfathered 
account balance would also be grandfathered. Notwithstanding the 
foregoing, the corporation may treat the account balance as of the 
freeze date as the grandfathered amount regardless of when the amount is 
paid and regardless of whether it has been credited with earnings or 
losses prior to payment.
    (vi) Compensation payable from a nonaccount balance plan--(A) In 
general. Except as otherwise provided in this paragraph (g), the 
grandfathered amount of payments from a nonaccount balance plan (as 
defined in Sec.  1.409A-1(c)(2)(i)(C)) that is a written binding 
contract in effect as of November 2, 2017, is the amount that the 
corporation is obligated to pay pursuant to the terms of the nonaccount 
balance plan in effect as of that date, as determined under applicable 
law. If under the terms of the plan, the corporation is obligated to pay 
the employee the benefit under the plan and has no right to terminate or 
materially amend the plan, then the grandfathered amount would be the 
benefit under the plan as of November 2, 2017, plus any additional 
accrued benefits that the corporation is obligated to pay in accordance 
with the terms of the plan as of November 2, 2017, through the date of 
payment.
    (B) Nonaccount balance plan providing right to terminate. If under 
the terms of the nonaccount balance plan in effect as of November 2, 
2017, the corporation may terminate the plan and distribute the total 
benefit to the employee, then the grandfathered amount would be the 
present value of the total benefit (lump sum value) determined as if the 
corporation had terminated the plan on November 2, 2017 or, if later, 
the earliest possible date the plan could be terminated in accordance 
with the terms of the plan (termination date). Whether an increase or 
decrease in the lump sum value after the termination date, through the 
earliest possible date the lump sum value could have been distributed to 
the employee, is grandfathered depends on whether the terms of the plan 
require the corporation to increase or decrease the lump sum value 
through the distribution date. For example, if the plan did not require 
the corporation to make further service or compensation credits, then 
any increase in the lump sum value for these credits after the 
termination date is not grandfathered. Notwithstanding the foregoing, 
the corporation may treat the lump sum value as of the termination date 
as the grandfathered amount regardless of when the amount is paid and 
regardless of whether it has increased or decreased prior to payment. 
For purposes of this paragraph

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(g)(1)(vi)(B), the lump sum value is determined based on the actuarial 
methods and assumptions provided in the plan in effect on November 2, 
2017, if the assumptions are reasonable, or any reasonable actuarial 
assumptions if the plan does not provide for applicable actuarial 
methods and assumptions or the terms of the plan were not reasonable. 
The determination of the lump sum value may not take into account the 
likelihood that payments will not be made (or will be reduced) because 
of the unfunded status of the plan, the risk that the employer, the 
trustee, or another party will be unwilling or unable to pay, the 
possibility of future plan amendments, the possibility of a future 
change in the law, or similar risks or contingencies. If the benefit 
provided under the plan in effect on November 2, 2017, is paid as a life 
annuity or other form of benefit that is not a single lump sum payment, 
the application of the grandfathered amount to the payments of the 
benefit is determined in accordance with the ordering rule of paragraph 
(g)(1)(viii) of this section.
    (C) Nonaccount balance plan providing right to discontinue future 
accrual of benefits. If under the terms of the nonaccount balance plan 
in effect as of November 2, 2017, the corporation has no right to 
terminate the plan, but may discontinue future accruals of benefits and 
distribute the benefit in accordance with the terms of the plan, then 
the grandfathered amount would be the lump sum value of the total 
benefit (lump sum value) determined as if the corporation had exercised 
the right to discontinue the future accrual of benefits on November 2, 
2017, or, if later, the earliest permissible date the corporation could 
exercise such right in accordance with the terms of the plan (the freeze 
date). If, after the freeze date, the plan required the corporation to 
increase or decrease the lump sum value through the payment date, then 
any increase to the grandfathered lump sum would also be grandfathered. 
Notwithstanding the foregoing, the corporation may treat the lump sum 
value determined as of the freeze date as the grandfathered amount 
regardless of when the amount is paid and regardless of whether it has 
been increased or decreased prior to payment. For purposes of this 
paragraph (g)(1)(vi)(C), the lump sum value is determined based on the 
actuarial methods and assumptions provided in the plan in effect on 
November 2, 2017, if the assumptions are reasonable, or any reasonable 
actuarial assumptions if the plan does not provide for applicable 
actuarial methods and assumptions or the terms of the plan were not 
reasonable. The determination of the lump sum value may not take into 
account the likelihood that payments will not be made (or will be 
reduced) because of the unfunded status of the plan, the risk that the 
employer, the trustee, or another party will be unwilling or unable to 
pay, the possibility of future plan amendments, the possibility of a 
future change in the law, or similar risks or contingencies. If the 
benefit paid under the plan in effect on November 2, 2017, is paid as a 
life annuity or other form of benefit that is not a single lump sum 
payment, the application of the grandfathered amount to the payments of 
the benefit is determined in accordance with the ordering rule of 
paragraph (g)(1)(viii) of this section.
    (vii) Grandfathered amount limited to a particular plan or 
arrangement. The grandfathered amount under a plan or arrangement 
applies solely to the amounts paid under that plan or arrangement, so 
that regardless of whether all of the grandfathered amount is paid to 
the participant (for example, regardless of whether some or all of the 
grandfathered amount under the plan is forfeited under the terms of the 
plan), no portion of that grandfathered amount may be treated as a 
grandfathered amount under any other separate plan or arrangement in 
which the employee is a participant.
    (viii) Ordering rule. If a portion of the amount payable under a 
plan or arrangement is a grandfathered amount and a portion is subject 
to this section, and payment under the plan or arrangement is made in a 
series of payments (including payments as a life annuity), the 
grandfathered amount is allocated to the first payment of an amount 
under the plan or arrangement that is otherwise deductible. If the 
grandfathered amount exceeds the initial payment, the excess is 
allocated to

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the next payment of an amount under the plan or arrangement that is 
otherwise deductible, and this process is repeated until the entire 
grandfathered amount has been paid. Notwithstanding the foregoing, for 
amounts otherwise deductible for taxable years ending before December 
20, 2019, the grandfathered amount may be allocated to each payment on a 
pro rata basis or to the last otherwise deductible payment. If one of 
these two methods was used for taxable years ending before December 20, 
2019, then, for taxable years ending on or after December 20, 2019, the 
method must be changed to allocate any remaining grandfathered amount to 
the first payment for the remaining payments (treating as the first 
payment the first otherwise deductible amount for taxable years ending 
on or after December 20, 2019).
    (2) Material modifications. (i) If a written binding contract is 
modified on or after November 2, 2017, this section (and not Sec.  
1.162-27) applies to any payments made after the modification. A 
material modification occurs when the contract is amended to increase 
the amount of compensation payable to the employee. If a written binding 
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 before a material modification are not 
affected, but amounts received subsequent to the material modification 
are treated as paid pursuant to a new contract, rather than as paid 
pursuant to a written binding contract in effect on November 2, 2017.
    (ii) A modification of the contract that accelerates the payment of 
compensation is 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, 
any compensation paid or to be paid that is in excess of the amount that 
was originally payable to the employee under the contract will not be 
treated as resulting in a material modification if the additional amount 
is based on applying to the amount originally payable either a 
reasonable rate of interest or the rate of return on a predetermined 
actual investment as defined in Sec.  31.3121(v)(2)-1(d)(2)(i)(B) of 
this chapter (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 
reasonable rate of interest or the actual rate of return on the 
predetermined actual investment (including any decrease, as well as any 
increase, in the value of the investment). For an arrangement under 
which the grandfathered amounts are subject to increase or decrease 
based on the performance of a predetermined actual investment, the 
addition or substitution of a predetermined actual investment or 
reasonable interest rate as an investment alternative for amounts 
deferred is not treated as a material modification. However, a 
modification of a contract to defer payment of a grandfathered amount 
that results in payment of additional amounts (such as additional 
earnings) does not necessarily mean that the additional amounts are 
grandfathered amounts; for rules concerning the determination of 
grandfathered amounts see paragraph (g) of this section. Notwithstanding 
the foregoing, if compensation attributable to an option to purchase 
stock (other than an incentive stock option described in section 422 or 
a stock option granted under an employee stock purchase plan described 
in section 423) or a stock appreciation right is grandfathered, an 
extension of the exercise period that is extended in compliance with 
Sec.  1.409A-1(b)(5)(v)(C)(1) will not be treated as a material 
modification and the amount of compensation paid upon the exercise of 
the stock option or stock appreciation right will be grandfathered.
    (iii) 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 written binding contract 
if the facts and circumstances demonstrate that the additional 
compensation to be paid is based on substantially the same elements or 
conditions as the compensation that is otherwise paid pursuant to the 
written binding contract. However, a material

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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, the failure, in whole or in part, 
to exercise negative discretion under a contract does not result in the 
material modification of that contract (although the existence of the 
negative discretion under the contract may impact the initial 
determination of whether amounts under the contract are grandfathered 
amounts).
    (iv) If a grandfathered amount is subject to a substantial risk of 
forfeiture (as defined in Sec.  1.409A-1(d)), then a modification of the 
contract that results in a lapse of the substantial risk of forfeiture 
is not considered a material modification. Furthermore, for compensation 
received pursuant to the substantial vesting of restricted property, or 
the exercise of a stock option or stock appreciation right that does not 
provide for a deferral of compensation (as defined in Sec.  1.409A-
1(b)(5)(i) and (ii)), a modification of a written binding contract in 
effect on November 2, 2017, that results in a lapse of the substantial 
risk of forfeiture (as defined Sec.  1.83-3(c)) is not considered a 
material modification.
    (3) Examples. The following examples illustrate the provisions of 
this paragraph (g). For each example, assume for all relevant years that 
the corporation is a publicly held corporation within the meaning of 
paragraph (c)(1) of this section and is a calendar year taxpayer, and is 
not a ``smaller reporting company'' or ``emerging growth company'' for 
purposes of reporting under the Exchange Act. Furthermore, assume that, 
for each example, if any arrangement is subject to section 409A, then 
the arrangement complies with section 409A, and that no arrangement is 
subject to section 457A.
    (i) Example 1 (Multi-year agreement for annual salary)--(A) Facts. 
On October 2, 2017, Corporation X executed a three-year employment 
agreement with Employee A for an annual salary of $2,000,000 beginning 
on January 1, 2018. Employee A serves as the PFO of Corporation X for 
the 2017 through 2020 taxable years. The agreement provides for 
automatic extensions after the three-year term for additional one-year 
periods, unless the corporation exercises its option to terminate the 
agreement within 30 days before the end of the three-year term or, 
thereafter, within 30 days before each anniversary date. Termination of 
the employment agreement does not require the termination of Employee 
A's employment with Corporation X. Under applicable law, the agreement 
for annual salary constitutes a written binding contract in effect on 
November 2, 2017, to pay $2,000,000 of annual salary to Employee A for 
three years through December 31, 2020.
    (B) Conclusion. If this section applies, Employee A is a covered 
employee for Corporation X's 2018 through 2020 taxable years. Because 
the October 2, 2017, employment agreement is a written binding contract 
to pay Employee A an annual salary of $2,000,000, this section does not 
apply (and Sec.  1.162-27 does apply) to the deduction for Employee A's 
annual salary. Pursuant to Sec.  1.162-27(c)(2), Employee A is not a 
covered employee for Corporation X's 2018 through 2020 taxable years. 
The deduction for Employee A's annual salary for the 2018 through 2020 
taxable years is not subject to section 162(m)(1). However, the 
employment agreement is treated as renewed on January 1, 2021, unless it 
is previously terminated, and the deduction limit of this Sec.  1.162-33 
(and not Sec.  1.162-27) will apply to the deduction for any payments 
made under the employment agreement on or after that date.
    (ii) Example 2 (Agreement for severance based on annual salary and 
discretionary bonus)--(A) Facts. The facts are the same as in paragraph 
(g)(3)(i) of this section (Example 1), except that the employment 
agreement also requires Corporation X to pay Employee A severance if 
Corporation X terminates the employment relationship without cause 
during the term of the agreement. The amount of severance is equal to 
the sum of two times Employee A's annual salary plus two times Employee 
A's discretionary bonus (if any) paid within 24 months preceding 
termination. Under applicable law, the agreement for severance 
constitutes a written binding contract

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in effect on November 2, 2017, to pay $4,000,000 (two times Employee A's 
$2,000,000 annual salary) if Corporation X terminates Employee A's 
employment without cause during the term of the agreement.
    (B) Conclusion. If this section applies, Employee A is a covered 
employee for Corporation X's 2018 through 2020 taxable years. Because 
the October 2, 2017, employment agreement is a written binding contract 
to pay Employee A $4,000,000 if Employee A is terminated without cause 
prior to December 31, 2020, this section does not apply (and Sec.  
1.162-27 does apply) to the deduction for $4,000,000 of Employee A's 
severance. Pursuant to Sec.  1.162-27(c)(2), Employee A is not a covered 
employee for Corporation X's 2018 through 2020 taxable years. The 
deduction for $4,000,000 of Employee A's severance is not subject to 
section 162(m)(1). However, the employment agreement is treated as 
renewed on January 1, 2021, unless it is previously terminated, and this 
Sec.  1.162-33 (and not Sec.  1.162-27) will apply to the deduction for 
any payments made under the employment agreement, including for 
severance, on or after that date.
    (iii) Example 3 (Effect of discretionary bonus payment on agreement 
for severance based on annual salary and discretionary bonus)--(A) 
Facts. The facts are the same as in paragraph (g)(3)(ii) of this section 
(Example 2), except that, on October 31, 2017, Corporation X paid 
Employee A a discretionary bonus of $100,000, on May 14, 2018, 
Corporation X paid Employee A a discretionary bonus of $600,000, and on 
April 30, 2019, terminated Employee A's employment without cause. 
Pursuant to the terms of the employment agreement for severance, on May 
1, 2019, Corporation X paid to Employee A a $5,400,000 severance payment 
(the sum of two times the $2,000,000 annual salary, two times the 
$100,000 discretionary bonus, and two times the $600,000 discretionary 
bonus).
    (B) Conclusion. If this section applies, Employee A is a covered 
employee for Corporation X's 2019 taxable year. Because the October 2, 
2017, agreement is a written binding contract to pay Employee A 
$4,000,000 if Employee A is terminated without cause prior to December 
31, 2020, and $200,000 if Corporation X terminates Employee A's 
employment without cause prior to October 31, 2019, this section does 
not apply (and Sec.  1.162-27 does apply) to the deduction for 
$4,200,000 of Employee A's severance payment. The deduction for 
$4,200,000 of Employee A's severance payment is not subject to section 
162(m)(1). Because the October 2, 2017, agreement is not a written 
binding contract to pay Employee A's $600,000 discretionary bonus 
(since, as of November 2, 2017, Corporation X was not obligated under 
applicable law to make the bonus payment), the deduction for $1,200,000 
of the $5,400,000 payment is subject to this section (and not Sec.  
1.162-27).
    (iv) Example 4 (Effect of adjustment to annual salary on 
severance)--(A) Facts. The facts are the same as in paragraph (g)(3)(ii) 
of this section (Example 2), except that the employment agreement 
provides for discretionary increases in salary and, on January 1, 2019, 
Corporation X increased Employee A's annual salary from $2,000,000 to 
$2,050,000, an increase that was less than a reasonable, cost-of-living 
adjustment.
    (B) Conclusion (Annual salary). If this section applies, Employee A 
is a covered employee for Corporation X's 2018 through 2020 taxable 
years. Because the October 2, 2017, agreement is a written binding 
contract to pay Employee A an annual salary of $2,000,000, this section 
does not apply (and Sec.  1.162-27 does apply) to the deduction for 
Employee A's annual salary unless the change in the salary is a material 
modification. Even though the $50,000 increase is paid on the basis of 
substantially the same elements or conditions as the salary that is 
otherwise paid under the contract, the $50,000 increase does not 
constitute a material modification because it is less than or equal to a 
reasonable cost-of-living increase to the $2,000,000 annual salary 
Corporation X is required to pay under applicable law as of November 2, 
2017. However, the deduction for the $50,000 increase is subject to this 
section (and not Sec.  1.162-27).
    (C) Conclusion (Severance payment). Because the October 2, 2017, 
agreement is a written binding contract to pay Employee A severance of 
$4,000,000, this section would not apply (and Sec.  1.162-27

[[Page 325]]

would apply) to the deduction for this amount of severance unless the 
change in the employment agreement is a material modification. Even 
though the $100,000 increase in severance (two times the $50,000 
increase in salary) would be paid on the basis of substantially the same 
elements or conditions as the severance that would otherwise be paid 
pursuant to the written binding contract, the $50,000 increase in salary 
on which it is based does not constitute a material modification of the 
written binding contract since it is less than or equal to a reasonable 
cost-of-living increase. However, the deduction for the $100,000 
increase in severance is subject to this section (and not Sec.  1.162-
27).
    (v) Example 5 (Effect of adjustment to annual salary on severance)--
(A) Facts. The facts are the same as in paragraph (g)(3)(iv) of this 
section (Example 4), except that, on January 1, 2019, Corporation X 
increased Employee A's annual salary from $2,000,000 to $3,000,000, an 
increase that exceeds a reasonable, cost-of-living adjustment.
    (B) Conclusion (Annual salary). If this section applies, Employee A 
is a covered employee for Corporation X's 2018 through 2020 taxable 
years. Because the October 2, 2017, agreement is a written binding 
contract to pay Employee A an annual salary of $2,000,000, this section 
does not apply (and Sec.  1.162-27 does apply) to the deduction for 
Employee A's annual salary unless the change in the employment agreement 
is a material modification. The $1,000,000 increase 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 pursuant to the 
written binding contract, and it exceeds a reasonable, annual cost-of-
living increase from the $2,000,000 annual salary for 2018 that 
Corporation X is required to pay under applicable law as of November 2, 
2017. Because the written binding contract is materially modified as of 
January 1, 2019, the deduction for all annual salary paid to Employee A 
in 2019 and thereafter is subject to this section (and not Sec.  1.162-
27).
    (C) Conclusion (Severance payment). Because the October 2, 2017, 
agreement is a written binding contract to pay Employee A severance of 
$4,000,000, this section would not apply (and Sec.  1.162-27 would 
apply) to the deduction for this amount of severance unless the change 
in the employment agreement is a material modification. The additional 
$2,000,000 severance payment (two times the $1,000,000 increase in 
annual salary) constitutes a material modification of the written 
binding contract because the $1,000,000 increase in salary on which it 
is based constitutes a material modification of the written binding 
contract since it exceeds a reasonable cost-of-living increase from the 
$2,000,000 annual salary for 2018 that Corporation X is required to pay 
under applicable law as of November 2, 2017. Because the agreement is 
materially modified as of January 1, 2019, the deduction for any amount 
of severance paid to Employee A under the agreement is subject to this 
section (and not Sec.  1.162-27).
    (vi) Example 6 (Elective deferral of an amount that corporation was 
obligated to pay under applicable law)--(A) Facts. The facts are the 
same as in paragraph (g)(3)(i) of this section (Example 1), except that, 
on December 15, 2018, Employee A makes a deferral election under a 
nonqualified deferred compensation (NQDC) plan to defer $200,000 of 
annual salary earned and payable in 2019. Pursuant to the NQDC plan, the 
$200,000, including earnings, is to be paid in a lump sum on the date 
six months following Employee A's separation from service. The earnings 
are based on the Standard & Poor's 500 Index. Under applicable law, 
pursuant to the written binding contract in effect on November 2, 2017, 
(and absent the deferral agreement) Corporation X would have been 
obligated to pay $200,000 to Employee A in 2019, but is not obligated to 
pay any earnings on the $200,000 deferred pursuant to the deferral 
election Employee A makes on December 15, 2018. Employee A separates 
from service on December 15, 2020. On June 15, 2021, Corporation X pays 
$250,000 (the deferred $200,000 of salary plus $50,000 in earnings).
    (B) Conclusion. If this section applies, Employee A is a covered 
employee for Corporation X's 2021 taxable year. Employee A's NQDC plan 
is not a material

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modification of the written binding contract in effect on November 2, 
2017, because the earnings to be paid under the NQDC plan are based on a 
predetermined actual investment (as defined in Sec.  31.3121(v)(2)-
1(d)(2)(i)(B) of this chapter). The deduction for the $50,000 of 
earnings to be paid that exceed the amount originally payable to 
Employee A under the written binding contract ($200,000 of salary) are 
subject to this section (and not Sec.  1.162-27). This section does not 
apply (and Sec.  1.162-27 does apply) to the deduction for the $200,000 
portion of the $250,000 payment that Corporation X was obligated under 
applicable law to pay as of November 2, 2017. Pursuant to Sec.  1.162-
27(c)(2), Employee A is not a covered employee for Corporation X's 2021 
taxable year; thus, the deduction for the $200,000 payment is not 
subject to section 162(m)(1).
    (vii) Example 7 (Compensation subject to discretionary recovery by 
corporation)--(A) Facts. Employee B serves as the PFO of Corporation Z 
for its 2017 through 2019 taxable years. On October 2, 2017, Corporation 
Z executed a bonus agreement with Employee B that requires Corporation Z 
to pay Employee B a performance bonus of $3,000,000 on May 1, 2019, if 
Corporation Z's net earnings increase by at least 10% for its 2018 
taxable year based on the financial statements filed with the SEC. The 
agreement does not permit Corporation Z to reduce the amount of the 
bonus payment for any reason if the Corporation Z attains the net 
earnings performance target. However, the agreement provides that, if 
the bonus is paid and subsequently the financial statements are restated 
to show that the net earnings did not increase by at least 10%, then 
Corporation Z may, in its discretion, recover the $3,000,000 from 
Employee B within six months of the restatement. Under applicable law, 
the agreement for the performance bonus constitutes a written binding 
contract in effect on November 2, 2017, to pay $3,000,000 to Employee B 
if Corporation Z's net earnings increase by at least 10% for its 2018 
taxable year based on the financial statements filed with the SEC. On 
May 1, 2019, Corporation Z pays $3,000,000 to Employee B because its net 
earnings increased by at least 10% of its 2018 taxable year.
    (B) Conclusion. If this section applies, Employee B is a covered 
employee for Corporation Z's 2019 taxable year. Because the October 2, 
2017, agreement is a written binding contract to pay Employee B 
$3,000,000 if the applicable conditions are met, this section does not 
apply (and Sec.  1.162-27 does apply) to the deduction for the 
$3,000,000 regardless of whether Corporation Z's financial statements 
are restated to show that its net earnings did not increase by at least 
10%, and regardless of whether Corporation Z exercises its discretion to 
recover the bonus if Corporation Z's financial statements are restated 
to show that its net earnings did not increase by at least 10%.
    (viii) Example 8 (Performance bonus plan with negative discretion)--
(A) Facts. Employee E serves as the PEO of Corporation V for the 2017 
and 2018 taxable years. On February 1, 2017, Corporation V establishes a 
bonus plan, under which Employee E will receive a cash bonus of 
$1,500,000 if a specified performance goal is satisfied. The 
compensation committee retains the right, if the performance goal is 
met, to reduce the bonus payment to no less than $400,000 if, in its 
judgment, other subjective factors warrant a reduction. On November 2, 
2017, under applicable law, which takes into account the employer's 
ability to exercise negative discretion, the bonus plan established on 
February 1, 2017, constitutes a written binding contract to pay 
$400,000. On March 1, 2018, the compensation committee certifies that 
the performance goal was satisfied, but exercises its discretion to 
reduce the award to $500,000. On April 1, 2018, Corporation V pays 
$500,000 to Employee E. The payment satisfies the requirements of Sec.  
1.162-27(e)(2) through (5) as qualified performance-based compensation.
    (B) Conclusion. If this section applies, Employee E is a covered 
employee for Corporation V's 2018 taxable year. Because the February 1, 
2017, plan is a written binding contract to pay Employee E $400,000 if 
the performance goal is satisfied, this section does not apply (and 
Sec.  1.162-27 does apply) to the deduction for the $400,000 portion of 
the

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$500,000 payment. Furthermore, pursuant to paragraph (g)(2)(iii) of this 
section, the failure of the compensation committee to exercise its 
discretion to reduce the award further to $400,000, instead of $500,000, 
does not result in a material modification of the contract. Pursuant to 
Sec.  1.162-27(e)(1), the deduction for the $400,000 payment is not 
subject to section 162(m)(1) because the payment satisfies the 
requirements of Sec.  1.162-27(e)(2) through (5) as qualified 
performance-based compensation. The deduction for the remaining $100,000 
of the $500,000 payment is subject to this section (and not Sec.  1.162-
27) and therefore the status as qualified performance-based compensation 
is irrelevant to the application of section 162(m)(1) to this remaining 
amount.
    (ix) Example 9 (Equity-based compensation with underlying grants 
made prior to November 2, 2017)--(A) Facts. On January 2, 2017, 
Corporation T executed a 4-year employment agreement with Employee G to 
serve as its PEO, and Employee G serves as the PEO for the four-year 
term. Pursuant to the employment agreement, on January 2, 2017, 
Corporation T executed a grant agreement and granted to Employee G 
nonqualified stock options to purchase 1,000 shares of Corporation T 
stock, stock appreciation rights (SARs) on 1,000 shares, and 1,000 
shares of Corporation T restricted stock. On the date of grant, the 
stock options had no readily ascertainable fair market value as defined 
in Sec.  1.83-7(b), and neither the stock options nor the SARs provided 
for a deferral of compensation under Sec.  1.409A-1(b)(5)(i)(A) and (B). 
The stock options, SARs, and shares of restricted stock are subject to a 
substantial risk of forfeiture and all substantially vest on January 2, 
2020. Employee G may exercise the stock options and the SARs at any time 
from January 2, 2020, through January 2, 2027. On January 2, 2020, 
Employee G exercises the stock options and the SARs, and the 1,000 
shares of restricted stock become substantially vested (as defined in 
Sec.  1.83-3(b)). The grant agreement pursuant to which grants of the 
stock options, SARs, and shares of restricted stock are made constitutes 
a written binding contract under applicable law. The compensation 
attributable to the stock options and the SARs satisfy the requirements 
of Sec.  1.162-27(e)(2) through (5) as qualified performance-based 
compensation.
    (B) Conclusion. If this section applies, Employee G is a covered 
employee for Corporation T's 2020 taxable year. Because the January 2, 
2017, grant agreement constitutes a written binding contract, this 
section does not apply (and Sec.  1.162-27 does apply) to the deduction 
for compensation received pursuant to the exercise of the stock options 
and the SARs, or the restricted stock becoming substantially vested (as 
defined in Sec.  1.83-3(b)). Pursuant to Sec.  1.162-27(e)(1), the 
deduction attributable to the stock options and the SARs is not subject 
to section 162(m)(1) because the compensation satisfies the requirements 
of Sec.  1.162-27(e)(2) through (5) as qualified performance-based 
compensation. However, the deduction attributable to the restricted 
stock is subject to section 162(m)(1) because the compensation does not 
satisfy the requirements of Sec.  1.162-27(e)(2) through (5) as 
qualified performance-based compensation.
    (x) Example 10 (Plan in which an employee is not a participant on 
November 2, 2017)--(A) Facts. On October 2, 2017, Employee H executes an 
employment agreement with Corporation Y to serve as its PFO, and begins 
employment with Corporation Y. The employment agreement, which is a 
written binding contract under applicable law, provides that if Employee 
H continues in his position through April 1, 2018, Employee H will 
become a participant in the NQDC plan of Corporation Y and that Employee 
H's benefit accumulated on that date will be $3,000,000. On April 1, 
2021, Employee H receives a payment of $4,500,000 (the increase from 
$3,000,000 to $4,500,000 is not a result of a material modification as 
defined in paragraph (g)(2) of this section), which is the entire 
benefit accumulated under the plan through the date of payment.
    (B) Conclusion. If this section applies, Employee H is a covered 
employee for Corporation Y's 2021 taxable year. Even though Employee H 
was not eligible to participate in the NQDC plan on November 2, 2017, 
Employee H had the right to participate in the plan under a written 
binding contract as of that

[[Page 328]]

date. Because the amount required to be paid pursuant to the written 
binding contract is $3,000,000, this section does not apply (and Sec.  
1.162-27 does apply) to the deduction for the $3,000,000 portion of the 
$4,500,000. Pursuant to Sec.  1.162-27(c)(2), Employee H is not a 
covered employee of Corporation Y for the 2021 taxable year. The 
deduction for the $3,000,000 portion of the $4,500,000 is not subject to 
section 162(m)(1). The deduction for the remaining $1,500,000 portion of 
the payment is subject to this section (and not Sec.  1.162-27).
    (xi) Example 11 (Material modification of annual salary)--(A) Facts. 
On January 2, 2017, Corporation R executed a 5-year employment agreement 
with Employee I to serve as Corporation R's PFO, providing for an annual 
salary of $1,800,000. The agreement constitutes a written binding 
contract under applicable law. In 2017 and 2018, Employee I receives the 
salary of $1,800,000 per year. In 2019, Corporation R increases Employee 
I's salary by $40,000, which is less than a reasonable cost-of-living 
increase from $1,800,000. On January 1, 2020, Corporation R increases 
Employee I's salary to $2,400,000. The $560,000 increase exceeds a 
reasonable, annual cost-of-living increase from $1,840,000.
    (B) Conclusion ($1,840,000 Payment in 2019). If this section 
applies, Employee I is a covered employee for Corporation R's 2018 
through 2020 taxable years. Because the January 1, 2017, agreement is a 
written binding contract to pay Employee I an annual salary of 
$1,800,000, this section does not apply (and Sec.  1.162-27 does apply) 
to the deduction for Employee I's annual salary unless the change in the 
employment agreement is a material modification. Pursuant to Sec.  
1.162-27(c)(2), Employee I is not a covered employee of Corporation R 
for the 2019 taxable year, so the deduction for the $1,800,000 salary is 
not subject to section 162(m)(1). Even though the $40,000 increase is 
made on the basis of substantially the same elements or conditions as 
the salary, the $40,000 increase does not constitute a material 
modification of the written binding contract because the $40,000 is less 
than or equal to a reasonable cost-of-living increase. However, the 
deduction for the $40,000 increase is subject to this section (and not 
Sec.  1.162-27).
    (C) Conclusion (Salary increase to $2,400,000 in 2020). The $560,000 
increase in salary in 2020 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 salary, 
and it exceeds a reasonable, annual cost-of-living increase from 
$1,840,000. Because the written binding contract is materially modified 
as of January 1, 2020, the deduction for all salary paid to Employee I 
on and after January 1, 2020, is subject is subject to this section (and 
not Sec.  1.162-27).
    (xii) Example 12 (Additional payment not considered a material 
modification)--(A) Facts. The facts are the same as in paragraph 
(g)(3)(xi) of this section (Example 11), except that instead of an 
increase in salary, in 2020 Employee I receives a restricted stock grant 
subject to Employee I's continued employment for the balance of the 
contract.
    (B) Conclusion. The restricted stock grant is not a material 
modification of the written binding contract because any additional 
compensation paid to Employee I under the grant is not paid on the basis 
of substantially the same elements and conditions as Employee I's 
salary. However, the deduction attributable to the restricted stock 
grant is subject to this section (and not Sec.  1.162-27).
    (h) Effective/Applicability dates--(1) Effective date. This section 
is effective on December 30, 2020.
    (2) Applicability dates--(i) General applicability date. Except as 
otherwise provided in paragraph (h)(2)(ii) of this section, this section 
applies to taxable years beginning on or after December 30, 2020. 
Taxpayers may choose to apply this section for taxable years beginning 
after December 31, 2017, and before December 30, 2020 provided the 
taxpayer applies this section in its entirety and in a consistent 
manner.
    (ii) Special applicability dates--(A) Definition of covered 
employee. The definition of covered employee in paragraph (c)(2)(i) of 
this section applies to taxable years ending on or after September 10, 
2018. However, for a corporation whose fiscal year and taxable year do 
not end on the same date, the rule in paragraph (c)(2)(i)(B) of this 
section requiring the determination of the

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three most highly compensated executive officers to be made pursuant to 
the rules under the Exchange Act applies to taxable years ending on or 
after December 20, 2019.
    (B) Definition of predecessor of a publicly held corporation--(1) 
Publicly held corporations that become privately held. The definition of 
predecessor of a publicly held corporation in paragraph (c)(2)(ii)(A) of 
this section applies to any publicly held corporation that becomes a 
privately held corporation for a taxable year beginning after December 
31, 2017, and, subsequently, again becomes a publicly held corporation 
on or after December 30, 2020. The definition of predecessor of a 
publicly held corporation in paragraph (c)(2)(ii)(A) of this section 
does not apply to any publicly held corporation that became a privately 
held corporation for a taxable year beginning before January 1, 2018, 
with respect to the earlier period as a publicly held corporation; or a 
publicly held corporation that becomes a privately held corporation for 
a taxable year beginning after December 31, 2017, and, subsequently, 
again becomes a publicly held corporation before December 30, 2020.
    (2) Corporate transactions. The definition of predecessor of a 
publicly held corporation in paragraphs (c)(2)(ii)(B) through (H) of 
this section applies to corporate transactions that occur (as provided 
in the transaction timing rule of paragraph (c)(2)(ii)(I) of this 
section) on or after December 30, 2020. With respect to any of the 
following corporate transactions occurring after December 20, 2019, and 
before December 30, 2020, excluding target corporations from the 
definition of the term ``predecessor'' is not a reasonable good faith 
interpretation of the statute:
    (i) A publicly held target corporation the stock or assets of which 
are acquired by another publicly held corporation in a transaction to 
which section 381(a) applies.
    (ii) A publicly held target corporation, at least 80% of the total 
voting power of the stock of which, and at least 80% of the total value 
of the stock of which, are acquired by a publicly held acquiring 
corporation (including an affiliated group).
    (C) Definition of compensation. The definition of compensation 
provided in paragraph (c)(3)(ii) of this section (relating to 
distributive share of partnership deductions for compensation paid) 
applies to any deduction for compensation that is paid after December 
18, 2020. The definition of compensation in paragraph (c)(3)(ii) does 
not apply to compensation paid pursuant to a written binding contract 
that is in effect on December 20, 2019, and that is not materially 
modified after that date. For purposes of this paragraph (h)(3), written 
binding contract and material modification have the same meanings as 
provided in paragraphs (g)(1) and (2) of this section.
    (D) Corporations that become publicly held. The rule in paragraph 
(d) of this section (providing that the deduction limitation of 
paragraph (b) of this section applies to a deduction for any 
compensation that is otherwise deductible for the taxable year ending on 
or after the date that a privately held corporation becomes a publicly 
held corporation) applies to corporations that become publicly held 
after December 20, 2019. A privately held corporation that becomes a 
publicly held corporation on or before December 20, 2019, may rely on 
the transition rules provided in Sec.  1.162-27(f)(1) until the earliest 
of the events provided in Sec.  1.162-27(f)(2). A subsidiary that is a 
member of an affiliated group (as defined in Sec.  1.162-27(c)(1)(ii)) 
may rely on transition relief provided in Sec.  1.162-27(f)(4) if it 
becomes a separate publicly held corporation (whether in a spin-off 
transaction or otherwise) on or before December 20, 2019.
    (E) Transition rules. Except for the transition rules in paragraphs 
(g)(1)(v) through (vii) of this section, the transition rules in 
paragraphs (g)(1) and (2) of this section (providing that this section 
does not apply to compensation payable under a written binding contract 
which was in effect on November 2, 2017, and which is not modified in 
any material respect on or after such date) apply to taxable years 
ending on or after September 10, 2018.

[T.D. 9932, 85 FR 86492, Dec. 30, 2020]

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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 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

[[Page 331]]

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 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

[[Page 332]]

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:

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


[[Page 333]]

    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 $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.

[[Page 334]]

    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 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

[[Page 335]]

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 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-

[[Page 336]]

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.

    (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

[[Page 337]]

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 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

[[Page 338]]

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.
    (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

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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).

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

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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 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

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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 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

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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 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.

[[Page 343]]

    (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 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;

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    (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.

    (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

[[Page 345]]

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) 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,

[[Page 346]]

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 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

[[Page 347]]

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 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.

[[Page 348]]

    (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 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

[[Page 349]]

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, 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]

[[Page 350]]



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.

    (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

[[Page 351]]

469(e)(2)(B) and this paragraph (a)(4), the $5,000 interest expense 
allocated to other expenditures is taken into account in computing M's 
net active income, but the interest expense allocated to the passive 
activity expenditure and the portfolio expenditure is not taken into 
account for such purposes.
    (iv) Since M is a corporation, the $3,000 interest expense allocated 
to the portfolio expenditure is allowable without regard to section 
163(d). If M were an individual, however, the interest expense allocated 
to the portfolio expenditure would be treated as investment interest for 
purposes of applying the limitation of section 163(d).

    (b) Definitions. For purposes of this section--
    (1) ``Former passive activity'' means an activity described in 
section 469(f)(3), but only if an unused deduction or credit (within the 
meaning of section 469(f)(1) (A) or (B)) is allocable to the activity 
under section 469(b) for the taxable year.
    (2) ``Former passive activity expenditure'' means an expenditure 
that is taken into account under section 469 in computing the income or 
loss from a former passive activity of the taxpayer or an expenditure 
(including an expenditure properly chargeable to capital account) that 
would be so taken into account if such expenditure were otherwise 
deductible.
    (3) ``Investment expenditure'' means an expenditure (other than a 
passive activity expenditure) properly chargeable to capital account 
with respect to property held for investment (within the meaning of 
section 163(d)(5)(A)) or an expenditure in connection with the holding 
of such property.
    (4) ``Passive activity expenditure'' means an expenditure that is 
taken into account under section 469 in computing income or loss from a 
passive activity of the taxpayer or an expenditure (including an 
expenditure properly chargeable to capital account) that would be so 
taken into account if such expenditure were otherwise deductible. For 
purposes of this section, the term ``passive activity expenditure'' does 
not include any expenditure with respect to any low-income housing 
project in any taxable year in which any benefit is allowed with respect 
to such project under section 502 of the Tax Reform Act of 1986.
    (5) ``Personal expenditure'' means an expenditure that is not a 
trade or business expenditure, a passive activity expenditure, or an 
investment expenditure.
    (6) ``Portfolio expenditure'' means an investment expenditure 
properly chargeable to capital account with respect to property 
producing income of a type described in section 469(e)(1)(A) or an 
investment expenditure for an expense clearly and directly allocable to 
such income.
    (7) ``Trade or business expenditure'' means an expenditure (other 
than a passive activity expenditure or an investment expenditure) in 
connection with the conduct of any trade or business other than the 
trade or business of performing services as an employee.
    (c) Allocation of debt and interest expense--(1) Allocation in 
accordance with use of proceeds. Debt is allocated to expenditures in 
accordance with the use of the debt proceeds and, except as provided in 
paragraph (m) of this section, interest expense accruing on a debt 
during any period is allocated to expenditures in the same manner as the 
debt is allocated from time to time during such period. Except as 
provided in paragraph (m) of this section, debt proceeds and related 
interest expense are allocated solely by reference to the use of such 
proceeds, and the allocation is not affected by the use of an interest 
in any property to secure the repayment of such debt or interest. The 
following example illustrates the principles of this paragraph (c)(1):

    Example. Taxpayer A, an individual, pledges corporate stock held for 
investment as security for a loan and uses the debt proceeds to purchase 
an automobile for personal use. Interest expense accruing on the debt is 
allocated to the personal expenditure to purchase the automobile even 
though the debt is secured by investment property.

    (2) Allocation period--(i) Allocation of debt. Debt is allocated to 
an expenditure for the period beginning on the date the proceeds of the 
debt are used or treated as used under the rules of this section to make 
the expenditure and ending on the earlier of--
    (A) The date the debt is repaid; or
    (B) The date the debt is reallocated in accordance with the rules in 
paragraphs (c)(4) and (j) of this section.

[[Page 352]]

    (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.
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                 ........  .........................

[[Page 353]]

 
                                        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):

    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.

[[Page 354]]

 
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.
    (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

[[Page 355]]

(c)(4)(iv) applies only if all expenditures from an account during the 
same calendar month are similarly treated. The following example 
illustrates the application of this paragraph (c)(4)(iv):

    Example. On January 10, taxpayer G opens a checking account, 
depositing $500 of proceeds of Debt A and $1,000 of unborrowed funds. 
The following chart summarizes the transactions which occur during the 
year with respect to the account (note that these facts are the same as 
the facts of the example in paragraph (c)(4)(ii) of this section):

------------------------------------------------------------------------
                   Date                              Transaction
------------------------------------------------------------------------
Jan. 10...................................  $500 proceeds of Debt A and
                                             $1,000 unborrowed funds
                                             deposited.
Jan. 11...................................  $500 proceeds of Debt B
                                             deposited.
Feb. 17...................................  $800 personal expenditure.
Feb. 26...................................  $700 passive activity
                                             expenditure.
June 21...................................  $1,000 proceeds of Debt C
                                             deposited.
Nov. 24...................................  $800 investment expenditure.
Dec. 20...................................  $600 personal expenditure.
------------------------------------------------------------------------


Assume that G chooses to apply the optional rule of this paragraph 
(c)(4)(iv) to all expenditures. For purposes of determining the date on 
which debt is allocated to the $800 personal expenditure made on 
February 17, the $500 treated as made from the proceeds of Debt A and 
the $300 treated as made from the proceeds of Debt B are treated as 
expenditures occurring on February 1. Accordingly, Debt A is allocated 
to an investment expenditure for the account from January 10 through 
January 31 and to the personal expenditure from February 1 through 
December 31, and $300 of Debt B is allocated to an investment 
expenditure for the account from January 11 through January 31 and to 
the personal expenditure from February 1 through December 31. The 
remaining $200 of Debt B is allocated to an investment expenditure for 
the account from January 11 through January 31 and to the passive 
activity expenditure from February 1 through December 31. The $800 of 
Debt C used to make the investment expenditure on November 24 is 
allocated to an investment expenditure for the account from June 21 
through October 31 and to an investment expenditure from November 1 
through December 31. The remaining $200 of Debt C is allocated to an 
investment expenditure for the account from June 21 through November 30 
and to a personal expenditure from December 1 through December 31.

    (v) Simultaneous deposits--(A) In general. If the proceeds of two or 
more debts are deposited in an account simultaneously, such proceeds are 
treated for purposes of this paragraph (c)(4) as deposited in the order 
in which the debts were incurred.
    (B) Order in which debts incurred. If two or more debts are incurred 
simultaneously or are treated under applicable law as incurred 
simultaneously, the debts are treated for purposes of this paragraph 
(c)(4)(v) as incurred in any order the taxpayer selects.
    (C) Borrowings on which interest accrues at different rates. If 
interest does not accrue at the same fixed or variable rate on the 
entire amount of a borrowing, each portion of the borrowing on which 
interest accrues at a different fixed or variable rate is treated as a 
separate debt for purposes of this paragraph (c)(4)(v).
    (vi) Multiple accounts. The rules in this paragraph (c)(4) apply 
separately to each account of a taxpayer.
    (5) Allocation of debt; proceeds received in cash--(i) Expenditure 
within 15 days of receiving debt proceeds. If a taxpayer receives the 
proceeds of a debt in cash, the taxpayer may treat any cash expenditure 
made within 15 days after receiving the cash as made from such debt 
proceeds to the extent thereof and may treat such expenditure as made on 
the date the taxpayer received the cash. The following example 
illustrates the rule in this paragraph (c)(5)(i):

    Example. Taxpayer F incurs a $1,000 debt on August 4 and receives 
the debt proceeds in cash. F deposits $1,500 cash in an account on 
August 15 and on August 27 writes a check on the account for a passive 
activity expenditure. In addition, F engages in numerous other cash 
transactions throughout the month of August, and numerous deposits of 
borrowed and unborrowed amounts and expenditures occur with respect to 
the account during the same period. Notwithstanding these other 
transactions, F may treat $1,000 of the deposit on August 15 as an 
expenditure made from the debt proceeds on August 4. In addition, under 
the rule in paragraph (c)(4)(v)(B) of this section, F may treat the 
passive activity expenditure on August 27 as made from the $1,000 debt 
proceeds treated as deposited in the account.

    (ii) Other expenditures. Except as provided in paragraphs (c)(5) (i) 
and (iii) of this section, any debt proceeds a taxpayer (other than a 
corporation) receives in cash are treated as used to make personal 
expenditures. For purposes of this paragraph (c)(5), debt proceeds are 
received in cash if, for example, a withdrawal of cash from an account 
is treated under the rules of this

[[Page 356]]

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 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.

[[Page 357]]

    (ii) Assume that J repays $50,000 of the debt. The repayment is 
treated as a repayment of $2,941 ($50,000 x $5,000/$85,000) of the debt 
used to pay borrowing costs and a repayment of $47,059 ($50,000 x 
$80,000/$85,000) of the remaining debt. Under paragraph (d) of this 
section, J is treated as repaying the $42,500 of debt allocated to the 
personal expenditure ($2,500 of debt used to pay borrowing costs and 
$40,000 of remaining debt). In addition, assuming that under paragraph 
(d)(2) J chooses to treat the allocation to the passive activity 
expenditure as having occurred before the allocation to the investment 
expenditure, J is treated as repaying $7,500 of debt allocated to the 
passive activity expenditure ($441 of debt used to pay borrowing costs 
and $7,059 of remaining debt).

    (iv) Allocation of debt before actual receipt of debt proceeds. If 
interest properly accrues on a debt during any period before the debt 
proceeds are actually received or used to make an expenditure, the debt 
is allocated to an investment expenditure for such period.
    (7) Antiabuse rules. [Reserved]
    (d) Debt repayments--(1) General ordering rule. If, at the time any 
portion of a debt is repaid, such debt is allocated to more than one 
expenditure, the debt is treated for purposes of this section as repaid 
in the following order:
    (i) Amounts allocated to personal expenditures;
    (ii) Amounts allocated to investment expenditures and passive 
activity expenditures (other than passive activity expenditures 
described in paragraph (d)(1)(iii) of this section);
    (iii) Amounts allocated to passive activity expenditures in 
connection with a rental real estate activity with respect to which the 
taxpayer actively participates (within the meaning of section 469(i));
    (iv) Amounts allocated to former passive activity expenditures; and
    (v) Amounts allocated to trade or business expenditures and to 
expenditures described in the last sentence of paragraph (b)(4) of this 
section.
    (2) Supplemental ordering rules for expenditures in same class. 
Amounts allocated to two or more expenditures that are described in the 
subdivision of paragraph (d)(1) of this section (e.g., amounts allocated 
to different personal expenditures) are treated as repaid in the order 
in which the amounts were allocated (or reallocated) to such 
expenditures. For purposes of this paragraph (d)(2), the taxpayer may 
treat allocations and reallocations that occur on the same day as 
occurring in any order (without regard to the order in which 
expenditures are treated as made under paragraph (c)(4)(iii)(A) of this 
section).
    (3) Continuous borrowings. In the case of borrowings pursuant to a 
line of credit or similar account or arrangement that allows a taxpayer 
to borrow funds periodically under a single loan agreement--
    (i) All borrowings on which interest accrues at the same fixed or 
variable rate are treated as a single debt; and
    (ii) Borrowings or portions of borrowings on which interest accrues 
at different fixed or variable rates are treated as different debts, and 
such debts are treated as repaid for purposes of this paragraph (d) in 
the order in which such borrowings are treated as repaid under the loan 
agreement.
    (4) Examples. The following examples illustrate the application of 
this paragraph (d):

    Example 1. Taxpayer B borrows $100,000 (``Debt A'') on July 12, 
immediately deposits the proceeds in an account, and uses the debt 
proceeds to make the following expenditures on the following dates:

August 31--$40,000 passive activity expenditure 1.
October 5--$20,000 passive activity expenditure 2.
December 24--$40,000 personal expenditure.


On January 19 of the following year, B repays $90,000 of Debt A (leaving 
$10,000 of Debt A outstanding). The $40,000 of Debt A allocated to the 
personal expenditure, the $40,000 allocated to passive activity 
expenditure 1, and $10,000 of the $20,000 allocated to passive activity 
expenditure 2 are treated as repaid.
    Example 2. (i) Taxpayer A obtains a line of credit. Interest on any 
borrowing on the line of credit accrues at the lender's ``prime lending 
rate'' on the date of the borrowing plus two percentage points. The loan 
documents provide that borrowings on the line of credit are treated as 
repaid in the order the borrowings were made. A borrows $30,000 
(``Borrowing 1'') on the line of credit and immediately uses $20,000 of 
the debt proceeds to make a personal expenditure (``personal expenditure 
1'') and $10,000 to make a trade or business expenditure (``trade or 
business expenditure 1''). A subsequently borrows another $20,000 
(``Borrowing 2'') on the line of credit and immediately uses $15,000 of 
the

[[Page 358]]

debt proceeds to make a personal expenditure (``personal expenditure 
2'') and $5,000 to make a trade or business expenditure (``trade or 
business expenditure 2''). A then repays $40,000 of the borrowings.
    (ii) If the prime lending rate plus two percentage points was the 
same on both the date of Borrowing 1 and the date of Borrowing 2, the 
borrowings are treated for purposes of this paragraph (d) as a single 
debt, and A is treated as having repaid $35,000 of debt allocated to 
personal expenditure 1 and personal expenditure 2, and $5,000 of debt 
allocated to trade or business expenditure 1.
    (iii) If the prime lending rate plus two percentage points was 
different on the date of Borrowing 1 and Borrowing 2, the borrowings 
are treated as two debts, and, in accordance with the loan agreement, 
the $40,000 repaid amount is treated as a repayment of Borrowing 1 and 
$10,000 of Borrowing 2. Accordingly, A is treated as having repaid 
$20,000 of debt allocated to personal expenditure 1, $10,000 of debt 
allocated to trade or business expenditure 1, and $10,000 of debt 
allocated to personal expenditure 2.

    (e) Debt refinancings--(1) In general. To the extent proceeds of any 
debt (the ``replacement debt'') are used to repay any portion of a debt, 
the replacement debt is allocated to the expenditures to which the 
repaid debt was allocated. The amount of replacement debt allocated to 
any such expenditure is equal to the amount of debt allocated to such 
expenditure that was repaid with proceeds of the replacement debt. To 
the extent proceeds of the replacement debt are used for expenditures 
other than repayment of a debt, the replacement debt is allocated to 
expenditures in accordance with the rules of this section.
    (2) Example. The following example illustrates the application of 
this paragraph (e):

    Example. Taxpayer C borrows $100,000 (``Debt A'') on July 12, 
immediately deposits the debt proceeds in an account, and uses the 
proceeds to make the following expenditures on the following dates (note 
that the facts of this example are the same as the facts of example (1) 
in paragraph (d)(4) of this section):

August 31--$40,000 passive activity expenditure 1.
October 5--$20,000 passive activity expenditure 2.
December 24--$40,000 personal expenditure 1.


On January 19 of the following year, C borrows $120,000 (``Debt B'') and 
uses $90,000 of the proceeds of repay $90,000 of Debt A (leaving $10,000 
of Debt A outstanding). In addition, C uses $30,000 of the proceeds of 
Debt B to make a personal expenditure (``personal expenditure 2''). 
Debt B is allocated $40,000 to personal expenditure 1, $40,000 to 
passive activity expenditure 1, $10,000 to passive activity expenditure 
2, and $30,000 to personal expenditure 2. Under paragraph (d)(1) of 
this section, Debt B will be treated as repaid in the following order: 
(1) amounts allocated to personal expenditure 1, (2) amounts allocated 
to personal expenditure 2, (3) amounts allocated to passive activity 
expenditure 1, and (4) amounts allocated to passive activity 
expenditure 2.

    (f) Debt allocated to distributions by passthrough entities. 
[Reserved]
    (g) Repayment of passthrough entity debt. [Reserved]
    (h) Debt allocated to expenditures for interests in passthrough 
entities. [Reserved]
    (i) Allocation of debt to loans between passthrough entities and 
interest holders. [Reserved]
    (j) Reallocation of debt--(1) Debt allocated to capital 
expenditures--(i) Time of reallocation. Except as provided in paragraph 
(j)(2) of this section, debt allocated to an expenditure properly 
chargeable to capital account with respect to an asset (the ``first 
expenditure'') is reallocated to another expenditure on the earlier of--
    (A) The date on which proceeds from a disposition of such asset are 
used for another expenditure; or
    (B) The date on which the character of the first expenditure changes 
(e.g., from a passive activity expenditure to an expenditure that is not 
a passive activity expenditure) by reason of a change in the use of the 
asset with respect to which the first expenditure was capitalized.
    (ii) Limitation on amount reallocated. The amount of debt 
reallocated under paragraph (j)(1)(i)(A) of this section may not exceed 
the proceeds from the disposition of the asset. The amount of debt 
reallocated under paragraph (j)(1)(i)(B) of this section may not exceed 
the fair market value of the asset on the date of the change in use. In 
applying this paragraph (j)(1)(ii) with respect to a debt in any case in 
which

[[Page 359]]

two or more debts are allocable to expenditures properly chargeable to 
capital account with respect to the same asset, only a ratable portion 
(determined with respect to any such debt by dividing the amount of such 
debt by the aggregate amount of all such debts) of the fair market value 
or proceeds from the disposition of such asset shall be taken into 
account.
    (iii) Treatment of loans made by the taxpayer. Except as provided in 
paragraph (j)(1)(iv) of this section, an expenditure to make a loan is 
treated as an expenditure properly chargeable to capital account with 
respect to an asset, and for purposes of paragraph (j)(1)(i)(A) of this 
section any repayment of the loan is treated as a disposition of the 
asset. Paragraph (j)(3) of this section applies to any repayment of a 
loan in installments.
    (iv) Treatment of accounts. Debt allocated to an account under 
paragraph (c)(4)(i) of this section is treated as allocated to an 
expenditure properly chargeable to capital account with respect to an 
asset, and any expenditure from the account is treated as a disposition 
of the asset. See paragraph (c)(4) of this section for rules under which 
debt proceeds allocated to an account are treated as used for another 
expenditure.
    (2) Disposition proceeds in excess of debt. If the proceeds from the 
disposition of an asset exceed the amount of debt reallocated by reason 
of such disposition, or two or more debts are reallocated by reason of 
the disposition of an asset, the proceeds of the disposition are treated 
as an account to which the rules in paragraph (c)(4) of this section 
apply.
    (3) Special rule for deferred payment sales. If any portion of the 
proceeds of a disposition of an asset are received subsequent to the 
disposition--
    (i) The portion of the proceeds to be received subsequent to the 
disposition is treated for periods prior to the receipt as used to make 
an investment expenditure; and
    (ii) Debt reallocated by reason of the disposition is allocated to 
such investment expenditure to the extent such debt exceeds the proceeds 
of the disposition previously received (other than proceeds used to 
repay such debt).
    (4) Examples. The following examples illustrate the application of 
this paragraph (j):

    Example 1. On January 1, 1988, taxpayer D sells an asset for 
$25,000. Immediately before the sale, the amount of debt allocated to 
expenditures properly chargeable to capital account with respect to the 
asset was $15,000. The proceeds of the disposition are treated as an 
account consisting of $15,000 of debt proceeds and $10,000 of unborrowed 
funds to which paragraph (c)(4) of this section applies. Thus, if D 
immediately makes a $10,000 personal expenditure from the proceeds and 
within 15 days deposits the remaining proceeds in an account, D may, 
pursuant to paragraph (c)(4)(iii)(B) of this section, treat the entire 
$15,000 deposited in the account as proceeds of a debt.
    Example 2. The facts are the same as in example (1) except that, 
instead of receiving all $25,000 of the sale proceeds on January 1, 
1988, D receives 5,000 on that date, $10,000 on January 1, 1989, and 
$10,000 on January 1, 1990. D does not use any portion of the sale 
proceeds to repay the debt. Between January 1, 1988, and December 31, 
1988, D is treated under paragraph (j)(3) of this section as making an 
investment expenditure of $20,000 to which $10,000 of debt is allocated. 
In addition, the remaining $5,000 of debt is reallocated on January 1, 
1988, in accordance with D's use of the sales proceeds received on that 
date. Between January 1, 1989, and December 31, 1989, D is treated as 
making an investment expenditure of $10,000 to which no debt is 
allocated. In addition, as of January 1, 1989, $10,000 of debt is 
reallocated in accordance with D's use of the sales proceeds received on 
that date.
    Example 3. The facts are the same as in example (2), except that D 
immediately uses the $5,000 sale proceeds received on January 1, 1988, 
to repay $5,000 of the $15,000 debt. Between January 1, 1988, and 
December 31, 1988, D is treated as making an investment expenditure of 
$20,000 to which the remaining balance ($10,000) of the debt is 
reallocated. The results in 1989 are as described in example (2).

    (k) Modification of rules in the case of interest expense allocated 
to foreign source income. [Reserved]
    (l) [Reserved]
    (m) Coordination with other provisions--(1) Effect of other 
limitations--(i) In general. All debt is allocated among expenditures 
pursuant to the rules in this section, without regard to any

[[Page 360]]

limitations on the deductibility of interest expense on such debt. The 
applicability of the passive loss and nonbusiness interest limitations 
to interest on such debt, however, may be affected by other limitations 
on the deductibility of interest expense.
    (ii) Disallowance provisions. (Interest expense that is not 
allowable as a deduction by reason of a disallowance provision (within 
the meaning of paragraph (m)(7)(ii) of this section) is not taken into 
account for any taxable year for purposes of applying the passive loss 
and nonbusiness interest limitations.
    (iii) Deferral provisions. Interest expense that is not allowable as 
a deduction for the taxable year in which paid or accrued by reason of a 
deferral provision (within the meaning of paragraph (m)(7)(iii) of this 
section) is allocated in the same manner as the debt giving rise to the 
interest expense is allocated for such taxable year. Such interest 
expense is taken into account for purposes of applying the passive loss 
and nonbusiness interest limitations for the taxable year in which such 
interest expense is allowable under such deferral provision.
    (iv) Capitalization provisions. Interest expense that is capitalized 
pursuant to a capitalization provision (within the meaning of paragraph 
(m)(7)(i) of this section) is not taken into account as interest for any 
taxable year for purposes of applying the passive loss and nonbusiness 
interest limitations.
    (2) Effect on other limitations--(i) General rule. Except as 
provided in paragraph (m)(2)(ii) of this section, any limitation on the 
deductibility of an item (other than the passive loss and nonbusiness 
interest limitations) applies without regard to the manner in which debt 
is allocated under this section. Thus, for example, interest expense 
treated under section 265(a)(2) as interest on indebtedness incurred or 
continued to purchase or carry obligations the interest on which is 
wholly exempt from Federal income tax is not deductible regardless of 
the expenditure to which the underlying debt is allocated under this 
section.
    (ii) Exception. Capitalization provisions (within the meaning of 
paragraph (m)(7)(i) of this section) do not apply to interest expense 
allocated to any personal expenditure under the rules of this section.
    (3) Qualified residence interest. Qualified residence interest 
(within the meaning of section 163(h)(3)) is allowable as a deduction 
without regard to the manner in which such interest expense is allocated 
under the rules of this section. In addition, qualified residence 
interest is not taken into account in determining the income or loss 
from any activity for purposes of section 469 or in determining the 
amount of investment interest for purposes of section 163(d). The 
following example illustrates the rule in this paragraph (m)(3):

    Example. Taxpayer E, an individual, incurs a $20,000 debt secured by 
a residence and immediately uses the proceeds to purchase an automobile 
exclusively for E's personal use. Under the rules in this section, the 
debt and interest expense on the debt are allocated to a personal 
expenditure. If, however, the interest on the debt is qualified 
residence interest within the meaning of section 163(h)(3), the interest 
is not treated as personal interest for purposes of section 163(h).

    (4) Interest described in section 163(h)(2)(E). Interest described 
in section 163(h)(2)(E) is allowable as a deduction without regard to 
the rules of this section.
    (5) Interest on deemed distributee debt. [Reserved]
    (6) Examples. The following examples illustrate the relationship 
between the passive loss and nonbusiness interest limitations and other 
limitations on the deductibility of interest expense:

    Example 1. Debt is allocated pursuant to the rules in this section 
to an investment expenditure for the purchase of taxable investment 
securities. Pursuant to section 265(a)(2), the debt is treated as 
indebtedness incurred or continued to purchase or carry obligations the 
interest on which is wholly exempt from Federal income tax, and, 
accordingly, interest on the debt is disallowed. If section 265(a)(2) 
subsequently ceases to apply (because, for example, the taxpayer ceases 
to hold any tax-exempt obligations), and the debt at such time continues 
to be allocated to an investment expenditure, interest on the debt that 
accrues after such time is subject to section 163(d).
    Example 2. An accrual method taxpayer incurs a debt payable to a 
cash method lender who is related to the taxpayer within the meaning of 
section 267(b). During the period

[[Page 361]]

in which interest on the debt is not deductible by reason of section 
267(a)(2), the debt is allocated to a passive activity expenditure. 
Thus, interest that accrues on the debt for such period is also 
allocated to the passive activity expenditure. When such interest 
expense becomes deductible under section 267(a)(2), it will be allocated 
to the passive activity expenditure, regardless of how the debt is 
allocated at such time.
    Example 3. A taxpayer incurs debt that is allocated under the rules 
of this section to an investment expenditure. Under section 263A(f), 
however, interest expense on such debt is capitalized during the 
production period (within the meaning of section 263A(f)(4)(B)) of 
property used in a passive activity of the taxpayer. The capitalized 
interest expense is not allocated to the investment expenditure, and 
depreciation deductions attributable to the capitalized interest expense 
are subject to the passive loss limitation as long as the property is 
used in a passive activity. However, interest expense on the debt for 
periods after the production period is allocated to the investment 
expenditure as long as the debt remains allocated to the investment 
expenditure.

    (7) Other limitations on interest expense--(i) Capitalization 
provisions. A capitalization provision is any provision that requires or 
allows interest expense to be capitalized. Capitalization provisions 
include sections 263(g), 263A(f), and 266.
    (ii) Disallowance provisions. A disallowance provision is any 
provision (other than the passive loss and nonbusiness interest 
limitations) that disallows a deduction for interest expense for all 
taxable years and is not a capitalization provision. Disallowance 
provisions include sections 163(f)(2), 264(a)(2), 264(a)(4), 265(a)(2), 
265(b)(2), 279(a), 291(e)(1)(B)(ii), 805(b)(1), and 834(c)(5).
    (iii) Deferral provisions. A deferral provision is any provision 
(other than the passive loss and nonbusiness interest limitations) that 
disallows a deduction for interest expense for any taxable year and is 
not a capitalization or disallowance provision. Deferral provisions 
include sections 267(a)(2), 465, 1277, and 1282.
    (n) Effective date--(1) In general. This section applies to interest 
expense paid or accrued in taxable years beginning after December 31, 
1986.
    (2) Transitional rule for certain expenditures. For purposes of 
determining whether debt is allocated to expenditures made on or before 
August 3, 1987, paragraphs (c)(4)(iii)(B) and (c)(5)(i) of this section 
are applied by substituting ``90 days'' for ``15 days.''
    (3) Transitional rule for certain debt--(i) General rule. Except as 
provided in paragraph (n)(3)(ii) of this section, any debt outstanding 
on December 31, 1986, that is properly attributable to a business or 
rental activity is treated for purposes of this section as debt 
allocated to expenditures properly chargeable to capital account with 
respect to the assets held for use or for sale to customers in such 
business or rental activity. Debt is properly attributable to a business 
or rental activity for purposes of this section (regardless of whether 
such debt otherwise would be allocable under this section to 
expenditures in connection with such activity) if the taxpayer has 
properly and consistently deducted interest expense (including interest 
subject to limitation under section 163(d) as in effect prior to the Tax 
Reform Act of 1986) on such debt on Schedule C, E, or F of Form 1040 in 
computing income or loss from such business or rental activity for 
taxable years beginning before January 1, 1987. For purposes of this 
paragraph (n)(3), amended returns filed after July 2, 1987 are 
disregarded in determining whether a taxpayer has consistently deducted 
interest expense on Schedule C, E, or F of Form 1040 in computing income 
or loss from a business or rental activity.
    (ii) Exceptions--(A) Debt financed distributions by passthrough 
entities. [Reserved]
    (B) Election out. This paragraph (n)(3) does not apply with respect 
to debt of a taxpayer who elects under paragraph (n)(3) (viii) of this 
section to allocate debt outstanding on December 31, 1986, in accordance 
with the provisions of this section other than this paragraph (n)(3) 
(i.e., in accordance with the use of the debt proceeds).
    (iii) Business or rental activity. For purposes of this paragraph 
(n)(3), a business or rental activity is any trade or business or rental 
activity of the taxpayer. For this purpose--
    (A) A trade or business includes a business or profession the income 
and deductions of which (or, in the case of a partner or S corporation 
shareholder,

[[Page 362]]

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 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).

[[Page 363]]

    (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.
    (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

[[Page 364]]

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.
    (ii) Determination of amount of qualified indebtedness.
    (iii) Determination of amount of qualified indebtedness for mixed-
use debt.
    (iv) Example.

[[Page 365]]

    (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 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

[[Page 366]]

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 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)

[[Page 367]]

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.
    (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

[[Page 368]]

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.
    (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

[[Page 369]]

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 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

[[Page 370]]

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 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

[[Page 371]]

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).
    (3) Allocation of adjusted purchase price and fair market value. If 
a property includes both a qualified residence and other property, the 
adjusted purchase

[[Page 372]]

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 before August 16, 1986, and the grandfathered amount of 
such debt is the

[[Page 373]]

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 of the interest paid on 
the mortgage is qualified residence interest.

[[Page 374]]

    (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 limit for this debt and any other debt

[[Page 375]]

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.
    (vi) Special rule for principal payments in excess of qualified 
expenses. For purposes of paragraph (n)(1)(iii)(B),

[[Page 376]]

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


[[Page 377]]



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 multiplied by the ratio of the average balance of the secured debt 
($20,000)

[[Page 378]]

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 taxpayer may elect the new residence

[[Page 379]]

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 after the date that 
construction is

[[Page 380]]

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 381]]



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 382]]

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 383]]

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 384]]

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 385]]


    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.  1.163-15  Debt proceeds distributed from any taxpayer account 
or from cash.

    (a) In general. Regardless of paragraphs (c)(4) and (5) of Sec.  
1.163-8T, in the case of debt proceeds deposited in an account, a 
taxpayer that is applying Sec.  1.163-8T or Sec.  1.163-14 may treat any 
expenditure made from any account of the taxpayer, or from cash, within 
30 days before or 30 days after debt proceeds are deposited in any 
account of the taxpayer as made from such proceeds to the extent 
thereof. Similarly, in the case of debt proceeds received in cash, a 
taxpayer that is applying Sec.  1.163-8T or Sec.  1.163-14 may treat any 
expenditure made from any account of the taxpayer, or from cash, within 
30 days before or 30 days after debt proceeds are received in cash as 
made from such proceeds to the extent thereof. For purposes of this 
section, terms used have the same meaning as in Sec.  1.163-8T(c)(4) and 
(5).
    (b) Applicability date. This section applies to taxable years 
beginning on or after March 22, 2021. However, taxpayers and their 
related parties, within the meaning of sections 267(b) (determined 
without regard to section 267(c)(3)) and 707(b)(1), may choose to apply 
the rules in this section to a taxable year beginning after December 31, 
2017, and before March 22, 2021, provided that those taxpayers and their 
related parties consistently apply all of

[[Page 386]]

the rules in this section to that taxable year and each subsequent 
taxable year.

[T.D. 9943, 86 FR 5521, Jan. 19, 2021]



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 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.  1.163(j)-0  Table of contents.

    This section lists the table of contents for Sec. Sec.  1.163(j)-1 
through 1.163(j)-11.
    Sec.  1.163(j)-1 Definitions.
    (a) In general.
    (b) Definitions.
    (1) Adjusted taxable income.
    (i) Additions.
    (ii) Subtractions.
    (iii) Depreciation, amortization, or depletion capitalized under 
section 263A.
    (iv) Application of Sec.  1.163(j)-1(b)(1)(ii)(C), (D), and (E).
    (A) Sale or other disposition.
    (1) In general.
    (2) Intercompany transactions.
    (3) Deconsolidations.
    (4) Nonrecognition transactions.
    (B) Deductions by members of a consolidated group.
    (1) In general.
    (2) Application of the alternative computation method.
    (C) Successor rules.
    (1) Successor assets.
    (2) Successor entities.
    (D) Anti-duplication rule.
    (1) In general.
    (2) Adjustments following deconsolidation.
    (E) Alternative computation method.
    (1) Alternative computation method for property dispositions.
    (2) Alternative computation method for dispositions of member stock.
    (3) Alternative computation method for dispositions of partnership 
interests.
    (F) Cap on negative adjustments.
    (1) In general.
    (2) Example.
    (G) Treatment of depreciation, amortization, or depletion 
capitalized under section 263A.
    (v) Other adjustments.
    (vi) Additional rules relating to adjusted taxable income in other 
sections.
    (vii) ATI cannot be less than zero.
    (viii) Examples.
    (2) Applicable CFC.
    (3) Business interest expense.

[[Page 387]]

    (i) In general.
    (ii) Special rules.
    (4) Business interest income.
    (i) In general.
    (ii) Special rules.
    (5) C corporation.
    (6) Cleared swap.
    (7) Consolidated group.
    (8) Consolidated return year.
    (9) Current-year business interest expense.
    (10) Disallowed business interest expense.
    (11) Disallowed business interest expense carryforward.
    (12) Disallowed disqualified interest.
    (13) Electing farming business.
    (14) Electing real property trade or business.
    (15) Excepted regulated utility trade or business.
    (i) In general.
    (A) Automatically excepted regulated utility trades or businesses.
    (B) Electing regulated utility trades or businesses.
    (C) Designated excepted regulated utility trades or businesses.
    (ii) Depreciation and excepted and non-excepted utility trades or 
businesses.
    (A) Depreciation.
    (B) Allocation of items.
    (iii) Election to be an excepted regulated utility trade or 
business.
    (A) In general.
    (B) Scope and effect of election.
    (1) In general.
    (2) Irrevocability.
    (C) Time and manner of making election.
    (1) In general.
    (2) Election statement contents.
    (3) Consolidated group's or partnership's trade or business.
    (4) Termination of election.
    (5) Additional guidance.
    (16) Excess business interest expense.
    (17) Excess taxable income.
    (18) Floor plan financing indebtedness.
    (19) Floor plan financing interest expense.
    (20) Group.
    (21) Intercompany transaction.
    (22) Interest.
    (i) In general.
    (ii) Swaps with significant nonperiodic payments.
    (A) In general.
    (B) Exception for cleared swaps.
    (C) Exception for non-cleared swaps subject to margin or collateral 
requirements.
    (iii) Other amounts treated as interest.
    (A) Treatment of premium.
    (1) Issuer.
    (2) Holder.
    (B) Treatment of ordinary income or loss on certain debt 
instruments.
    (C) Substitute interest payments.
    (D) Section 1258 gain.
    (E) Factoring income.
    (F) Section 163(j) interest dividends.
    (1) In general.
    (2) Limitation on amount treated as interest income.
    (3) Conduit amounts.
    (4) Holding period.
    (5) Exception to holding period requirement for money market funds 
and certain regularly declared dividends.
    (iv) Anti-avoidance rules.
    (A) Principal purpose to reduce interest expense.
    (1) Treatment as interest expense.
    (2) Corresponding treatment of amounts as interest income.
    (B) Interest income artificially increased.
    (C) Principal purpose.
    (D) Coordination with anti-avoidance rule in Sec.  1.163(j)-2(j).
    (v) Examples.
    (23) Interest expense.
    (24) Interest income.
    (25) Member.
    (26) Motor vehicle.
    (27) Old section 163(j).
    (28) Ownership change.
    (29) Ownership date.
    (30) Real estate investment trust.
    (31) Real property.
    (32) Regulated investment company.
    (33) Relevant foreign corporation.
    (34) S corporation.
    (35) Section 163(j) interest dividend.
    (i) In general.
    (ii) Reduction in the case of excess reported amounts.
    (iii) Allocation of excess reported amount.
    (A) In general.
    (B) Special rule for noncalendar year RICs.
    (iv) Definitions.
    (A) Reported section 163(j) interest dividend amount.

[[Page 388]]

    (B) Excess reported amount.
    (C) Aggregate reported amount.
    (D) Post-December reported amount.
    (E) Excess section 163(j) interest income.
    (v) Example.
    (36) Section 163(j) limitation.
    (37) Section 163(j) regulations.
    (38) Separate return limitation year.
    (39) Separate return year.
    (40) Separate tentative taxable income.
    (41) Tax-exempt corporation.
    (42) Tax-exempt organization.
    (43) Tentative taxable income.
    (i) In general.
    (ii) [Reserved]
    (iii) Special rules for defining tentative taxable income.
    (44) Trade or business.
    (i) In general.
    (ii) Excepted trade or business.
    (iii) Non-excepted trade or business.
    (45) Unadjusted basis.
    (46) United States shareholder.
    (c) Applicability date.
    (1) In general.
    (2) Anti-avoidance rules.
    (3) Swaps with significant nonperiodic payments.
    (i) In general.
    (ii) Anti-avoidance rule.
    (4) Paragraphs (b)(1)(iv)(A)(2) through (4), (B) through (G), 
(b)(22)(iii)(F), and (b)(35).

    Sec.  1.163(j)-2 Deduction for business interest expense limited.

    (a) Overview.
    (b) General rule.
    (1) In general.
    (2) 50 percent ATI limitation for taxable years beginning in 2019 or 
2020.
    (3) Election to use 2019 ATI in 2020.
    (i) In general.
    (ii) Short taxable years.
    (iii) Transactions to which section 381 applies.
    (iv) Consolidated groups.
    (4) Time and manner of making or revoking the elections.
    (c) Disallowed business interest expense carryforward.
    (1) In general.
    (2) Coordination with small business exemption.
    (3) Cross-references.
    (d) Small business exemption.
    (1) Exemption.
    (2) Application of the gross receipts test.
    (i) In general.
    (ii) Gross receipts of individuals.
    (iii) Partners and S corporation shareholders.
    (iv) Tax-exempt organizations.
    (3) Determining a syndicate's loss amount.
    (e) REMICs.
    (f) Trusts.
    (i) Calculation of ATI with respect to certain trusts and estates.
    (ii) Calculation of ATI with respect to certain beneficiaries.
    (g) Tax-exempt organizations.
    (h) Examples.
    (i) [Reserved]
    (j) Anti-avoidance rule.
    (1) In general.
    (2) Examples.
    (k) Applicability dates.
    (1) In general.
    (2) Paragraphs (b)(3)(iii), (b)(3)(iv), and (d)(3).
    Sec.  1.163(j)-3 Relationship of the section 163(j) limitation to 
other provisions affecting interest.
    (a) Overview.
    (b) Coordination of section 163(j) with certain other provisions.
    (1) In general.
    (2) Disallowed interest provisions.
    (3) Deferred interest provisions.
    (4) At risk rules, passive activity loss provisions, and limitation 
on excess business losses of noncorporate taxpayers.
    (5) Capitalized interest expenses.
    (6) Reductions under section 246A.
    (7) Section 381.
    (8) Section 382.
    (c) Examples.
    (d) Applicability date.
    Sec.  1.163(j)-4 General rules applicable to C corporations 
(including REITs, RICs, and members of consolidated groups) and tax-
exempt corporations.
    (a) Scope.
    (b) Characterization of items of income, gain, deduction, or loss.
    (1) Interest expense and interest income.
    (2) Adjusted taxable income.
    (3) Investment interest, investment income, investment expenses, and 
certain other tax items of a partnership with a C corporation partner.

[[Page 389]]

    (i) Characterization as expense or income properly allocable to a 
trade or business.
    (ii) Effect of characterization on partnership.
    (iii) Separately stated interest expense and interest income of a 
partnership not treated as excess business interest expense or excess 
taxable income of a C corporation partner.
    (iv) Treatment of deemed inclusions of a domestic partnership that 
are not allocable to any trade or business.
    (4) Application to RICs and REITs.
    (i) In general.
    (ii) Tentative taxable income of RICs and REITs.
    (iii) Other adjustments to adjusted taxable income for RICs and 
REITs.
    (5) Application to tax-exempt corporations.
    (6) Adjusted taxable income of cooperatives.
    (7) Examples.
    (c) Effect on earnings and profits.
    (1) In general.
    (2) Special rule for RICs and REITs.
    (3) Special rule for partners that are C corporations.
    (4) Examples.
    (d) Special rules for consolidated groups.
    (1) Scope.
    (2) Calculation of the section 163(j) limitation for members of a 
consolidated group.
    (i) In general.
    (ii) Interest.
    (iii) Calculation of business interest expense and business interest 
income for a consolidated group.
    (iv) Calculation of adjusted taxable income.
    (v) Treatment of intercompany obligations.
    (A) In general.
    (B) Repurchase premium.
    (3) Investment adjustments.
    (4) Examples.
    (e) Ownership of partnership interests by members of a consolidated 
group.
    (1) [Reserved]
    (2) Change in status of a member.
    (3) Basis adjustments under Sec.  1.1502-32.
    (4) Excess business interest expense and Sec.  1.1502-36.
    (f) Cross-references.
    (g) Applicability date.
    (1) In general.
    (2) [Reserved]
    Sec.  1.163(j)-5 General rules governing disallowed business 
interest expense carryforwards for C corporations.
    (a) Scope and definitions.
    (1) Scope.
    (2) Definitions.
    (i) Allocable share of the consolidated group's remaining section 
163(j) limitation.
    (ii) Consolidated group's remaining section 163(j) limitation.
    (iii) Remaining current-year interest ratio.
    (b) Treatment of disallowed business interest expense carryforwards.
    (1) In general.
    (2) Deduction of business interest expense.
    (3) Consolidated groups.
    (i) In general.
    (ii) Deduction of business interest expense.
    (A) General rule.
    (B) Section 163(j) limitation equals or exceeds the current-year 
business interest expense and disallowed business interest expense 
carryforwards from prior taxable years.
    (C) Current-year business interest expense and disallowed business 
interest expense carryforwards exceed section 163(j) limitation.
    (iii) Departure from group.
    (iv) Example: Deduction of interest expense.
    (c) Disallowed business interest expense carryforwards in 
transactions to which section 381(a) applies.
    (d) Limitations on disallowed business interest expense 
carryforwards from separate return limitation years.
    (1) General rule.
    (A) Cumulative section 163(j) SRLY limitation.
    (B) Subgrouping.
    (2) Deduction of disallowed business interest expense carryforwards 
arising in a SRLY.
    (3) Examples.
    (e) Application of section 382.
    (1) Pre-change loss.
    (2) Loss corporation.
    (3) Ordering rules for utilization of pre-change losses and for 
absorption of the section 382 limitation.

[[Page 390]]

    (4) Disallowed business interest expense from the pre-change period 
in the year of a testing date.
    (5) Recognized built-in loss.
    (f) Overlap of SRLY limitation with section 382.
    (g) Additional limitations.
    (h) Applicability date.

    Sec.  1.163(j)-6 Application of the business interest deduction 
        limitation to partnerships and subchapter S Corporations.

    (a) Overview.
    (b) Definitions.
    (1) Section 163(j) items.
    (2) Partner basis items.
    (3) Remedial items.
    (4) Excess business interest income.
    (5) Deductible business interest expense.
    (6) Section 163(j) excess items.
    (7) Non-excepted assets.
    (8) Excepted assets.
    (c) Business interest income and business interest expense of the 
partnership.
    (1) Modification of business interest income for partnerships.
    (2) Modification of business interest expense for partnerships.
    (3) Transition rule.
    (4) Character of business interest expense.
    (d) Adjusted taxable income of a partnership.
    (1) Tentative taxable income of a partnership.
    (2) Section 734(b), partner basis items, and remedial items.
    (3) Section 743(b) adjustments and publicly traded partnerships.
    (4) Modification of adjusted taxable income for partnerships.
    (5) Election to use 2019 adjusted taxable income for taxable years 
beginning in 2020.
    (e) Adjusted taxable income and business interest income of 
partners.
    (1) Modification of adjusted taxable income for partners.
    (2) Partner basis items and remedial items.
    (3) Disposition of partnership interests.
    (4) Double counting of business interest income and floor plan 
financing interest expense prohibited.
    (5) Partner basis items, remedial items, and publicly traded 
partnerships.
    (6) [Reserved]
    (f) Allocation and determination of section 163(j) excess items made 
in the same manner as nonseparately stated taxable income or loss of the 
partnership.
    (1) Overview.
    (i) In general.
    (ii) Relevance solely for purposes of section 163(j).
    (iii) Exception applicable to publicly traded partnerships.
    (2) Steps for allocating deductible business interest expense and 
section 163(j) excess items.
    (i) Partnership-level calculation required by section 163(j)(4)(A).
    (ii) Determination of each partner's relevant section 163(j) items.
    (iii) Partner-level comparison of business interest income and 
business interest expense.
    (iv) Matching partnership and aggregate partner excess business 
interest income.
    (v) Remaining business interest expense determination.
    (vi) Determination of final allocable ATI.
    (A) Positive allocable ATI.
    (B) Negative allocable ATI.
    (C) Final allocable ATI.
    (vii) Partner-level comparison of 30 percent of adjusted taxable 
income and remaining business interest expense.
    (viii) Partner priority right to ATI capacity excess determination.
    (ix) Matching partnership and aggregate partner excess taxable 
income.
    (x) Matching partnership and aggregate partner excess business 
interest expense.
    (xi) Final section 163(j) excess item and deductible business 
interest expense allocation.
    (g) Carryforwards.
    (1) In general.
    (2) Treatment of excess business interest expense allocated to 
partners.
    (3) Excess taxable income and excess business interest income 
ordering rule.
    (4) Special rule for taxable years beginning in 2019 and 2020.
    (h) Basis adjustments.
    (1) Section 704(d) ordering.

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    (2) Excess business interest expense basis adjustments.
    (3) Partner basis adjustment upon disposition of partnership 
interest.
    (4)-(5) [Reserved]
    (i)-(j) [Reserved]
    (k) Investment items and certain other items.
    (l) S corporations.
    (1) In general.
    (i) Corporate level limitation.
    (ii) Short taxable periods.
    (2) Character of deductible business interest expense.
    (3) Adjusted taxable income of an S corporation.
    (4) Adjusted taxable income and business interest income of S 
corporation shareholders.
    (i) Adjusted taxable income of S corporation shareholders.
    (ii) Disposition of S corporation stock.
    (iii) Double counting of business interest income and floor plan 
financing interest expense prohibited.
    (iv) [Reserved]
    (5) Carryforwards.
    (6) Basis adjustments and disallowed business interest expense 
carryforwards.
    (7) Accumulated adjustment accounts.
    (8) Termination of qualified subchapter S subsidiary election.
    (9) Investment items.
    (10) Application of section 382.
    (m) Partnerships and S corporations not subject to section 163(j).
    (1) Exempt partnerships and S corporations.
    (2) Partnerships and S corporations engaged in excepted trades or 
businesses.
    (3) Treatment of excess business interest expense from partnerships 
that are exempt entities in a succeeding taxable year.
    (4) S corporations with disallowed business interest expense 
carryforwards prior to becoming exempt entities.
    (n) Treatment of self-charged lending transactions between 
partnerships and partners.
    (o) Examples.
    (p) Applicability dates.
    (1) In general.
    (2) Paragraphs (c)(1) and (2), (d)(3) through (5), (e)(5), 
(f)(1)(iii), (g)(4), (n), and (o)(24) through (29), and (34) through 
(36).

Sec.  1.163(j)-7 Application of the section 163(j) limitation to foreign 
              corporations and United States shareholders.

    (a) Overview.
    (b) General rule regarding the application of section 163(j) to 
relevant foreign corporations.
    (c) Application of section 163(j) to CFC group members of a CFC 
group.
    (1) Scope.
    (2) Calculation of section 163(j) limitation for a CFC group for a 
specified period.
    (i) In general.
    (ii) Certain transactions between CFC group members disregarded.
    (iii) [Reserved]
    (iv) [Reserved]
    (3) Deduction of business interest expense.
    (i) CFC group business interest expense.
    (A) In general.
    (B) Modifications to relevant terms.
    (ii) Carryforwards treated as attributable to the same taxable year.
    (iii) Multiple specified taxable years of a CFC group member with 
respect to a specified period.
    (iv) Limitation on pre-group disallowed business interest expense 
carryforward.
    (A) General rule.
    (1) CFC group member pre-group disallowed business interest expense 
carryforward.
    (2) Subgrouping.
    (3) Transition rule.
    (B) Deduction of pre-group disallowed business interest expense 
carryforwards.
    (4) Currency translation.
    (5) Special rule for specified periods beginning in 2019 or 2020.
    (i) 50 percent ATI limitation applies to a specified period of a CFC 
group.
    (ii) Election to use 2019 ATI applies to a specified period of a CFC 
group.
    (A) In general.
    (B) Specified taxable years that do not begin in 2020.
    (d) Determination of a specified group and specified group members.
    (1) Scope.
    (2) Rules for determining a specified group.

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    (i) Definition of a specified group.
    (ii) Indirect ownership.
    (iii) Specified group parent.
    (iv) Qualified U.S. person.
    (v) Stock.
    (vi) Options treated as exercised.
    (vii) When a specified group ceases to exist.
    (3) Rules for determining a specified group member.
    (e) Rules and procedures for treating a specified group as a CFC 
group.
    (1) Scope.
    (2) CFC group and CFC group member.
    (i) CFC group.
    (ii) CFC group member.
    (3) Duration of a CFC group.
    (4) Joining or leaving a CFC group.
    (5) Manner of making or revoking a CFC group election.
    (i) In general.
    (ii) Revocation by election.
    (iii) Timing.
    (iv) Election statement.
    (v) Effect of prior CFC group election.
    (6) Annual information reporting.
    (f) Treatment of a CFC group member that has ECI.
    (1) In general.
    (2) [Reserved]
    (g) Rules concerning the computation of adjusted taxable income of a 
relevant foreign corporation.
    (1) Tentative taxable income.
    (2) Treatment of certain dividends.
    (3) Treatment of certain foreign income taxes.
    (4) Anti-abuse rule.
    (i) In general.
    (ii) ATI adjustment amount.
    (A) In general.
    (B) Special rule for taxable years or specified periods beginning in 
2019 or 2020.
    (iii) Applicable partnership.
    (h) Election to apply safe-harbor.
    (1) In general.
    (2) Eligibility for safe-harbor election.
    (i) Stand-alone applicable CFC.
    (ii) CFC group.
    (iii) Currency translation.
    (3) Eligible amount.
    (i) Stand-alone applicable CFC.
    (ii) CFC group.
    (iii) Additional rules for determining an eligible amount.
    (4) Qualified tentative taxable income.
    (5) Manner of making a safe-harbor election.
    (i) In general.
    (ii) Election statement.
    (6) Special rule for taxable years or specified periods beginning in 
2019 or 2020.
    (i)-(j) [Reserved]
    (k) Definitions.
    (1) Applicable partnership.
    (2) Applicable specified taxable year.
    (3) ATI adjustment amount.
    (4) [Reserved]
    (5) [Reserved]
    (6) CFC group.
    (7) CFC group election.
    (8) CFC group member.
    (9) [Reserved]
    (10) Cumulative section 163(j) pre-group carryforward limitation.
    (11) Current group.
    (12) Designated U.S. person.
    (13) ECI deemed corporation.
    (14) Effectively connected income.
    (15) Eligible amount.
    (16) Former group.
    (17) Loss member.
    (18) Payment amount.
    (19) Pre-group disallowed business interest expense carryforward.
    (20) Qualified tentative taxable income.
    (21) Qualified U.S. person.
    (22) Relevant period.
    (23) Safe-harbor election.
    (24) Specified borrower.
    (25) Specified group.
    (26) Specified group member.
    (27) Specified group parent.
    (28) Specified lender.
    (29) Specified period.
    (i) In general.
    (ii) Short specified period.
    (30) Specified taxable year.
    (31) Stand-alone applicable CFC.
    (32) Stock.
    (l) Examples.
    (m) Applicability dates.
    (1) General applicability date.
    (2) Exception.
    (3) Early application.
    (i) Rules for paragraphs (b) and (g)(1) and (2) of this section.
    (ii) Rules for certain other paragraphs in this section.
    (4) Additional rules that must be applied consistently.

[[Page 393]]

    (5) Election for prior taxable years.
    Sec.  1.163(j)-8 [Reserved]
    Sec.  1.163(j)-9 Elections for excepted trades or businesses; safe 
harbor for certain REITs.
    (a) Overview.
    (b) Availability of election.
    (1) In general.
    (2) Special rules.
    (i) Exempt small businesses.
    (ii) Section 162 trade or business not required for electing real 
property trade or business.
    (c) Scope and effect of election.
    (1) In general.
    (2) Irrevocability.
    (3) Depreciation.
    (d) Time and manner of making election.
    (1) In general.
    (2) Election statement contents.
    (3) Consolidated group's trade or business.
    (4) Partnership's trade or business.
    (e) Termination of election.
    (1) In general.
    (2) Taxable asset transfer defined.
    (3) Related party defined.
    (4) Anti-abuse rule.
    (f) Additional guidance.
    (g) Examples.
    (h) Safe harbor for REITs.
    (1) In general.
    (2) REITs that do not significantly invest in real property 
financing assets.
    (3) REITs that significantly invest in real property financing 
assets.
    (4) REIT real property assets, interests in partnerships, and shares 
in other REITs.
    (i) Real property assets.
    (ii) Partnership interests.
    (iii) Shares in other REITs.
    (A) In general.
    (B) Information necessary.
    (iv) Tiered entities.
    (5) Value of shares in other REITs.
    (i) In general.
    (ii) Information necessary.
    (iii) Tiered REITs.
    (6) Real property financing assets.
    (7) Application of safe harbor for partnerships controlled by REITS.
    (8) REITs or partnerships controlled by REITs that do not apply the 
safe harbor.
    (i) [Reserved]
    (j) Special anti-abuse rule for certain real property trades or 
businesses.
    (1) In general.
    (2) Exceptions.
    (i) De minimis exception.
    (ii) Look-through exception.
    (iii) Inapplicability of exceptions to consolidated groups.
    (iv) Exception for certain REITs.
    (3) Allocations.
    (4) Examples.
    (k) Applicability date.

 Sec.  1.163(j)-10 Allocation of interest expense, interest income, and 
    other items of expense and gross income to an excepted trade or 
                                business.

    (a) Overview.
    (1) In general.
    (i) Purposes.
    (ii) Application of section.
    (2) Coordination with other rules.
    (i) In general.
    (ii) Treatment of investment interest, investment income, investment 
expenses, and certain other tax items of a partnership with a C 
corporation or tax-exempt corporation as a partner.
    (3) Application of allocation rules to foreign corporations and 
foreign partnerships.
    (4) Application of allocation rules to members of a consolidated 
group.
    (i) In general.
    (ii) Application of excepted business percentage to members of a 
consolidated group.
    (iii) Basis in assets transferred in an intercompany transaction.
    (5) Tax-exempt organizations.
    (6) Application of allocation rules to disallowed disqualified 
interest.
    (7) Examples.
    (b) Allocation of tax items other than interest expense and interest 
income.
    (1) In general.
    (2) Gross income other than dividends and interest income.
    (3) Dividends.
    (i) Look-through rule.
    (ii) Inapplicability of the look-through rule.
    (4) Gain or loss from the disposition of non-consolidated C 
corporation stock, partnership interests, or S corporation stock.
    (i) Non-consolidated C corporations.
    (ii) Partnerships and S corporations.
    (5) Expenses, losses, and other deductions.

[[Page 394]]

    (i) Expenses, losses, and other deductions that are definitely 
related to a trade or business.
    (ii) Other deductions.
    (6) Treatment of investment items and certain other items of a 
partnership with a C corporation partner.
    (7) Examples: Allocation of income and expense.
    (c) Allocating interest expense and interest income that is properly 
allocable to a trade or business.
    (1) General rule.
    (i) In general.
    (ii) De minimis exception.
    (2) Example.
    (3) Asset used in more than one trade or business.
    (i) General rule.
    (ii) Permissible methodologies for allocating asset basis between or 
among two or more trades or businesses.
    (iii) Special rules.
    (A) Consistent allocation methodologies.
    (1) In general.
    (2) Consent to change allocation methodology.
    (B) De minimis exception.
    (C) Allocations of excepted regulated utility trades or businesses.
    (1) In general.
    (2) Permissible method for allocating asset basis for utility trades 
or businesses.
    (3) De minimis rule for excepted utility trades or businesses.
    (4) Example.
    (D) Special allocation rule for real property trades or business 
subject to special anti-abuse rule.
    (1) In general.
    (2) Allocation methodology for real property.
    (3) Example.
    (4) Disallowed business interest expense carryforwards; floor plan 
financing interest expense.
    (5) Additional rules relating to basis.
    (i) Calculation of adjusted basis.
    (A) Non-depreciable property other than land.
    (B) Depreciable property other than inherently permanent structures.
    (C) Special rule for land and inherently permanent structures.
    (D) Depreciable or amortizable intangible property and depreciable 
income forecast method property.
    (E) Assets not yet used in a trade or business.
    (F) Trusts established to fund specific liabilities.
    (G) Inherently permanent structure.
    (ii) Partnership interests; stock in non-consolidated C 
corporations.
    (A) Partnership interests.
    (1) Calculation of asset basis.
    (2) Allocation of asset basis.
    (i) In general.
    (ii) De minimis rule.
    (iii) Partnership assets not properly allocable to a trade or 
business.
    (iv) Inapplicability of partnership look-through rule.
    (B) Stock in domestic non-consolidated corporations.
    (1) In general.
    (2) Domestic non-consolidated C corporations.
    (i) Allocation of asset basis.
    (ii) De minimis rule.
    (iii) Inapplicability of corporate look-through rule.
    (iv) Use of inside basis for purposes of C corporation look-through 
rule.
    (3) S corporations.
    (i) Calculation of asset basis.
    (ii) Allocation of asset basis.
    (iii) De minimis rule.
    (iv) Inapplicability of S corporation look-through rule.
    (C) Stock in relevant foreign corporations.
    (1) In general.
    (2) Special rule for CFC utilities.
    (D) Limitations on application of look-through rules.
    (1) Inapplicability of look-through rule to partnerships or non-
consolidated C corporations to which the small business exemption 
applies.
    (2) Limitation on application of look-through rule to C 
corporations.
    (D) Inapplicability of look-through rule to partnerships or non-
consolidated C corporations to which the small business exemption 
applies.
    (E) Tiered entities.
    (iii) Cash and cash equivalents and customer receivables.
    (iv) Deemed asset sale.
    (v) Other adjustments.
    (6) Determination dates; determination periods; reporting 
requirements.
    (i) Determination dates and determination periods.
    (A) Quarterly determination periods.

[[Page 395]]

    (B) Annual determination periods.
    (ii) Application of look-through rules.
    (iii) Reporting requirements.
    (A) Books and records.
    (B) Information statement.
    (iv) Failure to file statement.
    (7) Ownership threshold for look-through rules.
    (i) Corporations.
    (A) Asset basis.
    (B) Dividends.
    (ii) Partnerships.
    (iii) Inapplicability of look-through rule.
    (8) Anti-abuse rule.
    (d) Direct allocations.
    (1) In general.
    (2) Qualified nonrecourse indebtedness.
    (3) Assets used in more than one trade or business.
    (4) Adjustments to basis of assets to account for direct 
allocations.
    (5) Example: Direct allocation of interest expense.
    (e) Examples.
    (f) Applicability dates.
    (1) In general.
    (2) Paragraph (c)(5)(ii)(D)(2).
    Sec.  1.163(j)-11 Transition rules.
    (a) Overview.
    (b) Application of section 163(j) limitation if a corporation joins 
a consolidated group during a taxable year of the group beginning before 
January 1, 2018.
    (1) In general.
    (2) Example
    (c) Treatment of disallowed disqualified interest.
    (1) In general.
    (2) Earnings and profits.
    (3) Disallowed disqualified interest of members of an affiliated 
group.
    (i) Scope.
    (ii) Allocation of disallowed disqualified interest to members of 
the affiliated group.
    (A) In general.
    (B) Definitions.
    (1) Allocable share of the affiliated group's disallowed 
disqualified interest.
    (2) Disallowed disqualified interest ratio.
    (3) Exempt related person interest expense.
    (iii) Treatment of carryforwards.
    (4) Application of section 382.
    (i) Ownership change occurring before November 13, 2020.
    (A) Pre-change loss.
    (B) Loss corporation.
    (ii) Ownership change occurring on or after November 13, 2020.
    (A) Pre-change loss.
    (B) Loss corporation.
    (5) Treatment of excess limitation from taxable years beginning 
before January 1, 2018.
    (6) Example: Members of an affiliated group.
    (d) Applicability date.

[T.D. 9905, 85 FR 56760, Sept, 14, 2020, as amended by T.D. 9943, 86 FR 
5522, Jan. 19, 2021]



Sec.  1.163(j)-1  Definitions.

    Sec.  1.163(j)-1 Definitions.
    (a) In general. The definitions provided in this section apply for 
purposes of the section 163(j) regulations. For purposes of the rules 
set forth in Sec. Sec.  1.163(j)-2 through 1.163(j)-11, additional 
definitions for certain terms are provided in those sections.
    (b) Definitions--(1) Adjusted taxable income. The term adjusted 
taxable income (ATI) means the tentative taxable income of the taxpayer 
for the taxable year, with the adjustments in this paragraph (b)(1).
    (i) Additions. The amounts of the following items that were included 
in the computation of the taxpayer's tentative taxable income (if any) 
are added to tentative taxable income to determine ATI--
    (A) Any business interest expense, other than disallowed business 
interest expense carryforwards;
    (B) Any net operating loss deduction under section 172;
    (C) Any deduction under section 199A;
    (D) Subject to paragraph (b)(1)(iii) of this section, for taxable 
years beginning before January 1, 2022, any depreciation under section 
167, section 168, or section 168 of the Internal Revenue Code (Code) of 
1954 (former section 168);
    (E) Subject to paragraph (b)(1)(iii) of this section, for taxable 
years beginning before January 1, 2022, any amortization of intangibles 
(for example, under section 167 or 197) and other amortized expenditures 
(for example,

[[Page 396]]

under section 174(b), 195(b)(1)(B), 248, or 1245(a)(2)(C));
    (F) Subject to paragraph (b)(1)(iii) of this section, for taxable 
years beginning before January 1, 2022, any depletion under section 611;
    (G) Any deduction for a capital loss carryback or carryover; and
    (H) Any deduction or loss that is not properly allocable to a non-
excepted trade or business (for rules governing the allocation of items 
to an excepted trade or business, see Sec. Sec.  1.163(j)-1(b)(44) and 
1.163(j)-10).
    (ii) Subtractions. The amounts of the following items (if any) are 
subtracted from the taxpayer's tentative taxable income to determine ATI 
--
    (A) Any business interest income that was included in the 
computation of the taxpayer's tentative taxable income;
    (B) Any floor plan financing interest expense for the taxable year 
that was included in the computation of the taxpayer's tentative taxable 
income;
    (C) With respect to the sale or other disposition of property, the 
greater of the allowed or allowable depreciation, amortization, or 
depletion of the property, as provided under section 1016(a)(2), for the 
taxpayer (or, if the taxpayer is a member of a consolidated group, the 
consolidated group) for the taxable years beginning after December 31, 
2017, and before January 1, 2022, with respect to such property;
    (D) With respect to the sale or other disposition of stock of a 
member of a consolidated group by another member, the investment 
adjustments under Sec.  1.1502-32 with respect to such stock that are 
attributable to deductions described in paragraph (b)(1)(ii)(C) of this 
section;
    (E) With respect to the sale or other disposition of an interest in 
a partnership, the taxpayer's distributive share of deductions described 
in paragraph (b)(1)(ii)(C) of this section with respect to property held 
by the partnership at the time of such sale or other disposition to the 
extent such deductions were allowable under section 704(d);
    (F) Any income or gain that is not properly allocable to a non-
excepted trade or business (for rules governing the allocation of items 
to an excepted trade or business, see Sec. Sec.  1.163(j)-1(b)(44) and 
1.163(j)-10)) and that was included in the computation of the taxpayer's 
tentative taxable income; and
    (G) An amount equal to the sum of any specified deemed inclusions 
that were included in the computation of the taxpayer's tentative 
taxable income, reduced by the portion of the deduction allowed under 
section 250(a) by reason of the specified deemed inclusions. For this 
purpose, a specified deemed inclusion is the inclusion of an amount by a 
United States shareholder (as defined in section 951(b)) in gross income 
under section 78, 951(a), or 951A(a) with respect to an applicable CFC 
(as defined in Sec.  1.163(j)-1(b)(2)) that is properly allocable to a 
non-excepted trade or business. Furthermore, a specified deemed 
inclusion includes any amounts included in a domestic partnership's 
gross income under section 951(a) or 951A(a) with respect to an 
applicable CFC to the extent such amounts are attributable to investment 
income of the partnership and are allocated to a domestic C corporation 
that is a direct (or indirect partner) and treated as properly allocable 
to a non-excepted trade or business of the domestic C corporation under 
Sec. Sec.  1.163(j)-4(b)(3) and 1.163(j)-10. To determine the amount of 
a specified deemed inclusion described in this paragraph (b)(1)(ii)(G), 
the portion of a United States shareholder's inclusion under section 
951A(a) treated as being with respect to an applicable CFC is determined 
under section 951A(f)(2) and Sec.  1.951A-6(b)(2).
    (iii) Depreciation, amortization, or depletion capitalized under 
section 263A. For purposes of paragraph (b)(1)(i) of this section, 
amounts of depreciation, amortization, or depletion that are capitalized 
under section 263A during the taxable year are deemed to be included in 
the computation of the taxpayer's tentative taxable income for such 
taxable year, regardless of the period in which the capitalized amount 
is recovered. See Example 3 in Sec.  1.163(j)-2(h)(3).
    (iv) Application of Sec.  1.163(j)-1(b)(1)(ii)(C), (D), and (E)--(A) 
Sale or other disposition--(1) In general. For purposes of paragraphs 
(b)(1)(ii)(C), (D), and (E) and paragraphs (b)(1)(iv)(B) and (E) of this 
section, except as otherwise

[[Page 397]]

provided in this paragraph (b)(1)(iv)(A), the term sale or other 
disposition does not include a transfer of an asset to an acquiring 
corporation in a transaction to which section 381(a) applies.
    (2) Intercompany transactions. For purposes of paragraphs 
(b)(1)(ii)(C) and (D) and paragraphs (b)(1)(iv)(B) and (b)(1)(iv)(E)(1) 
and (2) of this section, the term sale or other disposition excludes all 
intercompany transactions, within the meaning of Sec.  1.1502-
13(b)(1)(i), to the extent necessary to achieve single-entity taxation 
of the consolidated group.
    (3) Deconsolidations. Notwithstanding any other rule in this 
paragraph (b)(1)(iv)(A), any transaction in which a member (S) leaves a 
consolidated group (selling group), including a section 381(a) 
transaction described in paragraph (b)(1)(iv)(A)(1) of this section, is 
treated as a taxable disposition of all S stock held by any member of 
the selling group for purposes of paragraphs (b)(1)(ii)(C) and (D) and 
paragraphs (b)(1)(iv)(B) and (b)(1)(iv)(E)(1) and (2) of this section, 
unless the transaction is described in Sec.  1.1502-13(j)(5)(i). 
Following S's deconsolidation, any subsequent sales or dispositions of S 
stock by the selling group do not trigger further adjustments under 
paragraphs (b)(1)(ii)(C) and (D) and paragraphs (b)(1)(iv)(B) and 
(b)(1)(iv)(E)(1) and (2) of this section. If a transaction is described 
in Sec.  1.1502-13(j)(5)(i), the transaction is not treated as a sale or 
other disposition for purposes of paragraphs (b)(1)(ii)(C) and (D) and 
paragraphs (b)(1)(iv)(B) and (b)(1)(iv)(E)(1) and (2) of this section. 
See also the successor rules in paragraph (b)(1)(iv)(C) of this section.
    (4) Nonrecognition transactions. The disposition of property, member 
stock (other than in a deconsolidation described in paragraph 
(b)(1)(iv)(A)(3) of this section), or partnership interests in a 
nonrecognition transaction, other than a section 381(a) transaction 
described in paragraph (b)(1)(iv)(A)(1) of this section, is treated as a 
taxable disposition of the property, member stock, or partnership 
interest disposed of for purposes of paragraph (b)(1)(iv)(E)(1)(i), 
(b)(1)(iv)(E)(2)(i), and (b)(1)(iv)(E)(3)(i) of this section, 
respectively. For example, if a taxpayer transfers property to a wholly 
owned, non-consolidated subsidiary, the transfer of the property is 
treated as a taxable disposition for purposes of paragraph 
(b)(1)(iv)(E)(1)(i) of this section notwithstanding the application of 
section 351.
    (B) Deductions by members of a consolidated group--(1) In general. 
If paragraph (b)(1)(ii)(C), (D), or (E) of this section applies to 
adjust the tentative taxable income of a consolidated group, and if the 
consolidated group does not use the alternative computation method in 
paragraph (b)(1)(iv)(E) of this section, the amount of the adjustment 
under paragraph (b)(1)(ii)(C) of this section equals the greater of the 
allowed or allowable depreciation, amortization, or depletion of the 
property, as provided under section 1016(a)(2), for the consolidated 
group for the taxable years beginning after December 31, 2017, and 
before January 1, 2022, with respect to such property.
    (2) Application of the alternative computation method. If paragraph 
(b)(1)(ii)(C), paragraph (b)(1)(ii)(D), or paragraph (b)(1)(ii)(E) of 
this section applies to adjust the tentative taxable income of a 
consolidated group, and if the consolidated group uses the alternative 
computation method in paragraph (b)(1)(iv)(E) of this section, the 
amount of the adjustment computed under paragraph (b)(1)(iv)(E)(1)(i), 
paragraph (b)(1)(iv)(E)(2)(i), or paragraph (b)(1)(iv)(E)(3)(i) of this 
section must take into account the net gain that would be taken into 
account by the consolidated group, including from intercompany 
transactions, determined by treating the sale or other disposition as a 
taxable transaction (see paragraphs (b)(1)(iv)(A)(3) and (4) of this 
section regarding deconsolidations and certain nonrecognition 
transactions, respectively).
    (C) Successor rules--(1) Successor assets. This paragraph 
(b)(1)(iv)(C)(1) applies if deductions described in paragraph 
(b)(1)(ii)(C) of this section are allowed or allowable to a consolidated 
group member (S) and either the depreciable property or S's stock is 
subsequently transferred to another member (S1) in an intercompany 
transaction in which the transferor receives S1 stock. If this paragraph 
(b)(1)(iv)(C)(1) applies,

[[Page 398]]

and if the transferor's basis in the S1 stock received in the 
intercompany transaction is determined, in whole or in part, by 
reference to its basis in the depreciable property or the S stock, the 
S1 stock received in the intercompany transaction is treated as a 
successor asset for purposes of paragraph (b)(1)(ii)(D) and 
(b)(1)(iv)(E)(2) of this section. Thus, except as otherwise provided in 
paragraph (b)(1)(iv)(D) of this section, the subsequent disposition of 
either the S1 stock or the S stock (or both) may require the application 
of the adjustment rules of paragraph (b)(1)(ii)(D) or paragraph 
(b)(1)(iv)(E)(2) of this section.
    (2) Successor entities. The acquiring corporation in a section 
381(a) transaction to which the exception in paragraph (b)(1)(iv)(A)(1) 
of this section applies is treated as a successor to the distributor or 
transferor corporation for purposes of paragraphs (b)(1)(ii)(C) through 
(E) and (b)(1)(iv)(B) and (E) of this section. Therefore, for example, 
in applying paragraphs (b)(1)(ii)(C) through (E) and (b)(1)(iv)(B) and 
(E) of this section, the acquiring corporation is treated as succeeding 
to the allowed or allowable items of the distributor or transferor 
corporation. Similarly, the surviving group in a transaction described 
in Sec.  1.1502-13(j)(5)(i) to which the exception in paragraph 
(b)(1)(iv)(A)(3) of this section applies is treated as a successor to 
the terminating group for purposes of paragraphs (b)(1)(ii)(C) through 
(E) and (b)(1)(iv)(B) and (E) of this section.
    (D) Anti-duplication rule--(1) In general. The aggregate of the 
subtractions from tentative taxable income of a consolidated group under 
paragraphs (b)(1)(ii)(C) through (E) or paragraphs (b)(1)(iv)(E)(1) 
through (3) of this section with respect to an item of property 
(including with regard to dispositions of successor assets described in 
paragraph (b)(1)(iv)(C)(1) of this section) cannot exceed the aggregate 
amount of the consolidated group members' deductions described in 
paragraph (b)(1)(ii)(C) of this section with respect to such item of 
property. In addition, once an item of property is no longer held by any 
member of a consolidated group (whether or not an adjustment to the 
tentative taxable income of the group is made under paragraph 
(b)(1)(ii)(C) of this section with respect to the direct or indirect 
disposition of that property), no further adjustment to the group's 
tentative taxable income is made under paragraph (b)(1)(ii)(D) or 
paragraph (b)(1)(iv)(E)(2) of this section in relation to the same 
property with respect to any subsequent stock disposition.
    (2) Adjustments following deconsolidation. If a corporation (S) 
leaves a consolidated group (Group 1) in a transaction that requires an 
adjustment under paragraph (b)(1)(ii)(D) or paragraph (b)(1)(iv)(E)(2) 
of this section, no further adjustment is required under paragraph 
(b)(1)(ii)(C) or (E) or paragraph (b)(1)(iv)(E) of this section in a 
separate return year (as defined in Sec.  1.1502-1(e)) of S with respect 
to depreciation, amortization, or depletion deductions allowed or 
allowable to Group 1. See paragraph (b)(1)(iv)(A) of this section for 
special rules regarding the meaning of the term ``sale or other 
disposition'' for purposes of the adjustments required under paragraphs 
(b)(1)(ii)(C) through (E) and paragraphs (b)(1)(iv)(B) and (E) of this 
section. For example, assume that S deconsolidates from Group 1 in a 
transaction not described in Sec.  1.1502-13(j)(5)(i) after holding 
property for which depreciation, amortization, or depletion deductions 
were allowed or allowable in Group 1. On the deconsolidation, S and 
Group 1 would adjust tentative taxable income with regard to that 
property. See paragraphs (b)(1)(iv)(A)(3), (b)(1)(ii)(D), and 
(b)(1)(iv)(E)(2) of this section. If, following the deconsolidation, S 
sells the property referred to in the previous sentence, no subtraction 
from tentative taxable income is made under paragraph (b)(1)(ii)(C) or 
paragraph (b)(1)(iv)(E)(1) of this section during S's separate return 
year with regard to the amounts included in Group 1. See paragraphs 
(b)(1)(iv)(A)(3), (b)(1)(ii)(D), and (b)(1)(iv)(E)(2) of this section.
    (E) Alternative computation method. If paragraph (b)(1)(ii)(C), (D), 
or (E) of this section applies to adjust the tentative taxable income of 
a taxpayer, the taxpayer may compute the amount of the adjustments 
required by such paragraph using the formulas in paragraph 
(b)(1)(iv)(E)(1), (2), and (3) of this

[[Page 399]]

section, respectively, provided that the taxpayer applies such formulas 
to all dispositions for which an adjustment is required under paragraph 
(b)(1)(ii)(C), (D), or (E) of this section. For special rules regarding 
the treatment of deconsolidating transactions and nonrecognition 
transactions, see paragraph (b)(1)(iv)(A)(3) and (4) of this section, 
respectively. For special rules regarding the application of the 
formulas in paragraph (b)(1)(iv)(E)(1), (2), and (3) of this section by 
consolidated groups, see paragraph (b)(1)(iv)(B)(2) of this section.
    (1) Alternative computation method for property dispositions. With 
respect to the sale or other disposition of property, the lesser of:
    (i) Any gain recognized on the sale or other disposition of such 
property by the taxpayer (or, if the taxpayer is a member of a 
consolidated group, the consolidated group); and
    (ii) The greater of the allowed or allowable depreciation, 
amortization, or depletion of the property, as provided under section 
1016(a)(2), for the taxpayer (or, if the taxpayer is a member of a 
consolidated group, the consolidated group) for the taxable years 
beginning after December 31, 2017, and before January 1, 2022, with 
respect to such property.
    (2) Alternative computation method for dispositions of member stock. 
With respect to the sale or other disposition by a member of a 
consolidated group of stock of another member for whom depreciation, 
amortization, or depletion was allowed or allowable with regard to an 
item of property (or stock of any successor to that member), the lesser 
of:
    (i) Any gain recognized on the sale or other disposition of such 
stock; and
    (ii) The investment adjustments under Sec.  1.1502-32 with respect 
to such stock that are attributable to deductions described in paragraph 
(b)(1)(ii)(C) of this section. The investment adjustments referred to in 
this paragraph (b)(1)(iv)(E)(2)(ii) include investment adjustments 
replicated in stock of members that are successor entities.
    (3) Alternative computation method for dispositions of partnership 
interests. With respect to the sale or other disposition of an interest 
in a partnership, the lesser of:
    (i) Any gain recognized on the sale or other disposition of such 
interest; and
    (ii) The taxpayer's (or, if the taxpayer is a consolidated group, 
the consolidated group's) distributive share of deductions described in 
paragraph (b)(1)(ii)(C) of this section with respect to property held by 
the partnership at the time of such sale or other disposition to the 
extent such deductions were allowable under section 704(d).
    (F) Cap on negative adjustments--(1) In general. A subtraction from 
(or negative adjustment to) tentative taxable income that is required 
under paragraph (b)(1)(ii)(C), (D), or (E) or paragraph (b)(1)(iv)(B) or 
(E) of this section is reduced to the extent the taxpayer establishes 
that the positive adjustments to tentative taxable income under 
paragraphs (b)(1)(i)(D) through (F) of this section in a prior taxable 
year did not result in an increase in the amount allowed as a deduction 
for business interest expense for such year. The extent to which the 
positive adjustments under paragraphs (b)(1)(i)(D) through (F) of this 
section resulted in an increase in the amount allowed as a deduction for 
business interest expense in a prior taxable year (such amount of 
positive adjustments, the negative adjustment cap) is determined after 
taking into account all other adjustments to tentative taxable income 
under paragraph (b)(1)(i) and (ii) of this section for that year, as 
established through books and records. The amount of the negative 
adjustment cap for a prior taxable year is reduced in future taxable 
years to the extent of negative adjustments under paragraphs 
(b)(1)(ii)(C) through (E) and paragraphs (b)(1)(iv)(B) and (E) of this 
section with respect to the prior taxable year.
    (2) Example. A is a calendar-year individual taxpayer engaged in a 
trade or business that is neither an excepted trade or business nor 
eligible for the small business exemption. A has no disallowed business 
interest expense carryforwards. In 2021, A has $100x of business 
interest expense, no business interest income or floor plan financing 
interest expense, and $400x of tentative taxable income. After taking 
into account the adjustments to tentative

[[Page 400]]

taxable income under paragraph (b)(1)(i) and (ii) of this section other 
than positive adjustments under paragraphs (b)(1)(i)(D) through (F) of 
this section, A has tentative taxable income of $450x. A increases its 
tentative taxable income by $30x (from $450x to $480x) under paragraph 
(b)(1)(i)(D) of this section to reflect $30x of depreciation deductions 
with respect to Asset Y in 2021. Thus, for 2021, A would have a section 
163(j) limitation of $135x ($450x x 30 percent) without regard to 
adjustments under paragraphs (b)(1)(i)(D) through (F) of this section. 
After the application of paragraph (b)(1)(i)(D) of this section, A has a 
section 163(j) limitation of $144x ($480x x 30 percent). In 2022, A 
sells Asset Y at a gain of $50x. Under paragraph (b)(1)(iv)(F)(1) of 
this section, A is not required to reduce its tentative taxable income 
in 2022 under paragraph (b)(1)(ii)(C) through (E) or paragraph 
(b)(1)(iv)(E) of this section. As established by A, the $30x addition to 
tentative taxable income under paragraph (b)(1)(i)(D) of this section 
resulted in no increase in the amount allowed as a deduction for 
business interest expense in 2021.
    (G) Treatment of depreciation, amortization, or depletion 
capitalized under section 263A. Paragraphs (b)(1)(ii)(C) through (E) of 
this section and this paragraph (b)(1)(iv) apply with respect to the 
sale or other disposition of property to which paragraph (b)(1)(iii) of 
this section applies. For example, if a taxpayer with depreciable 
machinery capitalizes the depreciation into inventory under section 
263A, paragraph (b)(1)(ii)(C) or paragraph (b)(1)(iv)(E) of this section 
(and, if the taxpayer is a consolidated group, paragraph (b)(1)(iv)(B) 
of this section) applies upon the disposition of the machinery, subject 
to the cap in paragraph (b)(1)(iv)(F) of this section. Similarly, the 
successor asset rules in paragraph (b)(1)(iv)(C)(1) of this section 
would apply if the depreciable machinery subsequently were transferred 
to another member (S1) in an intercompany transaction in which the 
transferor received S1 stock.
    (v) Other adjustments. ATI is computed with the other adjustments 
provided in Sec. Sec.  1.163(j)-2 through 1.163(j)-11.
    (vi) Additional rules relating to adjusted taxable income in other 
sections. (A) For rules governing the ATI of C corporations, see 
Sec. Sec.  1.163(j)-4(b)(2) and (3) and 1.163(j)-10(a)(2)(ii).
    (B) For rules governing the ATI of RICs and REITs, see Sec.  
1.163(j)-4(b)(4).
    (C) For rules governing the ATI of tax-exempt corporations, see 
Sec.  1.163(j)-4(b)(5).
    (D) For rules governing the ATI of consolidated groups, see Sec.  
1.163(j)-4(d)(2)(iv) and (v).
    (E) For rules governing the ATI of partnerships, see Sec.  1.163(j)-
6(d).
    (F) For rules governing the ATI of partners, see Sec. Sec.  
1.163(j)-6(e) and 1.163(j)-6(m)(1) and (2).
    (G) For rules governing partnership basis adjustments affecting ATI, 
see Sec.  1.163(j)-6(h)(2).
    (H) For rules governing the ATI of S corporations, see Sec.  
1.163(j)-6(l)(3).
    (I) For rules governing the ATI of S corporation shareholders, see 
Sec.  1.163(j)-6(l)(4).
    (J) For rules governing the ATI of certain beneficiaries of trusts 
and estates, see Sec.  1.163(j)-2(f).
    (vii) ATI cannot be less than zero. If the ATI of a taxpayer would 
be less than zero, the ATI of the taxpayer is zero.
    (viii) Examples. The examples in this paragraph (b)(1)(viii) 
illustrate the application of paragraphs (b)(1)(ii), (iii), and (iv) of 
this section. Unless otherwise indicated, A, B, P, S, and T are 
calendar-year domestic C corporations; P is the parent of a consolidated 
group of which S and T are members; the exemption for certain small 
businesses in Sec.  1.163(j)-2(d) does not apply; no entity is engaged 
in an excepted trade or business; no entity has business interest income 
or floor plan financing interest expense; and all amounts of interest 
expense are deductible except for the potential application of section 
163(j).
    (A) Example 1--(1) Facts. In 2021, A purchases a depreciable asset 
(Asset X) for $30x and fully depreciates Asset X under section 168(k). 
For the 2021 taxable year, A establishes that its ATI before adding back 
depreciation deductions with respect to Asset X under paragraph 
(b)(1)(i)(D) of this section is $130x, and that its ATI after adding

[[Page 401]]

back depreciation deductions with respect to Asset X under paragraph 
(b)(1)(i)(D) of this section is $160x. A incurs $45x of business 
interest expense in 2021. In 2024, A sells Asset X to an unrelated third 
party for $25x.
    (2) Analysis. A's section 163(j) limitation for 2021 is $48x ($160x 
x 30 percent). Thus, all $45x of A's business interest expense incurred 
in 2021 is deductible in that year. Under paragraph (b)(1)(ii)(C) of 
this section, A must subtract $30x from its tentative taxable income in 
computing its ATI for its 2024 taxable year. Alternatively, under 
paragraph (b)(1)(iv)(E)(1) of this section, A must subtract $25x (the 
lesser of $30x or $25x ($25x-$0x)) from its tentative taxable income in 
computing its ATI for its 2024 taxable year. However, the negative 
adjustments under paragraphs (b)(1)(ii)(C) and (b)(1)(iv)(E)(1) of this 
section are both subject to the negative adjustment cap in paragraph 
(b)(1)(iv)(F) of this section. Under that paragraph, A's negative 
adjustment under either paragraph (b)(1)(ii)(C) or paragraph 
(b)(1)(iv)(E)(1) of this section is capped at $20x, or $150x (the amount 
of ATI that A needed in order to deduct all $45x of business interest 
expense in 2021) minus $130x (the amount of A's tentative taxable income 
in 2021 before adding back any amounts under paragraph (b)(1)(i)(D) 
through (F) of this section). As established by A, the additional $10x 
($30x-$20x) of depreciation deductions that were added back to tentative 
taxable income in 2021 under paragraph (b)(1)(i)(D) of this section did 
not increase A's business interest expense deduction for that year.
    (3) Transfer of assets in a nonrecognition transaction to which 
section 381 applies. The facts are the same as in paragraph 
(b)(1)(viii)(A)(1) of this section, except that, rather than sell Asset 
X to an unrelated third party in 2024, A merges with and into an 
unrelated third party in 2024 in a transaction described in section 
368(a)(1)(A) in which no gain is recognized. As provided in paragraph 
(b)(1)(iv)(A)(1) of this section, the merger transaction is not treated 
as a ``sale or other disposition'' for purposes of paragraph 
(b)(1)(ii)(C) or paragraph (b)(1)(iv)(E)(1) of this section. Thus, no 
adjustment to tentative taxable income is required in 2024 under 
paragraph (b)(1)(ii)(C) or paragraph (b)(1)(iv)(E)(1) of this section.
    (4) Transfer of assets in a nonrecognition transaction to which 
section 351 applies. The facts are the same as in paragraph 
(b)(1)(viii)(A)(1) of this section, except that, rather than sell Asset 
X to an unrelated third party in 2024, A transfers Asset X to B (A's 
wholly owned subsidiary) in 2024 in a transaction to which section 351 
applies. The section 351 transaction is treated as a ``sale or other 
disposition'' for purposes of paragraphs (b)(1)(ii)(C) and 
(b)(1)(iv)(E)(1) of this section, and it is treated as a taxable 
disposition for purposes of paragraph (b)(1)(iv)(E)(1) of this section. 
See paragraph (b)(1)(iv)(A)(1) and (4) of this section. However, the 
negative adjustments under paragraphs (b)(1)(ii)(C) and (b)(1)(iv)(E)(1) 
of this section are both subject to the negative adjustment cap in 
paragraph (b)(1)(iv)(F) of this section. Thus, A must subtract $20x from 
its tentative taxable income in computing its ATI for its 2024 taxable 
year.
    (B) Example 2--(1) Facts. In 2021, S purchases a depreciable asset 
(Asset Y) for $30x and fully depreciates Asset Y under section 168(k). P 
reduces its basis in its S stock by $30x under Sec.  1.1502-32 to 
reflect S's depreciation deductions with respect to Asset Y. For the 
2021 taxable year, the P group establishes that its ATI before adding 
back S's depreciation deductions with respect to Asset Y under paragraph 
(b)(1)(i)(D) of this section is $130x, and that its ATI after adding 
back S's depreciation deductions with respect to Asset Y under paragraph 
(b)(1)(i)(D) of this section is $160x. The P group incurs $45x of 
business interest expense in 2021. In 2024, P sells all of its S stock 
to an unrelated third party at a gain of $25x.
    (2) Analysis. The P group's section 163(j) limitation for 2021 is 
$48x ($160x x 30 percent). Thus, all $45x of the P group's business 
interest expense incurred in 2021 is deductible in that year. Under 
paragraph (b)(1)(ii)(D) of this section, the P group must subtract $30x 
from its tentative taxable income in computing its ATI for its 2024 
taxable year. Alternatively, under paragraph (b)(1)(iv)(E)(2) of this 
section, the P group must subtract $25x (the lesser

[[Page 402]]

of $30x or $25x) from its tentative taxable income in computing its ATI 
for its 2024 taxable year. However, the negative adjustments under 
paragraphs (b)(1)(ii)(D) and (b)(1)(iv)(E)(2) of this section are both 
subject to the negative adjustment cap in paragraph (b)(1)(iv)(F) of 
this section. Under that paragraph, the P group's negative adjustment 
under either paragraph (b)(1)(ii)(D) or paragraph (b)(1)(iv)(E)(2) of 
this section is capped at $20x, or $150x (the amount of ATI the P group 
needed in order to deduct all $45x of business interest expense in 2021) 
minus $130x (the amount of the P group's tentative taxable income in 
2021 before adding back any amounts under paragraph (b)(1)(i)(D) through 
(F) of this section). As established by the P group, the additional $10x 
($30x-$20x) of depreciation deductions that were added back to tentative 
taxable income in 2021 under paragraph (b)(1)(i)(D) of this section did 
not increase the P group's business interest expense deduction for that 
year.
    (3) Disposition of less than all member stock. The facts are the 
same as in paragraph (b)(1)(viii)(B)(1) of this section, except that, in 
2024, P sells half of its S stock to an unrelated third party. The 
results are the same as in paragraph (b)(1)(viii)(B)(2) of this section. 
See paragraph (b)(1)(iv)(A)(3) of this section. Thus, the P group must 
subtract $20x from its tentative taxable income in computing its ATI for 
its 2024 taxable year. No further adjustment under paragraphs 
(b)(1)(ii)(C) and (D) or paragraphs (b)(1)(iv)(E)(1) and (2) of this 
section is required if P subsequently sells its remaining S stock or if 
S subsequently disposes of Asset Y. See paragraphs (b)(1)(iv)(A)(3) and 
(b)(1)(iv)(D) of this section.
    (4) Intercompany transfer; disposition of successor assets--(i) 
Adjustments in 2024. The facts are the same as in paragraph 
(b)(1)(viii)(B)(1) of this section, except that, rather than sell all of 
its S stock to an unrelated third party in 2024, P transfers all of its 
S stock to T in 2024 in a transaction to which section 351 applies and, 
in 2025, P sells all of its T stock to an unrelated third party at a 
gain of $40x. As provided in paragraph (b)(1)(iv)(A)(2) of this section, 
P's intercompany transfer of its S stock to T is not a ``sale or other 
disposition'' for purposes of paragraph (b)(1)(ii)(D) or paragraph 
(b)(1)(iv)(E)(2) of this section. Thus, no adjustment to tentative 
taxable income is required in 2024 under paragraph (b)(1)(ii)(D) or 
paragraph (b)(1)(iv)(E)(2) of this section.
    (ii) Adjustments in 2025. Pursuant to paragraph (b)(1)(iv)(C)(1) of 
this section, P's stock in T is treated as a successor asset for 
purposes of paragraph (b)(1)(ii)(D) and (b)(1)(iv)(E)(2) of this 
section. Moreover, P's sale of its T stock causes both T and S to 
deconsolidate. Thus, under paragraph (b)(1)(iv)(A)(3) of this section, 
the transaction is treated as a taxable disposition of all of the T 
stock and all of the S stock held by all members of the P group. Under 
the anti-duplication rule in paragraph (b)(1)(iv)(D) of this section, 
the total amount of gain recognized for purposes of paragraph 
(b)(1)(iv)(E)(2)(i) of this section is $40x, the greater of the gain on 
the disposition of the T stock ($40x) or on the disposition of the S 
stock ($25x). However, the negative adjustments under paragraph 
(b)(1)(iv)(E)(2) of this section are subject to the negative adjustment 
cap in paragraph (b)(1)(iv)(F) of this section. Thus, the P group must 
subtract $20x from its tentative taxable income in computing its ATI for 
its 2025 taxable year.
    (5) Alternative computation and non-deconsolidating disposition of 
member stock. The facts are the same as in paragraph (b)(1)(viii)(B)(1) 
of this section, except that, in 2024, P sells just ten percent of its S 
stock to an unrelated third party at a gain of $2.5x. Under paragraph 
(b)(1)(iv)(E)(2) of this section, the lesser of P's gain recognized on 
the sale of the S stock ($2.5x) and the investment adjustments under 
Sec.  1.1502-32 with respect to the S stock P sold ($3x) is $2.5x, an 
amount less than the $20x limitation under paragraph (b)(1)(iv)(F) of 
this section. Thus, the P group must subtract $2.5x from its tentative 
taxable income in computing its ATI for its 2024 taxable year.
    (6) Non-deconsolidating disposition of member stock followed by 
asset disposition. The facts are the same as in paragraph 
(b)(1)(viii)(B)(5) of this section, except that, in 2025, S sells Asset 
Y to an unrelated third party for a gain of

[[Page 403]]

$20x. Under paragraph (b)(1)(iv)(E)(1) of this section, the amount of 
the adjustment in 2025 is the lesser of two amounts. The first amount is 
the amount of S's gain recognized on the sale of Asset Y ($20x). See 
paragraph (b)(1)(iv)(E)(1)(i) of this section. The second amount is the 
amount of depreciation with respect to Asset Y (see paragraph 
(b)(1)(iv)(E)(1)(ii) of this section), reduced by the amount of 
depreciation previously taken into account in the computation under 
paragraph (b)(1)(iv)(E)(2)(ii) of this section ($30x-$3x, or $27x). See 
paragraph (b)(1)(iv)(D)(1) of this section. Thus, the amount of the 
adjustment under paragraphs (b)(1)(iv)(D) and (b)(1)(iv)(E)(1) of this 
section is $20x. In turn, this amount is subject to the negative 
adjustment cap under paragraph (b)(1)(iv)(F), which, after accounting 
for the negative adjustment on the earlier sale of S stock in 2024, is 
$17.5x ($20x-$2.5x). Accordingly, the P group must subtract $17.5x from 
its tentative taxable income in computing its ATI for its 2025 taxable 
year.
    (C) Example 3--(1) Facts. The facts are the same as in paragraph 
(b)(1)(viii)(B)(1) of this section, except that, in 2024, S sells Asset 
Y to an unrelated third party for $25x and, in 2025, P sells all of its 
S stock to an unrelated third party at a gain of $25x.
    (2) Analysis. The results are the same as in paragraph 
(b)(1)(viii)(B)(2) of this section. Thus, the P group must subtract $20x 
from its tentative taxable income in computing its ATI for its 2024 
taxable year. P's sale of all of its S stock in 2025 is a ``sale or 
other disposition'' for purposes of paragraph (b)(1)(ii)(D) and 
(b)(1)(iv)(E)(2) of this section. However, pursuant to paragraph 
(b)(1)(iv)(D)(1) of this section, no further adjustment to the P group's 
tentative taxable income is required in 2025 under paragraph 
(b)(1)(ii)(D) or paragraph (b)(1)(iv)(E)(2) of this section.
    (3) Disposition of S stock prior to S's asset disposition. The facts 
are the same as in paragraph (b)(1)(viii)(C)(1) of this section, except 
that, in 2024, P sells all of its S stock to an unrelated third party at 
a gain of $25x and, in 2025, S sells Asset Y to an unrelated third party 
for $25x. The results are the same as in paragraph (b)(1)(viii)(B)(2) of 
this section. Thus, the P group must subtract $20x from its tentative 
taxable income in computing its ATI for its 2024 taxable year. Pursuant 
to paragraph (b)(1)(iv)(D)(2) of this section, no adjustment to the 
acquiring group's tentative taxable income is required in 2025 under 
paragraph (b)(1)(ii)(C) or paragraph (b)(1)(iv)(E)(1) of this section.
    (4) Deconsolidation of S in nonrecognition transaction. The facts 
are the same as in paragraph (b)(1)(viii)(C)(3) of this section, except 
that, rather than sell all of its S stock to an unrelated third party, P 
causes S to merge with and into an unrelated third party in a 
transaction described in section 368(a)(1)(A). As provided in paragraph 
(b)(1)(iv)(A)(3) of this section, the merger transaction is treated as a 
taxable disposition of all of P's stock in S for purposes of paragraphs 
(b)(1)(ii)(D) and (b)(1)(iv)(E)(2) of this section because S leaves the 
P group. Thus, the results are the same as in paragraph 
(b)(1)(viii)(C)(3) of this section.
    (D) Example 4--(1) Facts. P wholly owns T, which wholly owns S. In 
2021, S purchases a depreciable asset (Asset Z) for $30x and fully 
depreciates Asset Z under section 168(k). T reduces its basis in its S 
stock, and P reduces its basis in its T stock, by $30x under Sec.  
1.1502-32 to reflect S's depreciation deductions with respect to Asset 
Z. For the 2021 taxable year, the P group establishes that its ATI 
before adding back S's depreciation deductions with respect to Asset Z 
under paragraph (b)(1)(i)(D) of this section is $130x, and that its ATI 
after adding back S's depreciation deductions with respect to Asset Z 
under paragraph (b)(1)(i)(D) of this section is $160x. The P group 
incurs $45x of business interest expense in 2021. In 2024, T sells all 
of its S stock to an unrelated third party at a gain of $25x. In 2025, P 
sells all of its T stock to an unrelated third party at a gain of $40x.
    (2) Analysis. The results are the same as in paragraph 
(b)(1)(viii)(B)(2) of this section. Thus, the P group must subtract $20x 
from its tentative taxable income in computing its ATI for its 2024 
taxable year. Pursuant to paragraph

[[Page 404]]

(b)(1)(iv)(D)(1) of this section, no negative adjustment to the P 
group's tentative taxable income is required in 2025 under paragraph 
(b)(1)(ii)(D) or paragraph (b)(1)(iv)(E)(2) of this section.
    (3) Disposition of T stock in 2024. The facts are the same as in 
paragraph (b)(1)(viii)(D)(1) of this section, except that, in 2024, P 
sells all of its T stock to another consolidated group at a gain of $40x 
and, in 2025, T sells all of its S stock to an unrelated party at a gain 
of $25x. Whereas the transaction described in paragraph 
(b)(1)(viii)(B)(4) of this section is treated as a taxable disposition 
of both the T stock and the S stock, only the actual disposition of the 
T stock in the transaction described in this paragraph 
(b)(1)(viii)(D)(3) is treated as a taxable disposition for purposes of 
paragraphs (b)(1)(ii)(D) and (b)(1)(iv)(E)(2) of this section. See 
paragraph (b)(1)(iv)(A)(3) of this section. However, the results are the 
same as in paragraph (b)(1)(viii)(B)(2) and (b)(1)(viii)(B)(4) of this 
section because of the negative adjustment cap in paragraph 
(b)(1)(iv)(F) of this section. Thus, the P group must subtract $20x from 
its tentative taxable income in computing its ATI for its 2024 taxable 
year. Pursuant to paragraph (b)(1)(iv)(D) of this section, no negative 
adjustment to the acquiring group's tentative taxable income is required 
in 2025 under paragraph (b)(1)(ii)(D) or paragraph (b)(1)(iv)(E)(2) of 
this section.
    (E) Example 5--(1) Facts. In 2021, A purchases Assets X and Y for 
$30x and $80x, respectively, and fully depreciates each asset under 
section 168(k). For the 2021 taxable year, A establishes that its ATI 
before adding back depreciation deductions with respect to Assets X and 
Y under paragraph (b)(1)(i)(D) of this section is $150x, and that its 
ATI after adding back depreciation deductions with respect to Assets X 
and Y under paragraph (b)(1)(i)(D) of this section is $260x. A incurs 
$75x of business interest expense in 2021. In 2024, A sells Assets X and 
Y to an unrelated third party for $40x and $90x, respectively.
    (2) Analysis. A's section 163(j) limitation for 2021 is $78x ($260x 
x 30 percent). Thus, all $75x of A's business interest expense incurred 
in 2021 is deductible in that year. Under paragraph (b)(1)(ii)(C) of 
this section, A must subtract $110x ($30x + $80x) from its tentative 
taxable income in computing its ATI for its 2024 taxable year. 
Alternatively, under paragraph (b)(1)(iv)(E)(1) of this section, A must 
subtract $30x with respect to Asset X (the lesser of $30x or $40x ($40x-
$0x)), and $80x with respect to Asset Y (the lesser of $80x or $90x 
($90x-$0x)), from its tentative taxable income in computing its ATI for 
its 2024 taxable year. However, the negative adjustments under 
paragraphs (b)(1)(ii)(C) and (b)(1)(iv)(E)(1) of this section are both 
subject to the negative adjustment cap in paragraph (b)(1)(iv)(F) of 
this section. Under that paragraph, A's negative adjustment in 2024 
under either paragraph (b)(1)(ii)(C) ($110x) or paragraph 
(b)(1)(iv)(E)(1) (also $110x) of this section is limited to $100x. This 
amount equals $250x (the amount of ATI that A needed in order to deduct 
all $75x of business interest expense in 2021) minus $150x (the amount 
of A's tentative taxable income in 2021 before adding back any amounts 
under paragraph (b)(1)(i)(D) through (F) of this section). As 
established by A, the additional $10x ($110x-$100x) of depreciation 
deductions that were added back to tentative taxable income in 2021 
under paragraph (b)(1)(i)(D) of this section did not increase A's 
business interest expense deduction for that year.
    (3) Sale of assets in different taxable years. The facts are the 
same as in paragraph (b)(1)(viii)(E)(1) of this section, except that A 
sells Asset Y to an unrelated third party for $90x in 2025. Under 
paragraph (b)(1)(ii)(C) of this section, A must subtract $30x from its 
tentative taxable income in computing its ATI for its 2024 taxable year. 
Alternatively, under paragraph (b)(1)(iv)(E)(1) of this section, A must 
subtract $30x (the lesser of $30x or $40x ($40x-$0x)) from its tentative 
taxable income in computing its ATI for its 2024 taxable year. Because 
A's negative adjustment cap for its 2021 taxable year is $100x (see 
paragraph (b)(1)(viii)(E)(2) of this section), A's negative adjustment 
in 2024 of $30x is not reduced under paragraph (b)(1)(iv)(F) of this 
section. In 2025, A must subtract $80x from its tentative taxable income

[[Page 405]]

under paragraph (b)(1)(ii)(C) of this section in computing its ATI. 
Alternatively, under paragraph (b)(1)(iv)(E)(1) of this section, A must 
subtract $80x (the lesser of $80x or $90x ($90x-$0x)) from its tentative 
taxable income in computing its ATI for its 2025 taxable year. However, 
the negative adjustments under paragraphs (b)(1)(ii)(C) and 
(b)(1)(iv)(E)(1) of this section are both subject to the negative 
adjustment cap in paragraph (b)(1)(iv)(F) of this section. Moreover, A's 
negative adjustment cap for its 2021 taxable year is reduced from $100x 
to $70x to reflect A's $30x negative adjustment in 2024. See paragraph 
(b)(1)(iv)(F) of this section. Thus, A's negative adjustment for 2025 
under either paragraph (b)(1)(ii)(C) or paragraph (b)(1)(iv)(E)(1) of 
this section is reduced from $80x to $70x. As established by A, the 
additional $10x ($110x-$100x) of depreciation deductions that were added 
back to tentative taxable income in 2021 under paragraph (b)(1)(i)(D) of 
this section did not increase A's business interest expense deduction 
for that year.
    (2) Applicable CFC. The term applicable CFC means a foreign 
corporation described in section 957, but only if the foreign 
corporation has at least one United States shareholder that owns, within 
the meaning of section 958(a), stock of the foreign corporation.
    (3) Business interest expense--(i) In general. The term business 
interest expense means interest expense that is properly allocable to a 
non-excepted trade or business or that is floor plan financing interest 
expense. Business interest expense also includes disallowed business 
interest expense carryforwards (as defined in paragraph (b)(11) of this 
section). However, business interest expense does not include amounts of 
interest expense carried forward to the taxable year from a prior 
taxable year due to the application of section 465 or section 469, which 
apply after the application of section 163(j). For the treatment of 
investment interest, see section 163(d); and for the treatment of 
personal interest, see section 163(h).
    (ii) Special rules. For special rules for defining business interest 
expense in certain circumstances, see Sec. Sec.  1.163(j)-3(b)(2) 
(regarding disallowed interest expense), 1.163(j)-4(b) (regarding C 
corporations) and 1.163(j)-4(d)(2)(iii) (regarding consolidated groups), 
1.163(j)-1(b)(9) (regarding current-year business interest expense), and 
1.163(j)-6(c) (regarding partnerships and S corporations).
    (4) Business interest income--(i) In general. The term business 
interest income means interest income includible in the gross income of 
a taxpayer for the taxable year which is properly allocable to a non-
excepted trade or business. For the treatment of investment income, see 
section 163(d).
    (ii) Special rules. For special rules defining business interest 
income in certain circumstances, see Sec. Sec.  1.163(j)-4(b) (regarding 
C corporations), 1.163(j)-4(d)(2)(iii) (regarding consolidated groups), 
and 1.163(j)-6(c) (regarding partnerships and S corporations).
    (5) C corporation. The term C corporation has the meaning provided 
in section 1361(a)(2).
    (6) Cleared swap. The term cleared swap means a swap that is cleared 
by a derivatives clearing organization, as such term is defined in 
section 1a of the Commodity Exchange Act (7 U.S.C. 1a), or by a clearing 
agency, as such term is defined in section 3 of the Securities Exchange 
Act of 1934 (15 U.S.C. 78c), that is registered as a derivatives 
clearing organization under the Commodity Exchange Act or as a clearing 
agency under the Securities Exchange Act of 1934, respectively, if the 
derivatives clearing organization or clearing agency requires the 
parties to the swap to post and collect margin or collateral.
    (7) Consolidated group. The term consolidated group has the meaning 
provided in Sec.  1.1502-1(h).
    (8) Consolidated return year. The term consolidated return year has 
the meaning provided in Sec.  1.1502-1(d).
    (9) Current-year business interest expense. The term current-year 
business interest expense means business interest expense that would be 
deductible in the current taxable year without regard to section 163(j) 
and that is not a disallowed business interest expense carryforward from 
a prior taxable year.

[[Page 406]]

    (10) Disallowed business interest expense. The term disallowed 
business interest expense means the amount of business interest expense 
for a taxable year in excess of the amount allowed as a deduction for 
the taxable year under section 163(j)(1) and Sec.  1.163(j)-2(b). For 
purposes of section 163(j) and the regulations in this part under 
section 163(j) of the Internal Revenue Code (Code) disallowed business 
interest expense is treated as ``paid or accrued'' in the taxable year 
in which the expense is deductible for Federal income tax purposes 
(without regard to section 163(j)) or in the taxable year in which a 
deduction for the business interest expense is permitted under section 
163(j), as the context may require.
    (11) Disallowed business interest expense carryforward. The term 
disallowed business interest expense carryforward means any business 
interest expense described in Sec.  1.163(j)-2(c).
    (12) Disallowed disqualified interest. The term disallowed 
disqualified interest means interest expense, including carryforwards, 
for which a deduction was disallowed under old section 163(j) (as 
defined in paragraph (b)(27) of this section) in the taxpayer's last 
taxable year beginning before January 1, 2018, and that was carried 
forward pursuant to old section 163(j).
    (13) Electing farming business. The term electing farming business 
means a trade or business that makes an election as provided in Sec.  
1.163(j)-9 or other published guidance and that is--
    (i) A farming business, as defined in section 263A(e)(4) or Sec.  
1.263A-4(a)(4);
    (ii) Any trade or business of a specified agricultural or 
horticultural cooperative, as defined in section 199A(g)(4); or
    (iii) Specifically designated by the Secretary in guidance published 
in the Federal Register or the Internal Revenue Bulletin (see Sec.  
601.601(d) of this chapter) as a farming business for purposes of 
section 163(j).
    (14) Electing real property trade or business. The term electing 
real property trade or business means a trade or business that makes an 
election as provided in Sec.  1.163(j)-9 or other published guidance and 
that is--
    (i) A real property trade or business described in section 
469(c)(7)(C) and Sec.  1.469-9(b)(2); or
    (ii) A REIT that qualifies for the safe harbor described in Sec.  
1.163(j)-9(h); or
    (iii) A trade or business specifically designated by the Secretary 
in guidance published in the Federal Register or the Internal Revenue 
Bulletin (see Sec.  601.601(d) of this chapter) as a real property trade 
or business for purposes of section 163(j).
    (15) Excepted regulated utility trade or business--(i) In general. 
The term excepted regulated utility trade or business means:
    (A) Automatically excepted regulated utility trades or businesses. A 
trade or business--
    (1) That furnishes or sells--
    (i) Electrical energy, water, or sewage disposal services;
    (ii) Gas or steam through a local distribution system; or
    (iii) Transportation of gas or steam by pipeline; but only
    (2) To the extent that the rates for the furnishing or sale of the 
items in paragraph (b)(15)(i)(A)(1) of this section--
    (i) Have been established or approved by a State or political 
subdivision thereof, by any agency or instrumentality of the United 
States, or by a public service or public utility commission or other 
similar body of any State or political subdivision thereof and are 
determined on a cost of service and rate of return basis; or
    (ii) Have been established or approved by the governing or 
ratemaking body of an electric cooperative; or
    (B) Electing regulated utility trades or businesses. A trade or 
business that makes a valid election under paragraph (b)(15)(iii) of 
this section; or
    (C) Designated excepted regulated utility trades or businesses. A 
trade or business that is specifically designated by the Secretary in 
guidance published in the Federal Register or the Internal Revenue 
Bulletin as an excepted regulated utility trade or business (see Sec.  
601.601(d) of this chapter) for section 163(j) purposes.
    (ii) Depreciation and excepted and non-excepted utility trades or 
businesses.

[[Page 407]]

    (A) Depreciation. Taxpayers engaged in an excepted trade or business 
described in paragraph (b)(15)(i) of this section cannot claim the 
additional first-year depreciation deduction under section 168(k) for 
any property that is primarily used in the excepted regulated utility 
trade or business.
    (B) Allocation of items. If a taxpayer is engaged in one or more 
excepted trades or businesses, as described in paragraph (b)(15)(i) of 
this section, and one or more non-excepted trades or businesses, the 
taxpayer must allocate items between the excepted and non-excepted 
utility trades or businesses. See Sec. Sec.  1.163(j)-1(b)(44) and 
1.163(j)-10(c)(3)(iii)(C). Some trades or businesses with de minimis 
furnishing or sales of items described in paragraph (b)(15)(i)(A)(1) of 
this section that are not sold pursuant to rates that are determined on 
a cost of service and rate of return basis or established or approved by 
the governing or ratemaking body of an electric cooperative, and are not 
subject to an election in paragraph (b)(15)(iii), are treated as 
excepted trades or businesses. See Sec.  1.163(j)-10(c)(3)(iii)(C)(3). 
For look-through rules applicable to certain CFCs that furnish or sell 
items described in paragraph (b)(15)(i)(A)(1) of this section that are 
not sold pursuant to rates that are determined on a cost of service and 
rate of return basis or established or approved by the governing or 
ratemaking body of an electric cooperative as described in paragraph 
(b)(15)(i)(A)(2) of this section, see Sec.  1.163(j)-10(c)(5)(ii)(C).
    (iii) Election to be an excepted regulated utility trade or 
business. (A) In general. A trade or business that is not an excepted 
regulated utility trade or business described in paragraph (b)(15)(i)(A) 
or (C) of this section and that furnishes or sells items described in 
paragraph (b)(15)(i)(A)(1) of this section is eligible to make an 
election to be an excepted regulated utility trade or business to the 
extent that the rates for furnishing or selling the items described in 
paragraph (b)(15)(i)(A)(1) of this section have been established or 
approved by a regulatory body described in paragraph (b)(15)(i)(A)(2)(i) 
of this section.
    (B) Scope and effect of election--(1) In general. An election under 
paragraph (b)(15)(iii) of this section is made with respect to each 
eligible trade or business of the taxpayer and applies only to the trade 
or business for which the election is made. An election under paragraph 
(b)(15)(iii) of this section applies to the taxable year in which the 
election is made and to all subsequent taxable years.
    (2) Irrevocability. An election under paragraph (b)(15)(iii) of this 
section is irrevocable.
    (C) Time and manner of making election--(1) In general. Subject to 
paragraph (b)(15)(iii)(C)(5) of this section, a taxpayer makes an 
election under paragraph (b)(15)(iii) by attaching an election statement 
to the taxpayer's timely filed original Federal income tax return, 
including extensions. A taxpayer may make elections for multiple trades 
or businesses on a single election statement.
    (2) Election statement contents. The election statement should be 
titled ``Section 1.163(j)-1(b)(15)(iii) Election'' and must contain the 
following information for each trade or business:
    (i) The taxpayer's name;
    (ii) The taxpayer's address;
    (iii) The taxpayer's social security number (SSN) or employer 
identification number (EIN);
    (iv) A description of the taxpayer's electing trade or business 
sufficient to demonstrate qualification for an election under this 
section, including the principal business activity code; and
    (v) A statement that the taxpayer is making an election under 
section 1.163(j)-1(b)(15)(iii).
    (3) Consolidated group's or partnership's trade or business. The 
rules in Sec.  1.163(j)-9(d)(3) and (4) apply with respect to an 
election under paragraph (b)(15)(iii) of this section for a consolidated 
group's or partnership's trade or business.
    (4) Termination of election. The rules in Sec.  1.163(j)-9(e) apply 
to determine when an election under paragraph (b)(15)(iii) of this 
section terminates.
    (5) Additional guidance. The rules and procedures regarding the time 
and manner of making an election under paragraph (b)(15)(iii) of this 
section and the election statement contents in

[[Page 408]]

paragraph (b)(15)(iii)(C)(2) of this section may be modified through 
other guidance (see Sec. Sec.  601.601(d) and 601.602 of this chapter). 
Additional situations in which an election may terminate under paragraph 
(b)(15)(iii)(C)(4) of this section may be provided through guidance 
published in the Federal Register or in the Internal Revenue Bulletin 
(see Sec.  601.601(d) of this chapter).
    (16) Excess business interest expense. For any partnership, the term 
excess business interest expense means the amount of disallowed business 
interest expense of the partnership for a taxable year under section 
Sec.  1.163(j)-2(b). With respect to a partner, see Sec.  1.163(j)-6(g) 
and (h).
    (17) Excess taxable income. With respect to any partnership or S 
corporation, the term excess taxable income means the amount which bears 
the same ratio to the partnership's ATI as--
    (i) The excess (if any) of--
    (A) The amount determined for the partnership or S corporation under 
section 163(j)(1)(B); over
    (B) The amount (if any) by which the business interest expense of 
the partnership, reduced by the floor plan financing interest expense, 
exceeds the business interest income of the partnership or S 
corporation; bears to
    (ii) The amount determined for the partnership or S corporation 
under section 163(j)(1)(B).
    (18) Floor plan financing indebtedness. The term floor plan 
financing indebtedness means indebtedness--
    (i) Used to finance the acquisition of motor vehicles held for sale 
or lease; and
    (ii) Secured by the motor vehicles so acquired.
    (19) Floor plan financing interest expense. The term floor plan 
financing interest expense means interest paid or accrued on floor plan 
financing indebtedness. For purposes of the section 163(j) regulations, 
all floor plan financing interest expense is treated as business 
interest expense. See paragraph (b)(3) of this section.
    (20) Group. The term group has the meaning provided in Sec.  1.1502-
1(a).
    (21) Intercompany transaction. The term intercompany transaction has 
the meaning provided in Sec.  1.1502-13(b)(1)(i).
    (22) Interest. The term interest means any amount described in 
paragraph (b)(22)(i), (ii), (iii), or (iv) of this section.
    (i) In general. Interest is an amount paid, received, or accrued as 
compensation for the use or forbearance of money under the terms of an 
instrument or contractual arrangement, including a series of 
transactions, that is treated as a debt instrument for purposes of 
section 1275(a) and Sec.  1.1275-1(d), and not treated as stock under 
Sec.  1.385-3, or an amount that is treated as interest under other 
provisions of the Code or the Income Tax Regulations. Thus, interest 
includes, but is not limited to, the following:
    (A) Original issue discount (OID), as adjusted by the holder for any 
acquisition premium or amortizable bond premium;
    (B) Qualified stated interest, as adjusted by the holder for any 
amortizable bond premium or by the issuer for any bond issuance premium;
    (C) Acquisition discount;
    (D) Amounts treated as taxable OID under section 1286 (relating to 
stripped bonds and stripped coupons);
    (E) Accrued market discount on a market discount bond to the extent 
includible in income by the holder under either section 1276(a) or 
1278(b);
    (F) OID includible in income by a holder that has made an election 
under Sec.  1.1272-3 to treat all interest on a debt instrument as OID;
    (G) OID on a synthetic debt instrument arising from an integrated 
transaction under Sec.  1.1275-6;
    (H) Repurchase premium to the extent deductible by the issuer under 
Sec.  1.163-7(c) (determined without regard to section 163(j));
    (I) Deferred payments treated as interest under section 483;
    (J) Amounts treated as interest under a section 467 rental 
agreement;
    (K) Amounts treated as interest under section 988;
    (L) Forgone interest under section 7872;
    (M) De minimis OID taken into account by the issuer;
    (N) Amounts paid or received in connection with a sale-repurchase 
agreement treated as indebtedness under Federal tax principles; however, 
in the

[[Page 409]]

case of a sale-repurchase agreement relating to tax-exempt bonds, the 
amount is not tax-exempt interest;
    (O) Redeemable ground rent treated as interest under section 163(c); 
and
    (P) Amounts treated as interest under section 636.
    (ii) Swaps with significant nonperiodic payments--(A) In general. 
Except as provided in paragraphs (b)(22)(ii)(B) and (C) of this section, 
a swap with significant nonperiodic payments is treated as two separate 
transactions consisting of an on-market, level payment swap and a loan. 
The loan must be accounted for by the parties to the contract 
independently of the swap. The time value component associated with the 
loan, determined in accordance with Sec.  1.446-3(f)(2)(iii)(A), is 
recognized as interest expense to the payor and interest income to the 
recipient.
    (B) Exception for cleared swaps. Paragraph (b)(22)(ii)(A) of this 
section does not apply to a cleared swap (as defined in paragraph (b)(6) 
of this section).
    (C) Exception for non-cleared swaps subject to margin or collateral 
requirements. Paragraph (b)(22)(ii)(A) of this section does not apply to 
a non-cleared swap that requires the parties to meet the margin or 
collateral requirements of a federal regulator or that provides for 
margin or collateral requirements that are substantially similar to a 
cleared swap or a non-cleared swap subject to the margin or collateral 
requirements of a federal regulator. For purposes of this paragraph 
(b)(22)(ii)(C), the term federal regulator means the Securities and 
Exchange Commission (SEC), the Commodity Futures Trading Commission 
(CFTC), or a prudential regulator, as defined in section 1a(39) of the 
Commodity Exchange Act (7 U.S.C. 1a), as amended by section 721 of the 
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, 
Public Law 111-203, 124 Stat. 1376, Title VII.
    (iii) Other amounts treated as interest--(A) Treatment of premium--
(1) Issuer. If a debt instrument is issued at a premium within the 
meaning of Sec.  1.163-13, any ordinary income under Sec.  1.163-
13(d)(4) is treated as interest income of the issuer.
    (2) Holder. If a taxable debt instrument is acquired at a premium 
within the meaning of Sec.  1.171-1 and the holder elects to amortize 
the premium, any amount deductible as a bond premium deduction under 
section 171(a)(1) and Sec.  1.171-2(a)(4)(i)(A) or (C) is treated as 
interest expense of the holder.
    (B) Treatment of ordinary income or loss on certain debt 
instruments. If an issuer of a contingent payment debt instrument 
subject to Sec.  1.1275-4(b), a nonfunctional currency contingent 
payment debt instrument subject to Sec.  1.988-6, or an inflation-
indexed debt instrument subject to Sec.  1.1275-7 recognizes ordinary 
income on the debt instrument in accordance with the rules in Sec.  
1.1275-4(b), Sec.  1.988-6(b)(2), or Sec.  1.1275-7(f), whichever is 
applicable, the ordinary income is treated as interest income of the 
issuer. If a holder of a contingent payment debt instrument subject to 
Sec.  1.1275-4(b), a nonfunctional currency contingent payment debt 
instrument subject to Sec.  1.988-6, or an inflation-indexed debt 
instrument subject to Sec.  1.1275-7 recognizes an ordinary loss on the 
debt instrument in accordance with the rules in Sec.  1.1275-4(b), Sec.  
1.988-6(b)(2), or Sec.  1.1275-7(f), whichever is applicable, the 
ordinary loss is treated as interest expense of the holder.
    (C) Substitute interest payments. A substitute interest payment 
described in Sec.  1.861-2(a)(7) is treated as interest expense to the 
payor only if the payment relates to a sale-repurchase agreement or a 
securities lending transaction that is not entered into by the payor in 
the ordinary course of the payor's business. A substitute interest 
payment described in Sec.  1.861-2(a)(7) is treated as interest income 
to the recipient only if the payment relates to a sale-repurchase 
agreement or a securities lending transaction that is not entered into 
by the recipient in the ordinary course of the recipient's business; 
however, in the case of a sale-repurchase agreement or a securities 
lending transaction relating to tax-exempt bonds, the recipient of a 
substitute payment does not receive tax-exempt interest income. This 
paragraph (b)(22)(iii)(C) does not apply to an amount described in 
paragraph (b)(22)(i)(N) of this section.
    (D) Section 1258 gain. Any gain treated as ordinary gain under 
section 1258 is treated as interest income.

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    (E) Factoring income. The excess of the amount that a taxpayer 
collects on a factored receivable (or realizes upon the sale or other 
disposition of the factored receivable) over the amount paid for the 
factored receivable by the taxpayer is treated as interest income. For 
purposes of this paragraph (b)(22)(iii)(E), the term factored receivable 
includes any account receivable or other evidence of indebtedness, 
whether or not issued at a discount and whether or not bearing stated 
interest, arising out of the disposition of property or the performance 
of services by any person, if such account receivable or evidence of 
indebtedness is acquired by a person other than the person who disposed 
of the property or provided the services that gave rise to the account 
receivable or evidence of indebtedness. This paragraph (b)(22)(iii)(E) 
does not apply to an amount described in paragraph (b)(22)(i)(C) or (E) 
of this section.
    (F) Section 163(j) interest dividends--(1) In general. Except as 
otherwise provided in this paragraph (b)(22)(iii)(F), a section 163(j) 
interest dividend is treated as interest income.
    (2) Limitation on amount treated as interest income. A shareholder 
may not treat any part of a section 163(j) interest dividend as interest 
income to the extent the amount of the section 163(j) interest dividend 
exceeds the excess of the amount of the entire dividend that includes 
the section 163(j) interest dividend over the sum of the conduit amounts 
other than interest-related dividends under section 871(k)(1)(C) and 
section 163(j) interest dividends that affect the shareholder's 
treatment of that dividend.
    (3) Conduit amounts. For purposes of paragraph (b)(22)(iii)(F)(2) of 
this section, the term conduit amounts means, with respect to any 
category of income (including tax-exempt interest) earned by a RIC for a 
taxable year, the amounts identified by the RIC (generally in a 
designation or written report) in connection with dividends of the RIC 
for that taxable year that are subject to a limit determined by 
reference to that category of income. For example, a RIC's conduit 
amount with respect to its net capital gain is the amount of the RIC's 
capital gain dividends under section 852(b)(3)(C).
    (4) Holding period. Except as provided in paragraph 
(b)(22)(iii)(F)(5) of this section, no dividend is treated as interest 
income under paragraph (b)(22)(iii)(F)(1) of this section if the 
dividend is received with respect to a share of RIC stock--
    (i) That is held by the shareholder for 180 days or less (taking 
into account the principles of section 246(c)(3) and (4)) during the 
361-day period beginning on the date which is 180 days before the date 
on which the share becomes ex-dividend with respect to such dividend; or
    (ii) To the extent that the shareholder is under an obligation 
(whether pursuant to a short sale or otherwise) to make related payments 
with respect to positions in substantially similar or related property.
    (5) Exception to holding period requirement for money market funds 
and certain regularly declared dividends. Paragraph 
(b)(22)(iii)(F)(4)(i) of this section does not apply to dividends 
distributed by any RIC regulated as a money market fund under 17 CFR 
270.2a-7 (Rule 2a-7 under the 1940 Act) or to regular dividends paid by 
a RIC that declares section 163(j) interest dividends on a daily basis 
in an amount equal to at least 90 percent of its excess section 163(j) 
interest income, as defined in paragraph (b)(35)(iv)(E) of this section, 
and distributes such dividends on a monthly or more frequent basis.
    (iv) Anti-avoidance rules--(A) Principal purpose to reduce interest 
expense--(1) Treatment as interest expense. Any expense or loss 
economically equivalent to interest is treated as interest expense if a 
principal purpose of structuring the transaction(s) is to reduce an 
amount incurred by the taxpayer that otherwise would have been described 
in paragraph (b)(22)(i), (ii), or (iii) of this section. For this 
purpose, the fact that the taxpayer has a business purpose for obtaining 
the use of funds does not affect the determination of whether the manner 
in which the taxpayer structures the transaction(s) is with a principal 
purpose of reducing the taxpayer's interest expense. In addition, the 
fact that the taxpayer has obtained funds at a lower pre-tax cost

[[Page 411]]

based on the structure of the transaction(s) does not affect the 
determination of whether the manner in which the taxpayer structures the 
transaction(s) is with a principal purpose of reducing the taxpayer's 
interest expense. For purposes of this paragraph (b)(22)(iv)(A)(1), any 
expense or loss is economically equivalent to interest to the extent 
that the expense or loss is--
    (i) Deductible by the taxpayer;
    (ii) Incurred by the taxpayer in a transaction or series of 
integrated or related transactions in which the taxpayer secures the use 
of funds for a period of time;
    (iii) Substantially incurred in consideration of the time value of 
money; and
    (iv) Not described in paragraph (b)(22)(i), (ii), or (iii) of this 
section.
    (2) Corresponding treatment of amounts as interest income. If a 
taxpayer knows that an expense or loss is treated by the payor as 
interest expense under paragraph (b)(22)(iv)(A)(1) of this section, the 
taxpayer provides the use of funds for a period of time in the 
transaction(s) subject to paragraph (b)(22)(iv)(A)(1) of this section, 
the taxpayer earns income or gain with respect to the transaction(s), 
and such income or gain is substantially earned in consideration of the 
time value of money provided by the taxpayer, such income or gain is 
treated as interest income to the extent of the expense or loss treated 
by the payor as interest expense under paragraph (b)(22)(iv)(A)(1) of 
this section.
    (B) Interest income artificially increased. Notwithstanding 
paragraphs (b)(22)(i) through (iii) of this section, any income realized 
by a taxpayer in a transaction or series of integrated or related 
transactions is not treated as interest income of the taxpayer if and to 
the extent that a principal purpose for structuring the transaction(s) 
is to artificially increase the taxpayer's business interest income. For 
this purpose, the fact that the taxpayer has a business purpose for 
holding interest generating assets does not affect the determination of 
whether the manner in which the taxpayer structures the transaction(s) 
is with a principal purpose of artificially increasing the taxpayer's 
business interest income.
    (C) Principal purpose. Whether a transaction or a series of 
integrated or related transactions is entered into with a principal 
purpose described in paragraph (b)(22)(iv)(A) or (B) of this section 
depends on all the facts and circumstances related to the 
transaction(s), except for those facts described in paragraph 
(b)(22)(iv)(A) or (B) of this section. A purpose may be a principal 
purpose even though it is outweighed by other purposes (taken together 
or separately). Factors to be taken into account in determining whether 
one of the taxpayer's principal purposes for entering into the 
transaction(s) include the taxpayer's normal borrowing rate in the 
taxpayer's functional currency, whether the taxpayer would enter into 
the transaction(s) in the ordinary course of the taxpayer's trade or 
business, whether the parties to the transaction(s) are related persons 
(within the meaning of section 267(b) or section 707(b)), whether there 
is a significant and bona fide business purpose for the structure of the 
transaction(s), whether the transactions are transitory, for example, 
due to a circular flow of cash or other property, and the substance of 
the transaction(s).
    (D) Coordination with anti-avoidance rule in Sec.  1.163(j)-2(j). 
The anti-avoidance rules in paragraphs (b)(22)(iv)(A) through (C) of 
this section, rather than the anti-avoidance rules in Sec.  1.163(j)-
2(j), apply to determine whether an item is treated as interest expense 
or interest income.
    (v) Examples. The examples in this paragraph (b)(22)(v) illustrate 
the application of paragraph (b)(22)(iv) of this section. Unless 
otherwise indicated, A, B, C, D, and Bank are domestic C corporations 
that are publicly traded; the exemption for certain small businesses in 
Sec.  1.163(j)-2(d) does not apply; A is not engaged in an excepted 
trade or business; and all amounts of interest expense are deductible 
except for the potential application of section 163(j).
    (A) Example 1--(1) Facts. A is engaged in a manufacturing business 
and uses the calendar year as its annual accounting period. A's 
functional currency is the U.S. dollar and A conducts virtually all of 
its business in the U.S. dollar. A has no connection to Japan or the 
Japanese yen in the ordinary

[[Page 412]]

course of business. A projects that it will have business interest 
expense of $100x on an existing loan obligation with a stated principal 
amount of $2,000x (Loan 1) and no business interest income in its 
taxable year ending December 31, 2021. In early 2021, A enters into the 
following transactions, which A would not have entered into in the 
ordinary course of A's trade or business:
    (i) A enters into a loan obligation in which A borrows Japanese yen 
from Bank in an amount equivalent to $2,000x with an interest rate of 1 
percent (Loan 2) (at the time of the loan, the U.S. dollar equivalent 
interest rate on a loan of $2,000x is 5 percent);
    (ii) A enters into a foreign currency swap transaction (FX Swap) 
with Bank with a notional principal amount of $2,000x under which A 
receives Japanese yen at 1 percent multiplied by the amount of Japanese 
yen borrowed from Bank (which for 2021 equals $20x) and pays U.S. 
dollars at 5 percent multiplied by a notional amount of $2,000x ($100x 
per year);
    (iii) The FX Swap is not integrated with Loan 2 under Sec.  1.988-5; 
and
    (iv) A enters into a spot transaction with Bank to convert the 
proceeds of Loan 2 into $2,000x U.S. dollars and A uses the U.S. dollars 
to repay Loan 1.
    (2) Analysis. A principal purpose of A entering into the 
transactions with Bank was to try to reduce the amount incurred by A 
that otherwise would be interest expense; in effect, A sought to alter 
A's cost of borrowing by converting a substantial portion of its 
interest expense deductions on Loan 1 into section 165 deductions on the 
FX Swap ($100x interest expense related to Loan 1 compared to $20x 
interest expense related to Loan 2 and $80x section 165 deduction). A's 
functional currency is the U.S. dollar and A conducts virtually all of 
its business in the U.S. dollar. A has no connection to Japan or the 
Japanese yen and would not have entered into the transactions in the 
ordinary course of A's trade or business. The section 165 deductions 
related to the FX Swap were incurred by A in a series of transactions in 
which A secured the use of funds for a period of time and were 
substantially incurred in consideration of the time value of money. As a 
result, under paragraph (b)(22)(iv)(A)(1) of this section, for purposes 
of section 163(j), the $80x paid by A to Bank on the FX Swap is treated 
by A as interest expense.
    (B) Example 2--(1) Facts. A is engaged in a manufacturing business 
and uses the calendar year as its annual accounting period. A does not 
use gold in its manufacturing business. In 2021, A expects to borrow 
$1,000x for six months. In January 2021, A borrows from B two ounces of 
gold at a time when the spot price for gold is $500x per ounce. A agrees 
to return the two ounces of gold in six months. A sells the two ounces 
of gold to C for $1,000x. A then enters into a contract with D to 
purchase two ounces of gold six months in the future for $1,013x. In 
exchange for the use of $1,000x in cash for six months, A has sustained 
a loss of $13x in connection with these related transactions. A would 
not have entered into the gold transactions in the ordinary course of 
A's trade or business.
    (2) Analysis. In a series of related transactions, A has obtained 
the use of $1,000x for six months and created a loss of $13x 
substantially incurred in consideration of the time value of money. A 
would not have entered into the gold transactions in the ordinary course 
of A's trade or business. A entered into the transactions with a 
principal purpose of structuring the transactions to reduce its interest 
expense (in effect, A sought to convert what otherwise would be interest 
expense into a loss through the transactions). As a result, under 
paragraph (b)(22)(iv)(A)(1) of this section, for purposes of section 
163(j), the loss of $13x is treated by A as interest expense.
    (C) Example 3--(1) Facts. A is engaged in a manufacturing business 
and uses the calendar year as its annual accounting period. A's 
functional currency is the U.S. dollar and A conducts virtually all of 
its business in the U.S. dollar. A has no connection to Argentina or the 
Argentine peso as part of its ordinary course of business. As of January 
1, 2021, A expects to have adjusted taxable income (as defined in 
paragraph (b)(1) of this section) of $200x in the taxable year ending 
December 31, 2021. A also projects that it will have business interest 
expense of $70x

[[Page 413]]

on an existing loan in 2021. A has cash equivalents of $100x on which A 
expects to earn $5x of business interest income. In early 2021, A enters 
into the following transactions, which A would not have entered into in 
the ordinary course of A's trade or business:
    (i) A enters into a spot transaction with Bank to convert the $100x 
of cash equivalents into an amount in Argentine pesos equivalent to 
$100x and A uses the Argentine pesos to purchase an Argentine peso note 
(Note) issued by a subsidiary of Bank for the Argentine peso equivalent 
of $100x; the Note pays interest at a 10 percent rate; and
    (ii) A enters into a foreign currency swap transaction (FX Swap) 
with Bank with a notional principal amount of $100x under which A pays 
Argentine pesos at 10 percent multiplied by the amount of Argentine peso 
principal amount on the Note (which for 2021 equals $10x) and receives 
U.S. dollars at 5 percent multiplied by a notional amount of $100x ($5x 
per year).
    (2) Analysis. A principal purpose of A entering into the 
transactions was to increase the amount of business interest income 
received by A; in effect, A increased its business interest income by 
separately accounting for its net deduction of $5x per year on the FX 
Swap. A's functional currency is the U.S. dollar and A conducts 
virtually all of its business in the U.S. dollar. A has no connection to 
Argentina or the Argentine peso and would not have entered into the 
transactions in the ordinary course of A's trade or business. The FX 
Swap was incurred by A as a part of a transaction that A entered into 
with a principal purpose of artificially increasing its business 
interest income. As a result, under paragraph (b)(22)(iv)(B) of this 
section, for purposes of section 163(j), the $10x business interest 
income earned on the Note by A is reduced by $5x (the net $5x paid by A 
on the FX Swap).
    (D) Example 4--(1) Facts. A is wholly owned by FC, a foreign 
corporation organized in foreign country X. A uses the calendar year for 
its annual accounting period. FC has a better credit rating than A. A 
needs to borrow $2,000x in the taxable year ending December 31, 2021, to 
fund its business operations. A also projects that, if it borrows 
$2,000x on January 1, 2021, and pays a market rate of interest, it will 
have business interest expense of $100x in its taxable year ending 
December 31, 2021. In early 2021, A enters into the following 
transactions:
    (i) A enters into a loan obligation in which A borrows $2,000x from 
Bank with an interest rate of 3 percent (Loan 1);
    (ii) FC and Bank enter into a guarantee arrangement (Guarantee) 
under which FC agrees to guarantee Bank that Bank will be timely paid 
all of the amounts due on Loan 1; and
    (iii) A enters into a guarantee fee agreement with FC (Guarantee Fee 
Agreement) under which A agrees to pay FC $40x in return for FC entering 
into the Guarantee, which was not an agreement that A would have entered 
into in the ordinary course of A's trade or business.
    (2) Analysis. A principal purpose of A entering into the 
transactions was to reduce the amount incurred by A that otherwise would 
be interest expense; in effect, A sought to convert a substantial 
portion of its interest expense deductions on Loan 1 into section 162 
deductions on the Guarantee Fee Agreement ($100x interest expense had A 
borrowed without the Guarantee compared to $60x interest expense related 
to Loan 1 and $40x section 162 deduction). A would not have entered into 
the Guarantee Fee Agreement in the ordinary course of A's trade or 
business. The $40x section 162 deductions related to the Guarantee Fee 
Agreement were incurred by A in a series of transactions in which A 
secured the use of funds for a period of time and were substantially 
incurred in consideration of the time value of money. As a result, under 
paragraph (b)(22)(iv)(A)(1) of this section, for purposes of section 
163(j), the $40x paid by A to FC on the Guarantee Fee Agreement is 
treated by A as interest expense.
    (E) Example 5--(1) Facts. A, B, and C are equal partners in ABC 
partnership. ABC is considering acquiring an additional loan from a 
third-party lender to expand its business operations. However, ABC 
already has significant debt and interest expense. For the purpose of 
reducing the amount of additional

[[Page 414]]

interest expense ABC would have otherwise incurred by borrowing, A 
agrees to make an additional contribution to ABC for use in its business 
operations in exchange for a guaranteed payment for the use of capital 
under section 707(c).
    (2) Analysis. The guaranteed payment is deductible by ABC, incurred 
by ABC in a transaction in which ABC secures the use of funds for a 
period of time, substantially incurred in consideration of the time 
value of money, and not described in paragraph (b)(22)(i), (ii), or 
(iii) of this section. As a result, the guaranteed payment to A is 
economically equivalent to the interest that ABC would have incurred on 
an additional loan from a third-party lender. A principal purpose of A 
making a contribution in exchange for a guaranteed payment for the use 
of capital was to reduce the amount incurred by ABC that otherwise would 
be interest expense. As a result, under paragraph (b)(22)(iv)(A)(1) of 
this section, for purposes of section 163(j), such guaranteed payment is 
treated as interest expense of ABC for purposes of section 163(j). In 
addition, under paragraph (b)(22)(iv)(A)(2) of this section, if A knows 
that the guaranteed payment is treated as interest expense of ABC, 
because A provides the use of funds for a period of time in a 
transaction subject to paragraph (b)(22)(iv)(A)(1) of this section, A 
earns income or gain with respect to the transaction, and such income or 
gain is substantially earned in consideration of the time value of money 
provided by A, the guaranteed payment is treated as interest income of A 
for purposes of section 163(j).
    (23) Interest expense. The term interest expense means interest that 
is paid or accrued, or treated as paid or accrued, for the taxable year.
    (24) Interest income. The term interest income means interest that 
is included in gross income for the taxable year.
    (25) Member. The term member has the meaning provided in Sec.  
1.1502-1(b).
    (26) Motor vehicle. The term motor vehicle means a motor vehicle as 
defined in section 163(j)(9)(C).
    (27) Old section 163(j). The term old section 163(j) means section 
163(j) immediately prior to its amendment by Public Law 115-97, 131 
Stat. 2054 (2017).
    (28) Ownership change. The term ownership change has the meaning 
provided in section 382 and the regulations in this part under section 
382 of the Code.
    (29) Ownership date. The term ownership date has the meaning 
provided in section 382 and the regulations in this part under section 
382 of the Code.
    (30) Real estate investment trust. The term real estate investment 
trust (REIT) has the meaning provided in section 856.
    (31) Real property. The term real property includes--
    (i) Real property as defined in Sec.  1.469-9(b)(2); and
    (ii) Any direct or indirect right, including a license or other 
contractual right, to share in the appreciation in value of, or the 
gross or net proceeds or profits generated by, an interest in real 
property, including net proceeds or profits associated with tolls, rents 
or other similar fees.
    (32) Regulated investment company. The term regulated investment 
company (RIC) has the meaning provided in section 851.
    (33) Relevant foreign corporation. The term relevant foreign 
corporation means any foreign corporation whose classification is 
relevant under Sec.  301.7701-3(d)(1) for a taxable year, other than 
solely pursuant to section 881 or 882.
    (34) S corporation. The term S corporation has the meaning provided 
in section 1361(a)(1).
    (35) Section 163(j) interest dividend. The term section 163(j) 
interest dividend means a dividend paid by a RIC for a taxable year for 
which section 852(b) applies to the RIC, to the extent described in 
paragraph (b)(35)(i) or (ii) of this section, as applicable.
    (i) In general. Except as provided in paragraph (b)(35)(ii) of this 
section, a section 163(j) interest dividend is any dividend, or part of 
a dividend, that is reported by the RIC as a section 163(j) interest 
dividend in written statements furnished to its shareholders.
    (ii) Reduction in the case of excess reported amounts. If the 
aggregate reported amount with respect to the RIC for the taxable year 
exceeds the excess section 163(j) interest income of the RIC for such 
taxable year, the section 163(j) interest dividend is--

[[Page 415]]

    (A) The reported section 163(j) interest dividend amount; reduced by
    (B) The excess reported amount that is allocable to that reported 
section 163(j) interest dividend amount.
    (iii) Allocation of excess reported amount--(A) In general. Except 
as provided in paragraph (b)(35)(iii)(B) of this section, the excess 
reported amount, if any, that is allocable to the reported section 
163(j) interest dividend amount is that portion of the excess reported 
amount that bears the same ratio to the excess reported amount as the 
reported section 163(j) interest dividend amount bears to the aggregate 
reported amount.
    (B) Special rule for noncalendar year RICs. In the case of any 
taxable year that does not begin and end in the same calendar year, if 
the post-December reported amount equals or exceeds the excess reported 
amount for that taxable year, paragraph (b)(35)(iii)(A) of this section 
is applied by substituting ``post-December reported amount'' for 
``aggregate reported amount,'' and no excess reported amount is 
allocated to any dividend paid on or before December 31 of such taxable 
year.
    (iv) Definitions. The following definitions apply for purposes of 
this paragraph (b)(35):
    (A) Reported section 163(j) interest dividend amount. The term 
reported section 163(j) interest dividend amount means the amount of a 
dividend distribution reported to the RIC's shareholders under paragraph 
(b)(35)(i) of this section as a section 163(j) interest dividend.
    (B) Excess reported amount. The term excess reported amount means 
the excess of the aggregate reported amount over the RIC's excess 
section 163(j) interest income for the taxable year.
    (C) Aggregate reported amount. The term aggregate reported amount 
means the aggregate amount of dividends reported by the RIC under 
paragraph (b)(35)(i) of this section as section 163(j) interest 
dividends for the taxable year (including section 163(j) interest 
dividends paid after the close of the taxable year described in section 
855).
    (D) Post-December reported amount. The term post-December reported 
amount means the aggregate reported amount determined by taking into 
account only dividends paid after December 31 of the taxable year.
    (E) Excess section 163(j) interest income. The term excess section 
163(j) interest income means, with respect to a taxable year of a RIC, 
the excess of the RIC's business interest income for the taxable year 
over the sum of the RIC's business interest expense for the taxable year 
and the RIC's other deductions for the taxable year that are properly 
allocable to the RIC's business interest income.
    (v) Example--(A) Facts. X is a domestic C corporation that has 
elected to be a RIC. For its taxable year ending December 31, 2021, X 
has $100x of business interest income (all of which is qualified 
interest income for purposes of section 871(k)(1)(E)) and $10x of 
dividend income (all of which is qualified dividend income within the 
meaning of section 1(h)(11) and would be eligible for the dividends 
received deduction under section 243, determined as described in section 
854(b)(3)). X has $10x of business interest expense and $20x of other 
deductions. X has no other items for the taxable year. On December 31, 
2021, X pays a dividend of $80x to its shareholders, and reports, in 
written statements to its shareholders, $71.82x as a section 163(j) 
interest dividend; $10x as dividends that may be treated as qualified 
dividend income or as dividends eligible for the dividends received 
deduction; and $72.73x as interest-related dividends under section 
871(k)(1)(C). Shareholder A, a domestic C corporation, meets the holding 
period requirements in paragraph (b)(22)(iii)(F)(4) of this section with 
respect to the stock of X, and receives a dividend of $8x from X on 
December 31, 2021.
    (B) Analysis. X determines that $18.18x of other deductions are 
properly allocable to X's business interest income. X's excess section 
163(j) interest income under paragraph (b)(35)(iv)(E) of this section is 
$71.82x ($100x business interest income--($10x business interest expense 
+ $18.18x other deductions allocated) = $71.82x). Thus, X may report up 
to $71.82x of its dividends paid on December 31, 2021, as section 163(j) 
interest dividends to its shareholders.

[[Page 416]]

X may also report up to $10x of its dividends paid on December 31, 2021, 
as dividends that may be treated as qualified dividend income or as 
dividends that are eligible for the dividends received deduction. X 
determines that $9.09x of interest expense and $18.18x of other 
deductions are properly allocable to X's qualified interest income. 
Therefore, X may report up to $72.73x of its dividends paid on December 
31, 2021, as interest-related dividends under section 871(k)(1)(C) 
($100x qualified interest income--$27.27x deductions allocated = 
$72.73x). A treats $1x of its $8x dividend as a dividend eligible for 
the dividends received deduction and no part of the dividend as an 
interest-related dividend under section 871(k)(1)(C). Therefore, under 
paragraph (b)(22)(iii)(F)(2) of this section, A may treat $7x of the 
section 163(j) interest dividend as interest income for purposes of 
section 163(j) ($8x dividend--$1x conduit amount = $7x limitation).
    (36) Section 163(j) limitation. The term section 163(j) limitation 
means the limit on the amount of business interest expense that a 
taxpayer may deduct in a taxable year under section 163(j) and Sec.  
1.163(j)-2(b).
    (37) Section 163(j) regulations. The term section 163(j) regulations 
means this section and Sec. Sec.  1.163(j)-2 through 1.163(j)-11.
    (38) Separate return limitation year. The term separate return 
limitation year (SRLY) has the meaning provided in Sec.  1.1502-1(f).
    (39) Separate return year. The term separate return year has the 
meaning provided in Sec.  1.1502-1(e).
    (40) Separate tentative taxable income. The term separate tentative 
taxable income with respect to a taxpayer and a taxable year has the 
meaning provided in Sec.  1.1502-12, but for this purpose computed 
without regard to the application of the section 163(j) limitation and 
with the addition of the adjustments made in paragraph (b)(43)(ii) of 
this section and Sec.  1.163(j)-4(d)(2)(iv).
    (41) Tax-exempt corporation. The term tax-exempt corporation means 
any tax-exempt organization that is organized as a corporation.
    (42) Tax-exempt organization. The term tax-exempt organization means 
any entity subject to tax under section 511.
    (43) Tentative taxable income--(i) In general. The term tentative 
taxable income, with respect to a taxpayer and a taxable year, generally 
is determined in the same manner as taxable income under section 63 but 
for this purpose computed without regard to the application of the 
section 163(j) limitation. Tentative taxable income is computed without 
regard to any disallowed business interest expense carryforwards.
    (ii) [Reserved]
    (iii) Special rules for defining tentative taxable income. (A) For 
special rules defining the tentative taxable income of a RIC or REIT, 
see Sec.  1.163(j)-4(b)(4)(ii).
    (B) For special rules defining the tentative taxable income of 
consolidated groups, see Sec.  1.163(j)-4(d)(2)(iv).
    (C) For special rules defining the tentative taxable income of a 
partnership, see Sec.  1.163(j)-6(d)(1).
    (D) For special rules defining the tentative taxable income of an S 
corporation, see Sec.  1.163(j)-6(l)(3).
    (E) For special rules clarifying that tentative taxable income takes 
sections 461(l), 465, and 469 into account, see Sec.  1.163(j)-3(b)(4).
    (F) For special rules clarifying that tentative taxable income takes 
sections 461(l), 465, and 469 into account, see Sec.  1.163(j)-3(b)(4).
    (G) For special rules clarifying that tentative taxable income takes 
sections 461(l), 465, and 469 into account, see Sec.  1.163(j)-3(b)(4).
    (44) Trade or business--(i) In general. The term trade or business 
means a trade or business within the meaning of section 162.
    (ii) Excepted trade or business. The term excepted trade or business 
means the trade or business of performing services as an employee, an 
electing real property trade or business, an electing farming business, 
or an excepted regulated utility trade or business. For additional rules 
related to excepted trades or businesses, including elections made under 
section 163(j)(7)(B) and (C), see Sec.  1.163(j)-9.
    (iii) Non-excepted trade or business. The term non-excepted trade or 
business means any trade or business that is not an excepted trade or 
business.
    (45) Unadjusted basis. The term unadjusted basis means the basis as 
determined under section 1012 or other

[[Page 417]]

applicable sections of chapter 1 of subtitle A of the Code, including 
subchapters O (relating to gain or loss on dispositions of property), C 
(relating to corporate distributions and adjustments), K (relating to 
partners and partnerships), and P (relating to capital gains and losses) 
of the Code. Unadjusted basis is determined without regard to any 
adjustments described in section 1016(a)(2) or (3), any adjustments for 
tax credits claimed by the taxpayer (for example, under section 50(c)), 
or any adjustments for any portion of the basis that the taxpayer has 
elected to treat as an expense (for example, under section 179, 179B, or 
179C).
    (46) United States shareholder. The term United States shareholder 
has the meaning provided in section 951(b).
    (c) Applicability date--(1) In general. Except as provided in 
paragraphs (c)(2), (3), and (4) of this section, this section applies to 
taxable years beginning on or after November 13, 2020. However, 
taxpayers and their related parties, within the meaning of sections 
267(b) and 707(b)(1), may choose to apply the rules of this section to a 
taxable year beginning after December 31, 2017, and before November 13, 
2020 so long as the taxpayers and their related parties consistently 
apply the rules of the section 163(j) regulations, and, if applicable, 
Sec. Sec.  1.263A-9, 1.263A-15, 1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-
5, 1.382-6, 1.383-0, 1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 
1.1362-3, 1.1368-1, 1.1377-1, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-
79, 1.1502-91 through 1.1502-99 (to the extent they effectuate the rules 
of Sec. Sec.  1.382-2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4, to 
that taxable year. Additionally, taxpayers and their related parties 
within the meaning of sections 267(b) and 707(b)(1), otherwise relying 
on the notice of proposed rulemaking that was published on December 28, 
2018, in the Federal Register (83 FR 67490) in its entirety under Sec.  
1.163(j)-1(c), may alternatively choose to follow Sec.  1.163(j)-
1(b)(1)(iii), rather than proposed Sec.  1.163(j)-1(b)(1)(iii).
    (2) Anti-avoidance rules. The anti-avoidance rules in paragraph 
(b)(22)(iv) of this section apply to transactions entered into on or 
after September 14, 2020.
    (3) Swaps with significant nonperiodic payments--(i) In general. 
Except as provided in paragraph (c)(3)(ii) of this section, the rules 
provided in paragraph (b)(22)(ii) of this section apply to notional 
principal contracts entered into on or after September 14, 2021. 
However, taxpayers may choose to apply the rules provided in paragraph 
(b)(22)(ii) of this section to notional principal contracts entered into 
before September 14, 2021.
    (ii) Anti-avoidance rule. The anti-avoidance rules in paragraph 
(b)(22)(iv) of this section (applied without regard to the references to 
paragraph (b)(22)(ii) of this section) apply to a notional principal 
contract entered into on or after September 14, 2020.
    (4) Paragraphs (b)(1)(iv)(A)(2) through (4), (B) through (G), 
(b)(22)(iii)(F), and (b)(35). Paragraphs (b)(1)(iv)(A)(2) through (4), 
(b)(1)(iv)(B) through (G), (b)(22)(iii)(F), and (b)(35) of this section 
apply to taxable years beginning on or after March 22, 2021. Taxpayers 
and their related parties, within the meaning of sections 267(b) 
(determined without regard to section 267(c)(3)) and 707(b)(1), may 
choose to apply the rules in paragraphs (b)(1)(iv)(A)(2) through (4), 
(b)(1)(iv) (B) through (G), (b)(22)(iii)(F), and (b)(35) of this section 
to a taxable year beginning after December 31, 2017, and before March 
22, 2021, provided that those taxpayers and their related parties 
consistently apply all of the rules in the section 163(j) regulations 
contained in T.D. 9905 (Sec. Sec.  1.163(j)-0 through 1.163(j)-11, 
effective November 13, 2020) as modified by T.D. 9943 (effective January 
13, 2021), and, if applicable, Sec. Sec.  1.263A-9, 1.263A-15, 
1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 
1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 
1.1377-1, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 
1.1502-99 (to the extent they effectuate the rules of Sec. Sec.  1.382-
2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4 contained in T.D. 9905, 
as modified by T.D. 9943, to that taxable year and all subsequent 
taxable years.

[T.D. 9905, 85 FR 56760, Sept. 14, 2020, as amended by T.D. 9943, 86 FR 
5523, Jan. 19, 2021]

[[Page 418]]



Sec.  1.163(j)-2  Deduction for business interest expense limited.

    (a) Overview. This section provides general rules regarding the 
section 163(j) limitation. Paragraph (b) of this section provides rules 
regarding the basic computation of the section 163(j) limitation. 
Paragraph (c) of this section provides rules for disallowed business 
interest expense carryforwards. Paragraph (d) of this section provides 
rules regarding the small business exemption from the section 163(j) 
limitation. Paragraph (e) of this section that is part of provides rules 
regarding real estate mortgage investment conduits (REMICs). Paragraph 
(f) of this section provides rules regarding the calculation of ATI with 
respect to certain beneficiaries. Paragraph (g) of this section provides 
rules regarding tax-exempt organizations. Paragraph (h) of this section 
provides examples illustrating the application of this section. 
Paragraph (i) of this section is reserved. Paragraph (j) of this section 
provides an anti-avoidance rule.
    (b) General rule--(1) In general. Except as otherwise provided in 
this section or in Sec. Sec.  1.163(j)-3 through 1.163(j)-11, the amount 
allowed as a deduction for business interest expense for the taxable 
year cannot exceed the sum of--
    (i) The taxpayer's business interest income for the taxable year;
    (ii) 30 percent of the taxpayer's ATI for the taxable year, or zero 
if the taxpayer's ATI for the taxable year is less than zero; and
    (iii) The taxpayer's floor plan financing interest expense for the 
taxable year.
    (2) 50 percent ATI limitation for taxable years beginning in 2019 or 
2020--(i) In general. Except as otherwise provided in section 163(j)(10) 
and paragraph (b)(2) of this section, for any taxable year beginning in 
2019 or 2020, paragraph (b)(1)(ii) of this section is applied by 
substituting 50 percent for 30 percent. The 50 percent ATI limitation 
does not apply to partnerships for taxable years beginning in 2019. 
Further, for a partnership taxable year beginning in 2020 for which an 
election out of section 163(j)(10)(A)(i) has not been made, Sec.  
1.163(j)-6(f)(2)(xi) is applied by substituting two for ten-thirds when 
grossing up each partner's final ATI capacity excess amount.
    (ii) Election out of the 50 percent ATI limitation. A taxpayer may 
elect to not have paragraph (b)(2)(i) of this section apply for any 
taxable year beginning in 2019 or 2020. In the case of a partnership, 
the election must be made by the partnership and may be made only for 
taxable years beginning in 2020.
    (3) Election to use 2019 ATI in 2020--(i) In general. Subject to 
paragraph (b)(3)(ii), a taxpayer may elect to use the taxpayer's ATI for 
the last taxable year beginning in 2019 (2019 ATI) as the ATI for any 
taxable year beginning in 2020.
    (ii) Short taxable years. If an election is made under paragraph 
(b)(3)(i) of this section for a taxable year beginning in 2020 that is a 
short taxable year, the ATI for such taxable year is equal to the amount 
that bears the same ratio to 2019 ATI as the number of months in the 
short taxable year bears to 12.
    (iii) Transactions to which section 381 applies. For purposes of the 
election described in paragraph (b)(3)(i) of this section, and subject 
to the limitation in paragraph (b)(3)(ii) of this section, the 2019 ATI 
of the acquiring corporation in a transaction to which section 381 
applies equals the amount of the acquiring corporation's ATI for its 
last taxable year beginning in 2019.
    (iv) Consolidated groups. For purposes of the election described in 
paragraph (b)(3)(i) of this section, and subject to the limitation in 
paragraph (b)(3)(ii) of this section, the 2019 ATI of a consolidated 
group equals the amount of the consolidated group's ATI for its last 
taxable year beginning in 2019.
    (4) Time and manner of making or revoking the elections. The rules 
and procedures regarding the time and manner of making, or revoking, an 
election under paragraphs (b)(2) and (3) of this section are provided in 
Revenue Procedure 2020-22, 2020-18 I.R.B. 745, or in other guidance that 
may be issued (see Sec. Sec.  601.601(d) and 601.602 of this chapter).
    (c) Disallowed business interest expense carryforward--(1) In 
general. Any business interest expense disallowed under paragraph (b) of 
this section, or any disallowed disqualified interest that is properly 
allocable to a non-excepted trade or business under Sec.  1.163(j)-10, 
is

[[Page 419]]

carried forward to the succeeding taxable year as a disallowed business 
interest expense carryforward, and is therefore business interest 
expense that is subject to paragraph (b) of this section in such 
succeeding taxable year. Disallowed business interest expense 
carryforwards are not re-allocated between non-excepted and excepted 
trades or businesses in a succeeding taxable year. Instead, the 
carryforwards continue to be treated as allocable to a non-excepted 
trade or business. See Sec.  1.163(j)-10(c)(4).
    (2) Coordination with small business exemption. If disallowed 
business interest expense is carried forward under the rules of 
paragraph (c)(1) of this section to a taxable year in which the small 
business exemption in paragraph (d) of this section applies to the 
taxpayer, then the general rule in paragraph (b) of this section does 
not apply to limit the deduction of the disallowed business interest 
expense carryforward of the taxpayer in that taxable year. See Sec.  
1.163(j)-6(m)(3) for rules applicable to the treatment of excess 
business interest expense from a partnership that is not subject to 
section 163(j) in a succeeding taxable year, and see Sec.  1.163(j)-
6(m)(4) for rules applicable to S corporations with disallowed business 
interest expense carryforwards that are not subject to section 163(j) in 
a succeeding taxable year.
    (3) Cross-references--(i) For special rules regarding disallowed 
business interest expense carryforwards for taxpayers that are C 
corporations, including members of a consolidated group, see Sec.  
1.163(j)-5.
    (ii) For special rules regarding disallowed business interest 
expense carryforwards of S corporations, see Sec. Sec.  1.163(j)-5(b)(2) 
and 1.163(j)-6(l)(5).
    (iii) For special rules regarding disallowed business interest 
expense carryforwards from partnerships, see Sec.  1.163(j)-6.
    (iv)-(v) [Reserved]
    (d) Small business exemption--(1) Exemption. The general rule in 
paragraph (b) of this section does not apply to any taxpayer, other than 
a tax shelter as defined in section 448(d)(3), in any taxable year in 
which the taxpayer meets the gross receipts test of section 448(c) and 
the regulations in this part under section 448 of the Code for the 
taxable year. See Sec.  1.163(j)-9(b) for elections available under 
section 163(j)(7)(B) and 163(j)(7)(C) for real property trades or 
businesses or farming businesses that also may be exempt small 
businesses. See Sec.  1.163(j)-6(m) for rules applicable to partnerships 
and S corporations not subject to section 163(j).
    (2) Application of the gross receipts test--(i) In general. In the 
case of any taxpayer that is not a corporation or a partnership, and 
except as provided in paragraphs (d)(2)(ii), (iii), and (iv) of this 
section, the gross receipts test of section 448(c) and the regulations 
in this part under section 448 of the Code are applied in the same 
manner as if such taxpayer were a corporation or partnership.
    (ii) Gross receipts of individuals. Except as provided in paragraph 
(d)(2)(iii) of this section (regarding partnership and S corporation 
interests), an individual taxpayer's gross receipts include all items 
specified as gross receipts in regulations under section 448(c), whether 
or not derived in the ordinary course of the taxpayer's trade or 
business. For purposes of section 163(j), an individual taxpayer's gross 
receipts do not include inherently personal amounts, including, but not 
limited to, personal injury awards or settlements with respect to an 
injury of the individual taxpayer, disability benefits, Social Security 
benefits received by the taxpayer during the taxable year, and wages 
received as an employee that are reported on Form W-2.
    (iii) Partners and S corporation shareholders. Except when the 
aggregation rules of section 448(c) apply, each partner in a partnership 
includes a share of partnership gross receipts in proportion to such 
partner's distributive share (as determined under section 704) of items 
of gross income that were taken into account by the partnership under 
section 703. Additionally, each shareholder in an S corporation includes 
a pro rata share of S corporation gross receipts.
    (iv) Tax-exempt organizations. For purposes of section 163(j), the 
gross receipts of a tax-exempt organization include only gross receipts 
taken into account in determining its unrelated business taxable income.

[[Page 420]]

    (3) Determining a syndicate's loss amount. For purposes of section 
163(j), losses allocated under section 1256(e)(3)(B) and Sec.  1.448-
1T(b)(3) are determined without regard to section 163(j). See also Sec.  
1.1256(e)-2(b).
    (e) REMICs. For the treatment of interest expense by a REMIC as 
defined in section 860D, see Sec.  1.860C-2(b)(2)(ii).
    (f) Trusts--(i) Calculation of ATI with respect to certain trusts 
and estates. The ATI of a trust or a decedent's estate taxable under 
section 641 is computed without regard to deductions under sections 
642(c), 651, and 661.
    (ii) Calculation of ATI with respect to certain beneficiaries. The 
ATI of a beneficiary (including a tax-exempt beneficiary) of a trust or 
a decedent's estate is reduced by any income (including any 
distributable net income) received from the trust or estate by the 
beneficiary to the extent such income was necessary to permit a 
deduction under section 163(j)(1)(B) and Sec.  1.163(j)-2(b) for any 
business interest expense of the trust or estate that was in excess of 
any business interest income of the trust or estate.
    (g) Tax-exempt organizations. Except as provided in paragraph (d) of 
this section, the section 163(j) limitation applies to tax-exempt 
organizations for purposes of computing their unrelated business taxable 
income under section 512. For rules on determining the gross receipts of 
a tax-exempt organization for purposes of the small business exemption, 
see paragraph (d)(2)(iv) of this section. For special rules applicable 
to tax-exempt beneficiaries of a trust or a decedent's estate, see Sec.  
1.163(j)-2(f). For special rules applicable to tax-exempt corporations, 
see Sec.  1.163(j)-4. For special allocation rules applicable to tax-
exempt organizations, see Sec.  1.163(j)-10(a)(5).
    (h) Examples. The examples in this paragraph (h) illustrate the 
application of section 163(j) and the provisions of this section. Unless 
otherwise indicated, X and Y are domestic C corporations; C and D are 
U.S. resident individuals not subject to any foreign income tax; PRS is 
a domestic partnership with partners who are all individuals; all 
taxpayers use a calendar taxable year; the exemption for certain small 
businesses in section 163(j)(3) and paragraph (d) of this section does 
not apply; and the interest expense would be deductible but for section 
163(j).
    (1) Example 1: Limitation on business interest expense deduction--
(i) Facts. During its taxable year ending December 31, 2021, X has ATI 
of $100x. X has business interest expense of $50x, which includes $10x 
of floor plan financing interest expense, and business interest income 
of $20x.
    (ii) Analysis. For the 2021 taxable year, X's section 163(j) 
limitation is $60x, which is the sum of its business interest income 
($20x), plus 30 percent of its ATI ($100x x 30 percent = $30x), plus its 
floor plan financing interest expense ($10x). See Sec.  1.163(j)-2(b). 
Because X's business interest expense ($50x) does not exceed X's section 
163(j) limitation ($60x), X can deduct all $50x of its business interest 
expense for the 2021 taxable year.
    (2) Example 2: Carryforward of business interest expense--(i) Facts. 
The facts are the same as in Example 1 in paragraph (h)(1)(i) of this 
section, except that X has $80x of business interest expense, which 
includes $10x of floor plan financing interest expense.
    (ii) Analysis. As in Example 1 in paragraph (h)(1)(ii) of this 
section, X's section 163(j) limitation is $60x. Because X's business 
interest expense ($80x) exceeds X's section 163(j) limitation ($60x), X 
may only deduct $60x of its business interest expense for the 2021 
taxable year, and the remaining $20x of its business interest expense 
will be carried forward to the succeeding taxable year as a disallowed 
business interest expense carryforward. See Sec.  1.163(j)-2(c).
    (3) Example 3: ATI computation--(i) Facts. During the 2020 taxable 
year, Y has tentative taxable income of $30x, which is determined 
without regard to the application of the section 163(j) limitation on 
business interest expense. Y's tentative taxable income includes the 
following: $20x of business interest income; $50x of business interest 
expense, which includes $10x of floor plan financing interest expense; 
$25x of net operating loss deduction under section 172; and $15x of 
depreciation under section 167, of which $10x is capitalized to 
inventory under section

[[Page 421]]

263A. Of the $10x capitalized to inventory, only $7x is recovered 
through cost of goods sold during the 2020 taxable year and $3x remains 
in ending inventory at the end of the 2020 taxable year. The $3x of 
ending inventory is recovered through cost of goods sold during the 2021 
taxable year. Y also has a disallowed business interest expense 
carryforward from the prior year of $8x.
    (ii) Analysis. (A) For purposes of determining the section 163(j) 
limitation for 2020, Y's disallowed business interest expense 
carryforward is not taken into account in determining tentative taxable 
income or ATI. Y's ATI is $90x, calculated as follows:

                   Table 1 to Paragraph (h)(3)(ii)(A)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
    Tentative taxable income.................................       $30x
Less:
    Floor plan financing interest............................        10x
    Business interest income.................................        20x
                                                              ----------
                                                                      0x
------------------------------------------------------------------------

    (B) Plus:

                   Table 2 to Paragraph (h)(3)(ii)(B)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Business interest expense                                           $50x
Net operating loss deduction                                         25x
Depreciation                                                         15x
                                                              ----------
ATI                                                                  90x
------------------------------------------------------------------------

    (C) For Y's 2021 taxable year, the $3x of ending inventory that is 
recovered through cost of goods sold in 2021 is not added back to 
tentative taxable income (TTI) in determining ATI because it was already 
included as an addback in ATI in Y's 2020 taxable year. See Sec.  
1.163(j)-1(b)(1)(iii).
    (4) Example 4: Floor plan financing interest expense--(i) Facts. C 
is the sole proprietor of an automobile dealership that uses a cash 
method of accounting. In the 2021 taxable year, C paid $30x of interest 
on a loan that was obtained to purchase sedans for sale by the 
dealership. The indebtedness is secured by the sedans purchased with the 
loan proceeds. In addition, C paid $20x of interest on a loan, secured 
by the dealership's office equipment, which C obtained to purchase 
convertibles for sale by the dealership.
    (ii) Analysis. For the purpose of calculating C's section 163(j) 
limitation, only the $30x of interest paid on the loan to purchase the 
sedans is floor plan financing interest expense. The $20x paid on the 
loan to purchase the convertibles is not floor plan financing interest 
expense for purposes of section 163(j) because the indebtedness was not 
secured by the inventory of convertibles. However, because under Sec.  
1.163(j)-10 the interest paid on the loan to purchase the convertibles 
is properly allocable to C's dealership trade or business, and because 
floor plan financing interest expense is also business interest expense, 
C has $50x of business interest expense for the 2021 taxable year.
    (5) Example 5: Interest not properly allocable to non-excepted trade 
or business--(i) Facts. The facts are the same as in Example 4 in 
paragraph (h)(4)(i) of this section, except that the $20x of interest C 
pays is on acquisition indebtedness obtained to purchase C's personal 
residence and not to purchase convertibles for C's dealership trade or 
business.
    (ii) Analysis. Because the $20x of interest expense is not properly 
allocable to a non-excepted trade or business, and therefore is not 
business interest expense, C's only business interest expense is the 
$30x that C pays on the loan used to purchase sedans for sale in C's 
dealership trade or business. C deducts the $20x of interest related to 
his residence under the rules of section 163(h), without regard to 
section 163(j).
    (6) Example 6: Small business exemption--(i) Facts. During the 2021 
taxable year, D, the sole proprietor of a trade or business reported on 
Schedule C, has interest expense properly allocable to that trade or 
business. D does not conduct an electing real property trade or business 
or an electing farming business. D also earns gross income from 
providing services as an employee that is reported on a Form W-2. Under 
section 448(c) and the regulations in this part under section 448, D has 
average annual gross receipts of $21 million, including $1 million of 
wages in each of the three prior taxable years and $2 million of income 
from investments

[[Page 422]]

not related to a trade or business in each of the three prior taxable 
years. Also, in each of the three prior taxable years, D received $5 
million in periodic payments of compensatory damages awarded in a 
personal injury lawsuit.
    (ii) Analysis. Section 163(j) does not apply to D for the taxable 
year, because D qualifies for the small business exemption under Sec.  
1.163(j)-2(d). The wages that D receives as an employee and the 
compensatory damages that D received from D's personal injury lawsuit 
are not gross receipts, as provided in Sec.  1.163(j)-2(d)(2)(ii). D may 
deduct all of its business interest expense for the 2021 taxable year 
without regard to section 163(j).
    (7) Example 7: Partnership with excess business interest expense 
qualifies for the small business exemption in a succeeding taxable 
year--(i) Facts. X and Y are equal partners in partnership PRS. In 
addition to being partners in PRS, X and Y each operate their own sole 
proprietorships. For the taxable year ending December 31, 2021, PRS is 
subject to section 163(j) and has excess business interest expense of 
$10x. For the taxable year ending December 31, 2022, PRS has $40x of 
business interest expense, and X and Y have $20x of business interest 
expense from their respective sole proprietorships. For the taxable year 
ending December 31, 2022, PRS and Y qualify for the small business 
exemption under Sec.  1.163(j)-2(d), while X is subject to section 
163(j) and has a section 163(j) limitation of $22x.
    (ii) Partnership-level analysis. For the 2021 taxable year, PRS 
allocates the $10x of excess business interest expense equally to X and 
Y ($5x each). See Sec.  1.163(j)-6(f)(2). For the 2022 taxable year, 
section 163(j) does not apply to PRS because PRS qualifies for the small 
business exemption. As a result, none of PRS's $40x of business interest 
expense for the 2022 taxable year is subject to the section 163(j) 
limitation at the partnership level.
    (iii) Partner-level analysis. For the 2022 taxable year, each 
partner treats its $5x of excess business interest expense from PRS as 
paid or accrued in that year. See Sec.  1.163(j)-6(m)(3). This amount 
becomes business interest expense that each partner must subject to its 
own section 163(j) limitation, if any. With this $5x, each partner has 
$25x of business interest expense for the 2022 taxable year ($20x from 
its sole proprietorship, plus $5x of excess business interest expense 
treated as paid or accrued in the 2020 taxable year). X deducts $22x of 
its business interest expense pursuant to its section 163(j) limitation 
and carries forward the remainder ($3x) as a disallowed business 
interest expense carryforward to the taxable year ending December 31, 
2023. Y is not subject to section 163(j) because Y qualifies for the 
small business exemption. Y therefore deducts all $25x of its business 
interest expense for the 2022 taxable year.
    (8) Example 8: Aggregation of gross receipts--(i) Facts. X and Y are 
domestic C corporations under common control, within the meaning of 
section 52(a) and Sec.  1.52-1(b). X's only trade or business is a 
farming business described in Sec.  1.263A-4(a)(4). During the taxable 
year ending December 31, 2020, X has average annual gross receipts under 
section 448(c) of $6 million. During the same taxable year, Y has 
average annual gross receipts under section 448(c) of $21 million.
    (ii) Analysis. Because X and Y are under common control, they must 
aggregate gross receipts for purposes of section 448(c) and the small 
business exemption in Sec.  1.163(j)-2(d). See section 448(c)(2). 
Therefore, X and Y are both considered to have $27 million in average 
annual gross receipts for 2020. X and Y must separately apply section 
163(j) to determine any limitation on the deduction for business 
interest expense. Assuming X otherwise meets the requirements in Sec.  
1.163(j)-9 in 2020, X may elect for its farming business to be an 
excepted trade or business.
    (i) [Reserved]
    (j) Anti-avoidance rule--(1) In general. Arrangements entered into 
with a principal purpose of avoiding the rules of section 163(j) or the 
section 163(j) regulations, including the use of multiple entities to 
avoid the gross receipts test of section 448(c), may be disregarded or 
recharacterized by the Commissioner of the IRS to the extent necessary 
to carry out the purposes of section 163(j).
    (2) Examples. The examples in this paragraph (j)(2) illustrate the 
application of this section.

[[Page 423]]

    (i) Example 1--(A) Facts. Individual A operates an excepted trade or 
business (Business X) and a non-excepted trade or business (Business Y). 
With a principal purpose of avoiding the rules of section 163(j) or the 
regulations in this part under section 163(j) of the Code, A contributes 
Business X to newly-formed C corporation B in exchange for stock; A then 
causes B to borrow funds from a third party and distributes a portion of 
the borrowed funds to A for use in Business Y. B takes the position that 
its interest payments on the debt are not subject to the section 163(j) 
limitation because B is engaged solely in an excepted trade or business.
    (B) Analysis. A has entered into an arrangement with a principal 
purpose of avoiding the rules of section 163(j) or the regulations in 
this part under section 163(j). Thus, under paragraph (j)(1) of this 
section, the Commissioner of the IRS may disregard or recharacterize 
this transaction to the extent necessary to carry out the purposes of 
section 163(j). In this case, payments of interest on the debt may be 
recharacterized as payments of interest properly allocable to a non-
excepted trade or business subject to the section 163(j) limitation.
    (ii) Example 2--(A) Facts. Partnership UTP has two non-excepted 
trades or businesses. Business A has gross income of $1000x and gross 
deductions of $200x. Business B has gross income of $100x and gross 
deductions of $600x. With a principal purpose of avoiding the rules in 
section 163(j) or the regulations in this part under section 163(j), UTP 
and a partner of UTP form partnership LTP and UTP contributes Business B 
to LTP prior to borrowing funds. UTP takes the position that it does not 
take its share of LTP gross deductions into account when computing its 
ATI.
    (B) Analysis. UTP has entered into an arrangement with a principal 
purpose of avoiding the rules of section 163(j) or the regulations in 
this part under section 163(j). Thus, under paragraph (j)(1) of this 
section, the Commissioner of the IRS may disregard or recharacterize 
this transaction to the extent necessary to carry out the purposes of 
section 163(j). In this case, UTP's share of gross deductions from LTP 
may be recharacterized as gross deductions incurred directly by UTP 
solely for purposes of computing UTP's ATI.
    (k) Applicability dates. (1) In general. This section applies to 
taxable years beginning on or after November 13, 2020. However, 
taxpayers and their related parties, within the meaning of sections 
267(b) and 707(b)(1), may choose to apply the rules of this section to a 
taxable year beginning after December 31, 2017, so long as the taxpayers 
and their related parties consistently apply the rules of the section 
163(j) regulations, and, if applicable, Sec. Sec.  1.263A-9, 1.263A-15, 
1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 
1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 
1.1377-1, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 
1.1502-99 (to the extent they effectuate the rules of Sec. Sec.  1.382-
2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4, to that taxable year.
    (2) Paragraphs (b)(3)(iii), (b)(3)(iv), and (d)(3). Paragraphs 
(b)(3)(iii) and (iv) and (d)(3) of this section apply to taxable years 
beginning on or after March 22, 2021. However, taxpayers and their 
related parties, within the meaning of sections 267(b) (determined 
without regard to section 267(c)(3)) and 707(b)(1), may choose to apply 
the rules in paragraphs (b)(3)(iii), (b)(3)(iv), and (d)(3) of this 
section to a taxable year beginning after December 31, 2017, and before 
March 22, 2021, provided that those taxpayers and their related parties 
consistently apply all of the rules in paragraphs (b)(3)(iii) and (iv) 
of this section and the rules in the section 163(j) regulations 
contained in T.D. 9905 (Sec. Sec.  1.163(j)-0 through 1.163(j)-11, 
effective November 13, 2020) as modified by T.D. 9943 (effective January 
13, 2021), and, if applicable, Sec. Sec.  1.263A-9, 1.263A-15, 
1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 
1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 
1.1377-1, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 
1.1502-99 (to the extent they effectuate the rules of Sec. Sec.  1.382-
2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4 contained in T.D. 9905 
as modified by T.D. 9943, for that taxable

[[Page 424]]

year and for each subsequent taxable year.

[T.D. 9905, 85 FR 56760, Sept. 14, 2020, as amended by T.D. 9943, 86 FR 
5529, Jan. 19, 2021]



Sec.  1.163(j)-3  Relationship of the section 163(j) limitation 
to other provisions affecting interest.

    (a) Overview. This section contains rules regarding the relationship 
between section 163(j) and certain other provisions of the Code. 
Paragraph (b) of this section provides the general rules concerning the 
relationship between section 163(j) and certain other provisions of the 
Code. Paragraph (c) of this section provides examples illustrating the 
application of this section. For rules regarding the relationship 
between sections 163(j) and 704(d), see Sec.  1.163(j)-6(h)(1) and (2).
    (b) Coordination of section 163(j) with certain other provisions--
(1) In general. Section 163(j) and the regulations in this part under 
section 163(j) of the Code generally apply only to business interest 
expense that would be deductible in the current taxable year without 
regard to section 163(j). Thus, for example, a taxpayer must apply Sec.  
1.163-8T, if applicable, to determine which items of interest expense 
are investment interest under section 163(d) before applying the rules 
in this section to interest expense. Except as otherwise provided in 
this section, section 163(j) applies after the application of provisions 
that subject interest expense to disallowance, deferral, capitalization, 
or other limitation. For the rules that must be applied in determining 
whether excess business interest is paid or accrued by a partner, see 
section 163(j)(4)(B)(ii) and Sec.  1.163(j)-6.
    (2) Disallowed interest provisions. For purposes of section 163(j), 
business interest expense does not include interest expense that is 
permanently disallowed as a deduction under another provision of the 
Code, such as in section 163(e)(5)(A)(i), (f), (l), or (m), or section 
264(a), 265, 267A, or 279.
    (3) Deferred interest provisions. Other than sections 461(l), 465, 
and 469, Code provisions that defer the deductibility of interest 
expense, such as section 163(e)(3) and (e)(5)(A)(ii), 267(a)(2) and (3), 
1277, or 1282, apply before the application of section 163(j).
    (4) At risk rules, passive activity loss provisions, and limitation 
on excess business losses of noncorporate taxpayers. Section 163(j) 
generally applies to limit the deduction for business interest expense 
before the application of sections 461(l), 465, and 469. However, in 
determining tentative taxable income for purposes of computing ATI, 
sections 461(l), 465, and 469 are taken into account.
    (5) Capitalized interest expenses. Section 163(j) applies after the 
application of provisions that require the capitalization of interest, 
such as sections 263A and 263(g). Capitalized interest expense under 
those sections is not treated as business interest expense for purposes 
of section 163(j). For ordering rules that determine whether interest 
expense is capitalized under section 263A(f), see the regulations under 
section 263A(f), including Sec.  1.263A-9(g).
    (6) Reductions under section 246A. Section 246A applies before 
section 163(j). Any reduction in the dividends received deduction under 
section 246A reduces the amount of interest expense taken into account 
under section 163(j).
    (7) Section 381. Disallowed business interest expense carryforwards 
are items to which an acquiring corporation succeeds under section 
381(a). See section 381(c)(20) and Sec. Sec.  1.163(j)-5(c) and 
1.381(c)(20)-1.
    (8) Section 382. For rules governing the interaction of sections 
163(j) and 382, see section 382(d)(3) and (k)(1), Sec. Sec.  1.163(j)-
5(e) and 1.163(j)-11(c), the regulations in this part under sections 382 
and 383 of the Code, and Sec. Sec.  1.1502-91 through 1.1502-99.
    (c) Examples. The examples in this paragraph (c) illustrate the 
application of section 163(j) and the provisions of this section. Unless 
otherwise indicated, X and Y are calendar-year domestic C corporations; 
D is a U.S. resident individual not subject to any foreign income tax; 
none of the taxpayers have floor plan financing interest expense; and 
the exemption for certain small businesses in Sec.  1.163(j)-2(d) does 
not apply.
    (1) Example 1: Disallowed interest expense--(i) Facts. In 2021, X 
has $30x of

[[Page 425]]

interest expense. Of X's interest expense, $10x is permanently 
disallowed under section 265. X's business interest income is $3x and 
X's ATI is $90x.
    (ii) Analysis. Under paragraph (b)(2) of this section, the $10x 
interest expense that is permanently disallowed under section 265 cannot 
be taken into consideration for purposes of section 163(j) in the 2021 
taxable year. X's section 163(j) limitation, or the amount of business 
interest expense that X may deduct is limited to $30x under Sec.  
1.163(j)-2(b), determined by adding X's business interest income ($3x) 
and 30 percent of X's 2019 ATI ($27x). Therefore, in the 2021 taxable 
year, none of the $20x of X's deduction for its business interest 
expense is disallowed under section 163(j).
    (2) Example 2: Deferred interest expense--(i) Facts. In 2021, Y has 
no business interest income, $120x of ATI, and $70x of interest expense. 
Of Y's interest expense, $30x is not currently deductible under section 
267(a)(2). The $30x expense is allowed as a deduction under section 
267(a)(2) in 2022.
    (ii) Analysis. Under paragraph (b)(3) of this section, section 
267(a)(2) is applied before section 163(j). Accordingly, $30x of Y's 
interest expense cannot be taken into consideration for purposes of 
section 163(j) in 2021 because it is not currently deductible under 
section 267(a)(2). Accordingly, in 2021, if the interest expense is 
properly allocable to a non-excepted trade or business, Y will have $4x 
of disallowed business interest expense because the $40x of business 
interest expense in 2021 ($70x-$30x) exceeds 30 percent of its ATI for 
the taxable year ($36x). The $30x of interest expense not allowed as a 
deduction in the 2021 taxable year under section 267(a)(2) will be taken 
into account in determining the business interest expense deduction 
under section 163(j) in 2022, the taxable year in which it is allowed as 
a deduction under section 267(a)(2), if it is allocable to a trade or 
business. Additionally, the $4x of disallowed business interest expense 
in 2021 will be carried forward to 2022 as a disallowed business 
interest expense carryforward. See Sec.  1.163(j)-2(c).
    (3) Example 3: Passive activity loss--(i) Facts. D is engaged in a 
rental activity treated as a passive activity within the meaning of 
section 469. For the 2021 taxable year, D receives $200x of rental 
income and incurs $300x of expenses all properly allocable to the rental 
activity, consisting of $150x of interest expense, $60x of maintenance 
expenses, and $90x of depreciation expense. D's ATI is $400x.
    (ii) Analysis. Under paragraph (b)(4) of this section, section 
163(j) is applied before the section 469 passive loss rules apply, 
except that section 469 is taken into account in the determination of 
tentative taxable income for purposes of computing ATI. D's section 
163(j) limitation is $120x, determined by adding to D's business 
interest income ($0), floor plan financing ($0), and 30 percent of D's 
ATI ($120x). See Sec.  1.163(j)-2(b). Because D's business interest 
expense of $150x exceeds D's section 163(j) limitation for 2021, $30x of 
D's business interest expense is disallowed under section 163(j) and 
will be carried forward as a disallowed business interest expense 
carryforward. See Sec.  1.163(j)-2(c). Because the section 163(j) 
limitation is applied before the limitation under section 469, only 
$120x of the business interest expense allowable under section 163(j) is 
included in determining D's passive activity loss limitation for the 
2021 tax year under section 469. The $30x of disallowed business 
interest expense is not an allowable deduction under section 163(j) and, 
therefore, is not a deduction under section 469 in the current taxable 
year. See Sec.  1.469-2(d)(8).
    (4) Example 4: Passive activity loss by taxpayer that also 
participates in a non-passive activity--(i) Facts. For 2021, D has no 
business interest income and ATI of $1,000x, entirely attributable to a 
passive activity within the meaning of section 469. D has business 
interest expense of $1,000x, $900x of which is properly allocable to a 
passive activity and $100x of which is properly allocable to a non-
passive activity in which D materially participates. D has other 
business deductions that are not subject to section 469 of $600x, and a 
section 469 passive loss from the previous year of $250x.
    (ii) Analysis. Under paragraph (b)(4) of this section, section 
163(j) is applied before the section 469 passive loss rules

[[Page 426]]

apply. D's section 163(j) limitation is $300x, determined by adding D's 
business interest income ($0), floor plan financing ($0), and 30 percent 
of D's ATI ($300x)). Next, applying the limitation under section 469 to 
the $300x business interest expense deduction allowable under section 
163(a) and (j), $270x (a proportionate amount of the $300x (0.90 x 
$300x)) is business interest expense included in determining D's passive 
activity loss limitation under section 469, and $30x (a proportionate 
amount of the $300x (0.10 x $300)) is business interest expense not 
included in determining D's passive activity loss limitation under 
section 469. Because D's interest expense of $1,000x exceeds 30 percent 
of its ATI for 2021, $700x of D's interest expense is disallowed under 
section 163(j) and will be carried forward as a disallowed business 
interest expense carryforward. Section 469 does not apply to any portion 
of the $700x disallowed business interest expense because that business 
interest expense is not an allowable deduction under section 163(j) and, 
therefore, is not an allowable deduction under section 469 in the 
current taxable year. See Sec.  1.469-2(d)(8).
    (5) Example 5: ATI calculation with passive activity loss--(i) 
Facts. D is an individual who engages in a trade or business, V, as a 
sole proprietorship. D relies on employees to perform most of the work 
and, as a result, D does not materially participate in V. Therefore, V 
is a passive activity of D. V is not an excepted trade or business. In 
Year 1, V generates $500x of passive income, $400x of business interest 
expense, and $600x of ordinary and necessary expenses deductible under 
section 162 (not including any interest described in Sec.  1.163(j)-
1(b)(22)). No disallowed business interest expense carryforward has been 
carried to Year 1 from a prior year, and no amounts have been carried 
over to Year 1 from a prior year under either section 465(a)(2) or 
section 469(b).
    (ii) Tentative taxable income. Under Sec.  1.163(j)-1(b)(43), 
tentative taxable income is determined as though all business interest 
expense was not subject to the section 163(j) limitation. Sections 
461(l), 465, and 469 apply in the determination of tentative taxable 
income. For year 1, D has $500x of allowable deductions and a $500x 
tentative passive activity loss under section 469, because D's $1000x of 
passive expenses exceeds D's $500x of passive income from V. The 
tentative disallowance of $500x is generally allocated pro rata between 
D's passive expenses under Sec.  1.469-1T(f)(2)(ii)(A). In this case, 
fifty percent ($500x of passive activity loss divided by $1000x of total 
passive expenses) of each category of passive expense is tentatively 
disallowed: $200x of business interest expense and $300x of section 162 
expense. D's tentative taxable income is $0 (zero), which is determined 
by reducing $500x of gross income by the remaining $200x of business 
interest expense and $300x of section 162 expense ($500x-$200x-$300x).
    (iii) ATI. Under section Sec.  1.163(j)-1(b)(1), to determine ATI, D 
must add business interest expense to tentative taxable income, but only 
to the extent that the business interest expense reduced tentative 
taxable income, or $200x. The $200x of business interest expense that 
was tentatively disallowed under section 469 is not added to tentative 
taxable income to determine ATI. D's ATI is $200x, which is determined 
by adding the $200x of business interest expense that reduced tentative 
taxable income to D's tentative taxable income, or $0 (0 + $200x).
    (iv) Section 163(j) limitation. D's section 163(j) limitation in 
Year 1 is D's business interest income, or $0, plus 30 percent of ATI, 
or $60x (30 percent x $200x ATI), plus D's floor plan financing, or $0, 
for a total of $60x ($0 + $60x + $0). Before the application of section 
469, D has $60x of deductible business interest expense and $340x of 
disallowed business interest expense carryforward under Sec.  1.163(j)-
2(c).
    (v) Passive activity loss. Because D's passive deductions exceed the 
passive income from V, and D does not have any passive income from other 
sources, section 469 applies to limit D's passive loss from V. Having 
first applied section 163(j), D has $660x of passive expenses, 
determined by adding D's $60x of business interest expense that is 
allowed by section 163(j) as a deduction and $600x of section 162 
expense ($60x + $600x). D offsets $500x of the passive expenses against 
$500x of passive income; therefore, D has a passive activity loss

[[Page 427]]

of $160x in Year 1, determined as the excess of D's total passive 
expenses over D's passive income ($660x-$500x). The amount of D's loss 
from the passive activity that is disallowed under section 469 ($160x) 
is generally ratably allocated to each of D's passive activity 
deductions under Sec.  1.469-1T(f)(2)(ii)(A). As a general rule, each 
deduction is multiplied by the ratio of the total passive loss to total 
passive expenses (160x/660x). Of D's $60x business interest expense, 
$14.55x (($160x/$660x) x $60x) is disallowed in Year 1. Additionally, of 
D's $600x section 162 expense, $145.45x (($160x/$660x) x $600x) is 
disallowed. The amounts disallowed under section 469(a)(1) and Sec.  
1.469-2T(f)(2) are carried over to the succeeding taxable year under 
section 469(b) and Sec.  1.469-1(f)(4).
    (6) Example 6: Effect of passive activity loss carryforwards--(i) 
Facts. The facts are the same as in Example 5 in paragraph (c)(5)(i) of 
this section. In Year 2, V generates $500x of passive income, $100x of 
business interest expense, and $0 (zero) of other deductible expenses. D 
is not engaged in any other trade or business activities. A disallowed 
business interest expense carryforward of $340x has been carried to Year 
2 from Year 1. Under section 469, D has a suspended loss from Year 1 
that includes $14.55x of business interest expense and $145.45x of 
section 162 expense. These amounts are treated as passive activity 
deductions in Year 2.
    (ii) Tentative taxable income. To determine D's tentative taxable 
income, D must first determine D's allowable deductions. In year 2, D 
has $260x of allowable deductions, which includes $100x of business 
interest expense generated Year 2, $14.55x of business interest expense 
disallowed in Year 1 by section 469, and $145.45x of section 162 expense 
disallowed in Year 1 by section 469 ($100x + $14.55x + $145.45x)). D's 
disallowed business interest expense carryforward from Year 1 is not 
taken into account in determining tentative taxable income. See Sec.  
1.163(j)-1(b)(43). Additionally, the $14.55x of business interest 
expense disallowed in Year 1 by section 469 is not business interest 
expense in Year 2 because it was deductible after the application of 
section 163(j) (but before the application of section 469) in Year 1. D 
does not have a tentative passive activity loss in Year 2, because D's 
$500x of passive income from V exceeds D's $260x of tentative passive 
expenses. Therefore, D's tentative taxable income in Year 2 is $240x, 
which is determined by subtracting D's allowable deductions other than 
disallowed business interest expense carryforwards, or $260x, from D's 
gross income, or $500x ($500x-$260x).
    (iii) ATI. D's ATI in Year 2 is $340x, which is determined by adding 
D's business interest expense, or $100x, to D's tentative taxable 
income, or $240x ($240x + $100x). Because disallowed business interest 
expense carryforwards are not taken into account in determining 
tentative taxable income, there is no corresponding adjustment for 
disallowed business interest expense carryforwards in calculating ATI. 
Therefore, there is no adjustment for D's $340x of disallowed business 
interest expense carryforward in calculating D's ATI. D has no other 
adjustments to determine ATI.
    (iv) Section 163(j) limitation. D's section 163(j) limitation in 
Year 2 is $102x, which is determined by adding D's business interest 
income, or $0, 30 percent of D's ATI for year 2, $102 ($340x x 30 
percent), and D's floor plan financing for Year 2, or $0 ($0 + ($102x) + 
$0). Accordingly, before the application of section 469 in Year 2, $102x 
of D's $440x of total business interest expense (determined by adding 
$340x of disallowed business interest expense carryforward from Year 1 
and $100x of business interest expense in Year 2) is deductible. D has 
$338x of disallowed business interest expense carryforward that will 
carry forward to subsequent taxable years under Sec.  1.163(j)-2(c), 
determined by subtracting D's deductible business interest expense in 
Year 2, or $102x, from D's total business interest expense in Year 2, or 
$440x ($440x-$102x).
    (v) Section 469. After applying the section 163(j) limitation, D 
applies section 469 to determine if any amount of D's expense is a 
disallowed passive activity loss. For Year 2, D has $262x of passive 
expenses, determined by adding D's business interest expense deduction 
allowed by section 163(j) ($102x), D's section 162 expense carried 
forward from Year 1 under section 469 ($145.45x), and

[[Page 428]]

D's interest expense carried forward from Year 1 under section 469 which 
is not business interest expense in Year 2, or $14.55x ($102x + $145.45x 
+ $14.55x). Therefore, D has $238x of net passive income in Year 2, 
determined by reducing D's total passive income in Year 2 ($500x), by 
D's disallowed passive activity loss, or $262x ($500x-$262x). D does not 
have a passive activity loss in Year 2, and no part of D's $262x of 
passive expenses is disallowed in Year 2 under section 469.
    (7) Example 7: Capitalized interest expense--(i) Facts. In 2020, X 
has $50x of interest expense. Of X's interest expense, $10x is required 
to be capitalized under section 263A. X capitalizes this interest 
expense to a depreciable asset. X's business interest income is $9x and 
X's ATI is $80x. X makes the election in Sec.  1.163(j)-2(b)(2)(ii) to 
use 30 percent, rather than 50 percent, of ATI in determining X's 
section 163(j) limitation for the 2020 taxable year.
    (ii) Analysis. Under paragraph (b)(5) of this section, section 263A 
is applied before section 163(j). Accordingly, $10x of X's interest 
expense cannot be taken into consideration for purposes of section 
163(j) in 2020. Additionally, under paragraph (b)(5) of this section, 
X's $10 of capitalized interest expense is not business interest expense 
for purposes of section 163(j). As a result, when X recovers its 
capitalized interest expense through depreciation deductions, such 
capitalized interest expense will not be taken into account as business 
interest expense in determining X's section 163(j) limitation. X's 
section 163(j) limitation in 2020, or the amount of business interest 
expense that X may deduct, is limited to $33x under Sec.  1.163(j)-2(b), 
determined by adding X's business interest income ($9x) and 30 percent 
of X's 2020 ATI ($24x). X therefore has $7x of disallowed business 
interest expense in 2020 that will be carried forward to 2021 as a 
disallowed business interest expense carryforward.
    (d) Applicability date. This section applies to taxable years 
beginning on or after November 13, 2020. However, taxpayers and their 
related parties, within the meaning of sections 267(b) and 707(b)(1), 
may choose to apply the rules of this section to a taxable year 
beginning after December 31, 2017, so long as the taxpayers and their 
related parties consistently apply the rules of the section 163(j) 
regulations, and, if applicable, Sec. Sec.  1.263A-9, 1.263A-15, 
1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 
1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 
1.1377-1, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 
1.1502-99 (to the extent they effectuate the rules of Sec. Sec.  1.382-
2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4, to that taxable year.

[T.D. 9905, 85 FR 56760, Sept. 14, 2020]



Sec.  1.163(j)-4  General rules applicable to C corporations 
(including REITs, RICs, and members of consolidated groups) 
and tax-exempt corporations.

    (a) Scope. This section provides rules regarding the computation of 
items of income and expense under section 163(j) for taxpayers that are 
C corporations, including, for example, members of a consolidated group, 
REITs, RICs, tax-exempt corporations, and cooperatives. Paragraph (b) of 
this section provides rules regarding the characterization of items of 
income, gain, deduction, or loss. Paragraph (c) of this section provides 
rules regarding adjustments to earnings and profits. Paragraph (d) of 
this section provides rules applicable to members of a consolidated 
group. Paragraph (e) of this section provides rules governing the 
ownership of partnership interests by members of a consolidated group. 
Paragraph (f) of this section provides cross-references to other rules 
within the 163(j) regulations that may be applicable to C corporations.
    (b) Characterization of items of income, gain, deduction, or loss--
(1) Interest expense and interest income. Solely for purposes of section 
163(j), all interest expense of a taxpayer that is a C corporation is 
treated as properly allocable to a trade or business. Similarly, solely 
for purposes of section 163(j), all interest income of a taxpayer that 
is a C corporation is treated as properly allocable to a trade or 
business. For rules governing the allocation of interest expense and 
interest income between excepted and non-excepted trades or businesses, 
see Sec.  1.163(j)-10.
    (2) Adjusted taxable income. Solely for purposes of section 163(j), 
all items of

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income, gain, deduction, or loss of a taxpayer that is a C corporation 
are treated as properly allocable to a trade or business. For rules 
governing the allocation of tax items between excepted and non-excepted 
trades or businesses, see Sec.  1.163(j)-10.
    (3) Investment interest, investment income, investment expenses, and 
certain other tax items of a partnership with a C corporation partner--
(i) Characterization as expense or income properly allocable to a trade 
or business. For purposes of section 163(j), any investment interest, 
investment income, or investment expense (within the meaning of section 
163(d)) that a partnership pays, receives, or accrues and that is 
allocated to a C corporation partner as a separately stated item is 
treated by the C corporation partner as properly allocable to a trade or 
business of that partner. Similarly, for purposes of section 163(j), any 
other tax items of a partnership that are neither properly allocable to 
a trade or business of the partnership nor described in section 163(d) 
and that are allocated to a C corporation partner as separately stated 
items are treated as properly allocable to a trade or business of that 
partner.
    (ii) Effect of characterization on partnership. The characterization 
of a partner's tax items pursuant to paragraph (b)(3)(i) of this section 
does not affect the characterization of these items at the partnership 
level.
    (iii) Separately stated interest expense and interest income of a 
partnership not treated as excess business interest expense or excess 
taxable income of a C corporation partner. Investment interest expense 
and other interest expense of a partnership that is treated as business 
interest expense by a C corporation partner under paragraph (b)(3)(i) of 
this section is not treated as excess business interest expense of the 
partnership. Investment interest income and other interest income of a 
partnership that is treated as business interest income by a C 
corporation partner under paragraph (b)(3)(i) of this section is not 
treated as excess taxable income of the partnership. For rules governing 
excess business interest expense and excess taxable income, see Sec.  
1.163(j)-6.
    (iv) Treatment of deemed inclusions of a domestic partnership that 
are not allocable to any trade or business. If a United States 
shareholder that is a domestic partnership includes amounts in gross 
income under sections 951(a) or 951A(a) that are not properly allocable 
to a trade or business of the domestic partnership, then, 
notwithstanding paragraph (b)(3)(i) of this section, to the extent a C 
corporation partner, including an indirect partner in the case of tiered 
partnerships, takes such amounts into account as a distributive share in 
accordance with section 702 and Sec.  1.702-1(a)(8)(ii), the C 
corporation partner may not treat such amounts as properly allocable to 
a trade or business of the C corporation partner.
    (4) Application to RICs and REITs--(i) In general. Except as 
otherwise provided in paragraphs (b)(4)(ii) and (iii) of this section, 
the rules in this paragraph (b) apply to RICs and REITs.
    (ii) Tentative taxable income of RICs and REITs. The tentative 
taxable income of a RIC or REIT for purposes of calculating ATI is the 
tentative taxable income of the corporation, without any adjustment that 
would be made under section 852(b)(2) or 857(b)(2) to compute investment 
company taxable income or real estate investment trust taxable income, 
respectively. For example, the tentative taxable income of a RIC or REIT 
is not reduced by the deduction for dividends paid, but is reduced by 
the dividends received deduction (DRD) and the other deductions 
described in sections 852(b)(2)(C) and 857(b)(2)(A). See paragraph 
(b)(4)(iii) of this section for an adjustment to ATI in respect of these 
items.
    (iii) Other adjustments to adjusted taxable income for RICs and 
REITs. In the case of a taxpayer that, for a taxable year, is a RIC to 
which section 852(b) applies or a REIT to which section 857(b) applies, 
the taxpayer's ATI for the taxable year is increased by the amounts of 
any deductions described in section 852(b)(2)(C) or 857(b)(2)(A).
    (5) Application to tax-exempt corporations. The rules in this 
paragraph (b) apply to a tax-exempt corporation only with respect to 
that corporation's items of income, gain, deduction, or loss that are 
taken into account in computing the corporation's unrelated business 
taxable income, as defined in section 512.

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    (6) Adjusted taxable income of cooperatives. Solely for purposes of 
computing the ATI of a cooperative under Sec.  1.163(j)-1(b)(1), 
tentative taxable income is not reduced by the amount of any patronage 
dividend under section 1382(b)(1) or by any amount paid in redemption of 
nonqualified written notices of allocation distributed as patronage 
dividends under section 1382(b)(2) (for cooperatives subject to taxation 
under sections 1381 through 1388), any amount described in section 
1382(c) (for cooperatives described in section 1381(a)(1) and section 
521), or any equivalent amount deducted by an organization that operates 
on a cooperative basis but is not subject to taxation under sections 
1381 through 1388.
    (7) Examples. The principles of this paragraph (b) are illustrated 
by the following examples. For purposes of the examples in this 
paragraph (b)(7) of this section, T is a taxable domestic C corporation 
whose taxable year ends on December 31; T is neither a consolidated 
group member nor a RIC or a REIT; neither T nor PS1, a domestic 
partnership, owns at least 80 percent of the stock of any corporation; 
neither T nor PS1 qualifies for the small business exemption in Sec.  
1.163(j)-2(d) or is engaged in an excepted trade or business; T has no 
floor plan financing expense; all interest expense is deductible except 
for the potential application of section 163(j); and the facts set forth 
the only corporate or partnership activity.
    (i) Example 1: C corporation items properly allocable to a trade or 
business--(A) Facts. In taxable year 2021, T's tentative taxable income 
(without regard to the application of section 163(j)) is $320x. This 
amount is comprised of the following tax items: $1,000x of revenue from 
inventory sales; $500x of ordinary and necessary business expenses 
(excluding interest and depreciation); $200x of interest expense; $50x 
of interest income; $50x of depreciation deductions under section 168; 
and a $20x gain on the sale of stock.
    (B) Analysis. For purposes of section 163(j), each of T's tax items 
is treated as properly allocable to a trade or business. Thus, T's ATI 
for the 2021 taxable year is $520x ($320x of tentative taxable income + 
$200x business interest expense-$50x business interest income + $50x 
depreciation deductions = $520x), and its section 163(j) limitation for 
the 2021 taxable year is $206x ($50x of business interest income + 30 
percent of its ATI (30 percent x $520x) = $206x). As a result, all $200x 
of T's interest expense is deductible in the 2021 taxable year under 
section 163(j).
    (C) Taxable year beginning in 2022. The facts are the same as in 
Example 1 in paragraph (b)(7)(i)(A) of this section, except that the 
taxable year begins in 2022 and therefore depreciation deductions are 
not added back to ATI under Sec.  1.163(j)-1(b)(1)(i)(E). As a result, 
T's ATI for 2022 is $470x ($320x of tentative taxable income + $200x 
business interest expense-$50x business interest income = $470x), and 
its section 163(j) limitation for the 2022 taxable year is $191x ($50x 
of business interest income + 30 percent of its ATI (30 percent x $470x) 
= $191x). As a result, T may only deduct $191x of its business interest 
expense for the taxable year, and the remaining $9x is carried forward 
to the 2023 taxable year as a disallowed business interest expense 
carryforward. See Sec.  1.163(j)-2(c).
    (ii) Example 2: C corporation partner--(A) Facts. T and individual A 
each own a 50 percent interest in PS1, a general partnership. PS1 
borrows funds from a third party (Loan 1) and uses those funds to buy 
stock in publicly-traded corporation X. PS1's only activities are 
holding X stock (and receiving dividends) and making payments on Loan 1. 
In the 2021 taxable year, PS1 receives $150x in dividends and pays $100x 
in interest on Loan 1.
    (B) Analysis. For purposes of section 163(d) and (j), PS1 has 
investment interest expense of $100x and investment income of $150x, and 
PS1 has no interest expense or interest income that is properly 
allocable to a trade or business. PS1 allocates its investment interest 
expense and investment income equally to its two partners pursuant to 
Sec.  1.163(j)-6(k). Pursuant to paragraph (b)(3) of this section, T's 
allocable share of PS1's investment interest expense is treated as a 
business interest expense of T, and T's allocable share of PS1's 
investment income is treated as

[[Page 431]]

properly allocable to a trade or business of T. This business interest 
expense is not treated as excess business interest expense, and this 
income is not treated as excess taxable income. See paragraph 
(b)(3)(iii) of this section. T's treatment of its allocable share of 
PS1's investment interest expense and investment income as business 
interest expense and income properly allocable to a trade or business, 
respectively, does not affect the character of these items at the PS1 
level and does not affect the character of A's allocable share of PS1's 
investment interest and investment income.
    (C) Partnership engaged in a trade or business. The facts are the 
same as in Example 2 in paragraph (b)(7)(ii)(A) of this section, except 
that PS1 also is engaged in Business 1, and PS1 borrows funds from a 
third party to finance Business 1 (Loan 2). In 2021, Business 1 earns 
$150x of net income (excluding interest expense and depreciation), and 
PS1 pays $100x of interest on Loan 2. For purposes of section 163(d) and 
(j), PS1 treats the interest paid on Loan 2 as properly allocable to a 
trade or business. As a result, PS1 has investment interest expense of 
$100x (attributable to Loan 1), business interest expense of $100x 
(attributable to Loan 2), $150x of investment income, and $150x of 
income from Business 1. PS1's ATI is $150x (its net income from Business 
1 excluding interest and depreciation), and its section 163(j) 
limitation is $45x (30 percent x $150x). Pursuant to Sec.  1.163(j)-6, 
PS1 has $55x of excess business interest expense ($100x-$45x), half of 
which ($27.5x) is allocable to T. Additionally, pursuant to paragraph 
(b)(3)(i) of this section, T's allocable share of PS1's investment 
interest expense ($50x) is treated as a business interest expense of T 
for purposes of section 163(j), and T's allocable share of PS1's 
investment income ($75x) is treated as properly allocable to a trade or 
business of T. Therefore, with respect to T's interest in PS1, T is 
treated as having $50x of business interest expense that is not treated 
as excess business interest expense, $75x of income that is properly 
allocable to a trade or business, and $27.5x of excess business interest 
expense.
    (c) Effect on earnings and profits--(1) In general. In the case of a 
taxpayer that is a domestic C corporation, except as otherwise provided 
in paragraph (c)(2) of this section, the disallowance and carryforward 
under Sec.  1.163(j)-2 (and Sec.  1.163(j)-5, in the case of a taxpayer 
that is a consolidated group member) of a deduction for business 
interest expense of the taxpayer or of a partnership in which the 
taxpayer is a partner does not affect whether or when the business 
interest expense reduces the taxpayer's earnings and profits. In the 
case of a foreign corporation, the disallowance and carryforward of a 
deduction for the corporation's business interest expense under Sec.  
1.163(j)-2 does not affect whether and when such business interest 
expense reduces the corporation's earnings and profits. Thus, for 
example, if a United States person has elected under section 1295 to 
treat a passive foreign investment company (as defined in section 1297) 
(PFIC) as a qualified electing fund, then the disallowance and 
carryforward of a deduction for the PFIC's business interest expense 
under Sec.  1.163(j)-2 does not affect whether or when such business 
interest expense reduces the PFIC's earnings and profits.
    (2) Special rule for RICs and REITs. In the case of a taxpayer that 
is a RIC or a REIT for the taxable year in which a deduction for the 
taxpayer's business interest expense is disallowed under Sec.  1.163(j)-
2(b), or in which the RIC or REIT is allocated any excess business 
interest expense from a partnership under section 163(j)(4)(B)(i) and 
Sec.  1.163(j)-6, the taxpayer's earnings and profits are adjusted in 
the taxable year or years in which the business interest expense is 
deductible or, if earlier, in the first taxable year for which the 
taxpayer no longer is a RIC or a REIT.
    (3) Special rule for partners that are C corporations. If a taxpayer 
that is a C corporation is allocated any excess business interest 
expense from a partnership, and if all or a portion of the excess 
business interest expense has not yet been treated as business interest 
expense by the taxpayer at the time of the taxpayer's disposition of all 
or a portion of its interest in the partnership, the taxpayer must 
increase its earnings and profits immediately prior

[[Page 432]]

to the disposition by an amount equal to the amount of the basis 
adjustment required under section 163(j)(4)(B)(iii)(II) and Sec.  
1.163(j)-6(h)(3).
    (4) Examples. The principles of this paragraph (c) are illustrated 
by the following examples. For purposes of the examples in this 
paragraph (c)(4), except as otherwise provided in the examples, X is a 
taxable domestic C corporation whose taxable year ends on December 31; X 
is not a member of a consolidated group; X does not qualify for the 
small business exemption under Sec.  1.163(j)-2(d); X is not engaged in 
an excepted trade or business; X has no floor plan financing 
indebtedness; all interest expense is deductible except for the 
potential application of section 163(j); X has no accumulated earnings 
and profits at the beginning of the 2021 taxable year; and the facts set 
forth the only corporate activity.
    (i) Example 1: Earnings and profits of a taxable domestic C 
corporation other than a RIC or a REIT--(A) Facts. X is a corporation 
that does not intend to qualify as a RIC or a REIT for its 2021 taxable 
year. In that year, X has tentative taxable income (without regard to 
the application of section 163(j)) of $0, which includes $100x of gross 
income and $100x of interest expense on a loan from an unrelated third 
party. X also makes a $100x distribution to its shareholders that year.
    (B) Analysis. The $100x of interest expense is business interest 
expense for purposes of section 163(j) (see paragraph (b)(1) of this 
section). X's ATI in the 2021 taxable year is $100x ($0 of tentative 
taxable income computed without regard to $100x of business interest 
expense). Thus, X may deduct $30x of its $100x of business interest 
expense in the 2021 taxable year under Sec.  1.163(j)-2(b) (30 percent x 
$100x), and X may carry forward the remainder ($70x) to X's 2022 taxable 
year as a disallowed business interest expense carryforward under Sec.  
1.163(j)-2(c). Although X may not currently deduct all $100x of its 
business interest expense in the 2021 taxable year, X must reduce its 
earnings and profits in that taxable year by the full amount of its 
business interest expense ($100x) in that taxable year. As a result, no 
portion of X's distribution of $100x to its shareholders in the 2021 
taxable year is a dividend within the meaning of section 316(a).
    (ii) Example 2: RIC adjusted taxable income and earnings and 
profits--(A) Facts. X is a corporation that intends to qualify as a RIC 
for its 2021 taxable year. In that taxable year, X's only items are 
$100x of interest income, $50x of dividend income from C corporations 
that only issue common stock and in which X has less than a twenty 
percent interest (by vote and value), $10x of net capital gain, and 
$125x of interest expense. None of the dividends are received on debt 
financed portfolio stock under section 246A. The DRD determined under 
section 243(a) with respect to X's $50x of dividend income is $25x. X 
pays $42x in dividends to its shareholders, meeting the requirements of 
section 562 during X's 2021 taxable year, including $10x that X reports 
as capital gain dividends in written statements furnished to X's 
shareholders.
    (B) Analysis. (1) Under paragraph (b) of this section, all of X's 
interest expense is considered business interest expense, all of X's 
interest income is considered business interest income, and all of X's 
other income is considered to be properly allocable to a trade or 
business. Under paragraph (b)(4)(ii) of this section, prior to the 
application of section 163(j), X's tentative taxable income is $10x 
($100x business interest income + $50x dividend income + $10x net 
capital gain-$125x business interest expense-$25x DRD = $10x). Under 
paragraph (b)(4)(iii) of this section, X's ATI is increased by the DRD. 
As such, X's ATI for the 2021 taxable year is $60x ($10x tentative 
taxable income + $125x business interest expense-$100x business interest 
income + $25x DRD = $60x).
    (2) X may deduct $118x of its $125x of business interest expense in 
the 2021 taxable year under section 163(j)(1) ($100x business interest 
income + (30 percent x $60x of ATI) = $118x), and X may carry forward 
the remainder ($7x) to X's 2022 taxable year. See Sec.  1.163(j)-2(b) 
and (c).
    (3) After the application of section 163(j), X has taxable income of 
$17x ($100x interest income + $50x dividend income + $10x capital gain-
$25x DRD-$118x allowable interest expense = $17x) for the 2021 taxable 
year. X will

[[Page 433]]

have investment company taxable income (ICTI) in the amount of $0 ($17x 
taxable income-$10x capital gain + $25x DRD-$32x dividends paid 
deduction for ordinary dividends = $0). The excess of X's net capital 
gain ($10x) over X's dividends paid deduction determined with reference 
to capital gain dividends ($10x) is also $0.
    (4) Under paragraph (c)(2) of this section, X will not reduce its 
earnings and profits by the amount of interest expense disallowed as a 
deduction in the 2021 taxable year under section 163(j). Thus, X has 
current earnings and profits in the amount of $42x ($100x interest 
income + $50x dividend income + $10x capital gain-$118x allowable 
business interest expense = $42x) before giving effect to dividends paid 
during the 2021 taxable year.
    (iii) Example 3: Carryforward of disallowed interest expense--(A) 
Facts. The facts are the same as the facts in Example 2 in paragraph 
(c)(4)(ii)(A) of this section for the 2021 taxable year. In addition, X 
has $50x of interest income and $20x of interest expense for the 2022 
taxable year.
    (B) Analysis. Under paragraph (b) of this section, all of X's 
interest expense is considered business interest expense, all of X's 
interest income is considered business interest income, and all of X's 
other income is considered to be properly allocable to a trade or 
business. Because X's $50x of business interest income exceeds the $20x 
of business interest expense from the 2022 taxable year and the $7x of 
disallowed business interest expense carryforward from the 2021 taxable 
year, X may deduct $27x of business interest expense in the 2022 taxable 
year. Under paragraph (c)(2) of this section, X must reduce its current 
earnings and profits for the 2022 taxable year by the full amount of the 
deductible business interest expense ($27x).
    (iv) Example 4: REIT adjusted taxable income and earnings and 
profits--(A) Facts. X is a corporation that intends to qualify as a REIT 
for its 2021 taxable year. X is not engaged in an excepted trade or 
business and is not engaged in a trade or business that is eligible to 
make any election under section 163(j)(7). In that year, X's only items 
are $100x of mortgage interest income, $30x of dividend income from C 
corporations that only issue common stock and in which X has less than a 
ten percent interest (by vote and value), $10x of net capital gain from 
the sale of mortgages on real property that is not property described in 
section 1221(a)(1), and $125x of interest expense. None of the dividends 
are received on debt financed portfolio stock under section 246A. The 
DRD determined under section 243(a) with respect to X's $30x of dividend 
income is $15x. X pays $28x in dividends meeting the requirements of 
section 562 during X's 2021 taxable year, including $10x that X properly 
designates as capital gain dividends under section 857(b)(3)(B).
    (B) Analysis. (1) Under paragraph (b) of this section, all of X's 
interest expense is considered business interest expense, all of X's 
interest income is considered business interest income, and all of X's 
other income is considered to be properly allocable to a trade or 
business. Under paragraph (b)(4)(ii) of this section, prior to the 
application of section 163(j), X's tentative taxable income is $0 ($100x 
business interest income + $30x dividend income + $10x net capital gain-
$125x business interest expense-$15x DRD = $0). Under paragraph 
(b)(4)(iii) of this section, X's ATI is increased by the DRD. As such, 
X's ATI for the 2021 taxable year is $40x ($0 tentative taxable income + 
$125x business interest expense-$100x business interest income + $15x 
DRD = $40x).
    (2) X may deduct $112x of its $125x of business interest expense in 
the 2021 taxable year under section 163(j)(1) ($100x business interest 
income + (30 percent x $40x of ATI) = $112x), and X may carry forward 
the remainder of its business interest expense ($13x) to X's 2022 
taxable year.
    (3) After the application of section 163(j), X has taxable income of 
$13x ($100x business interest income + $30x dividend income + $10x 
capital gain-$15x DRD-$112x allowable business interest expense = $13x) 
for the 2021 taxable year. X will have real estate investment trust 
taxable income (REITTI) in the amount of $0 ($13x taxable income + $15x 
of DRD-$28x dividends paid deduction = $0).
    (4) Under paragraph (c)(2) of this section, X will not reduce 
earnings and

[[Page 434]]

profits by the amount of business interest expense disallowed as a 
deduction in the 2021 taxable year. Thus, X has current earnings and 
profits in the amount of $28x ($100x business interest income + $30x 
dividend income + $10x capital gain-$112x allowable business interest 
expense = $28x) before giving effect to dividends paid during X's 2021 
taxable year.
    (v) Example 5: Carryforward of disallowed interest expense--(A) 
Facts. The facts are the same as in Example 4 in paragraph (c)(4)(iv)(A) 
of this section for the 2021 taxable year. In addition, X has $50x of 
mortgage interest income and $20x of interest expense for the 2022 
taxable year. X has no other tax items for the 2022 taxable year.
    (B) Analysis. Because X's $50x of business interest income exceeds 
the $20x of business interest expense from the 2022 taxable year and the 
$13x of disallowed business interest expense carryforwards from the 2021 
taxable year, X may deduct $33x of business interest expense in 2022. 
Under paragraph (c)(2) of this section, X must reduce its current 
earnings and profits for 2022 by the full amount of the deductible 
interest expense ($33x).
    (d) Special rules for consolidated groups--(1) Scope. This paragraph 
(d) provides rules applicable to members of a consolidated group. For 
all members of a consolidated group for a consolidated return year, the 
computations required by section 163(j) and the regulations in this part 
under section 163(j) are made in accordance with the rules of this 
paragraph (d) unless otherwise provided elsewhere in the section 163(j) 
regulations. For rules governing the ownership of partnership interests 
by members of a consolidated group, see paragraph (e) of this section.
    (2) Calculation of the section 163(j) limitation for members of a 
consolidated group--(i) In general. A consolidated group has a single 
section 163(j) limitation, the absorption of which is governed by Sec.  
1.163(j)-5(b)(3)(ii).
    (ii) Interest. For purposes of determining whether amounts, other 
than amounts in respect of intercompany obligations (as defined in Sec.  
1.1502-13(g)(2)(ii)), intercompany items (as defined in Sec.  1.1502-
13(b)(2)), or corresponding items (as defined in Sec.  1.1502-13(b)(3)), 
are treated as interest within the meaning of Sec.  1.163(j)-1(b)(22), 
all members of a consolidated group are treated as a single taxpayer.
    (iii) Calculation of business interest expense and business interest 
income for a consolidated group. For purposes of calculating the section 
163(j) limitation for a consolidated group, the consolidated group's 
current-year business interest expense and business interest income, 
respectively, are the sum of each member's current-year business 
interest expense and business interest income, including amounts treated 
as business interest expense and business interest income under 
paragraph (b)(3) of this section.
    (iv) Calculation of adjusted taxable income. For purposes of 
calculating the ATI for a consolidated group, the tentative taxable 
income is the consolidated group's consolidated taxable income, 
determined under Sec.  1.1502-11 but without regard to any carryforwards 
or disallowances under section 163(j). Further, for purposes of 
calculating the ATI of the group, intercompany items and corresponding 
items are disregarded to the extent that they offset in amount. Thus, 
for example, certain portions of the intercompany items and 
corresponding items of a group member engaged in a non-excepted trade or 
business will not be included in ATI to the extent that the 
counterparties to the relevant intercompany transactions are engaged in 
one or more excepted trades or businesses.
    (v) Treatment of intercompany obligations--(A) In general. Except as 
otherwise provided in paragraph (d)(2)(v)(B) of this section, for 
purposes of determining a member's business interest expense and 
business interest income, and for purposes of calculating the 
consolidated group's ATI, all intercompany obligations, as defined in 
Sec.  1.1502-13(g)(2)(ii), are disregarded. Therefore, except as 
otherwise provided in paragraph (d)(2)(v)(B) of this section, interest 
expense and interest income from intercompany obligations are not 
treated as business interest expense and business interest income.
    (B) Repurchase premium. This paragraph (d)(2)(v)(B) applies if a 
member of a consolidated group purchases an obligation of another member 
of the

[[Page 435]]

same consolidated group in a transaction to which Sec.  1.1502-13(g)(5) 
applies. Notwithstanding the general rule of paragraph (d)(2)(v)(A) of 
this section, if, as a result of the deemed satisfaction of the 
obligation under Sec.  1.1502-13(g)(5)(ii), the debtor member has 
repurchase premium that is deductible under Sec.  1.163-7(c), such 
repurchase premium is treated as interest that is subject to the section 
163(j) limitation. See Sec.  1.163(j)-1(b)(22)(i)(H).
    (3) Investment adjustments. For rules governing investment 
adjustments within a consolidated group, see Sec.  1.1502-32(b).
    (4) Examples. The principles in this paragraph (d) are illustrated 
by the following examples. For purposes of the examples in this 
paragraph (d)(4), S is a member of the calendar-year consolidated group 
of which P is the common parent; the P group does not qualify for the 
small business exemption in Sec.  1.163(j)-2(d); no member of the P 
group is engaged in an excepted trade or business; all interest expense 
is deductible except for the potential application of section 163(j); 
and the facts set forth the only corporate activity.
    (i) Example 1: Calculation of the section 163(j) limitation--(A) 
Facts. In the 2021 taxable year, P has $50x of separate tentative 
taxable income after taking into account $65x of interest paid on a loan 
from a third party (without regard to any disallowance under section 
163(j)) and $35x of depreciation deductions under section 168. In turn, 
S has $40x of separate tentative taxable income in the 2021 taxable year 
after taking into account $10x of depreciation deductions under section 
168. S has no interest expense in the 2021 taxable year. The P group's 
tentative taxable income the 2021 taxable year is $90x, determined under 
Sec.  1.1502-11 without regard to any disallowance under section 163(j).
    (B) Analysis. As provided in paragraph (b)(1) of this section, P's 
interest expense is treated as business interest expense for purposes of 
section 163(j). If P and S were to apply the section 163(j) limitation 
on a separate-entity basis, then P's ATI would be $150x ($50x + $65x + 
$35x = $150x), its section 163(j) limitation would be $45x (30 percent x 
$150x = $45x), and a deduction for $20x of its $65x of business interest 
expense would be disallowed in the 2021 taxable year under section 
163(j). However, as provided in paragraph (d)(2) of this section, the P 
group computes a single section 163(j) limitation, and that computation 
begins with the P group's tentative taxable income (as determined prior 
to the application of section 163(j)), or $90x. The P group's ATI is 
$200x ($50x + $40x + $65x + $35x + $10x = $200x). Thus, the P group's 
section 163(j) limitation for the 2021 taxable year is $60x (30 percent 
x $200x = $60x). As a result, all but $5x of the P group's business 
interest expense is deductible in the 2021 taxable year. P carries over 
the $5x of disallowed business interest expense to the succeeding 
taxable year.
    (ii) Example 2: Intercompany obligations--(A) Facts. On January 1, 
2021, G, a corporation unrelated to P and S, lends P $100x in exchange 
for a note that accrues interest at a 10 percent annual rate. A month 
later, P lends $100x to S in exchange for a note that accrues interest 
at a 12 percent annual rate. In 2021, P accrues and pays $10x of 
interest to G on P's note, and S accrues and pays $12x of interest to P 
on S's note. For that year, the P group's only other items of income, 
gain, deduction, and loss are $40x of income earned by S from the sale 
of inventory, and a $30x deductible expense arising from P's payment of 
tort liability claims.
    (B) Analysis. As provided in paragraph (d)(2)(v) of this section, 
the intercompany obligation between P and S is disregarded in 
determining P and S's business interest expense and business interest 
income and in determining the P group's ATI. For purposes of section 
163(j), P has $10x of business interest expense and a $30x deduction for 
the payment of tort liability claims, and S has $40x of income. The P 
group's ATI is $10x ($40x-$30x = $10x), and its section 163(j) 
limitation is $3x (30 percent x $10x = $3x). The P group may deduct $3x 
of its business interest expense in the 2021 taxable year. A deduction 
for P's remaining $7x of business interest expense is disallowed in the 
2021 taxable year, and this amount is carried forward to the 2022 
taxable year.
    (e) Ownership of partnership interests by members of a consolidated 
group.

[[Page 436]]

    (1) [Reserved]
    (2) Change in status of a member. A change in status of a member 
(that is, becoming or ceasing to be a member of the group) is not 
treated as a disposition for purposes of section 163(j)(4)(B)(iii)(II) 
and Sec.  1.163(j)-6(h)(3).
    (3) Basis adjustments under Sec.  1.1502-32. A member's allocation 
of excess business interest expense from a partnership and the resulting 
decrease in basis in the partnership interest under section 
163(j)(4)(B)(iii)(I) is not a noncapital, nondeductible expense for 
purposes of Sec.  1.1502-32(b)(3)(iii). Additionally, an increase in a 
member's basis in a partnership interest under section 
163(j)(4)(B)(iii)(II) to reflect excess business interest expense not 
deducted by the consolidated group is not tax-exempt income for purposes 
of Sec.  1.1502-32(b)(3)(ii). Investment adjustments are made under 
Sec.  1.1502-32(b)(3)(i) when the excess business interest expense from 
the partnership is converted into business interest expense, deducted, 
and absorbed by the consolidated group. See Sec.  1.1502-32(b).
    (4) Excess business interest expense and Sec.  1.1502-36. Excess 
business interest expense is a Category D asset within the meaning of 
Sec.  1.1502-36(d)(4)(i).
    (f) Cross-references. For rules governing the treatment of 
disallowed business interest expense carryforwards for C corporations, 
including rules governing the treatment of disallowed business interest 
expense carryforwards when members enter or leave a consolidated group, 
see Sec.  1.163(j)-5. For rules governing the application of section 
163(j) to a C corporation or a consolidated group engaged in both 
excepted and non-excepted trades or businesses, see Sec.  1.163(j)-10.
    (g) Applicability date--(1) In general. This section applies to 
taxable years beginning on or after November 13, 2020. However, 
taxpayers and their related parties, within the meaning of sections 
267(b) and 707(b)(1), may choose to apply the rules of this section to a 
taxable year beginning after December 31, 2017, so long as the taxpayers 
and their related parties consistently apply the rules of the section 
163(j) regulations, and, if applicable, Sec. Sec.  1.263A-9, 1.263A-15, 
1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 
1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 
1.1377-1, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 
1.1502-99 (to the extent they effectuate the rules of Sec. Sec.  1.382-
2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4, to that taxable year.
    (2) [Reserved]

[T.D. 9905, 85 FR 56760, Sept. 14, 2020]



Sec.  1.163(j)-5  General rules governing disallowed business 
interest expense carryforwards for C corporations.

    (a) Scope and definitions--(1) Scope. This section provides rules 
regarding disallowed business interest expense carryforwards for 
taxpayers that are C corporations, including members of a consolidated 
group. Paragraph (b) of this section provides rules regarding the 
treatment of disallowed business interest expense carryforwards. 
Paragraph (c) of this section provides a cross-reference to other rules 
regarding disallowed business interest expense carryforwards in 
transactions to which section 381(a) applies. Paragraph (d) of this 
section provides rules regarding limitations on disallowed business 
interest expense carryforwards from separate return limitation years 
(SRLYs). Paragraph (e) of this section provides cross-references to 
other rules regarding the application of section 382 to disallowed 
business interest expense carryforwards. Paragraph (f) of this section 
provides a cross-reference to other rules regarding the overlap of the 
SRLY limitation with section 382. Paragraph (g) of this section 
references additional rules that may limit the deductibility of interest 
or the use of disallowed business interest expense carryforwards.
    (2) Definitions--(i) Allocable share of the consolidated group's 
remaining section 163(j) limitation. The term allocable share of the 
consolidated group's remaining section 163(j) limitation means, with 
respect to any member of a consolidated group, the product of the 
consolidated group's remaining section 163(j) limitation and the 
member's remaining current-year interest ratio.

[[Page 437]]

    (ii) Consolidated group's remaining section 163(j) limitation. The 
term consolidated group's remaining section 163(j) limitation means the 
amount of the consolidated group's section 163(j) limitation calculated 
pursuant to Sec.  1.163(j)-4(d)(2), reduced by the amount of interest 
deducted by members of the consolidated group pursuant to paragraph 
(b)(3)(ii)(C)(2) of this section.
    (iii) Remaining current-year interest ratio. The term remaining 
current-year interest ratio means, with respect to any member of a 
consolidated group for a particular taxable year, the ratio of the 
remaining current-year business interest expense of the member after 
applying the rule in paragraph (b)(3)(ii)(C)(2) of this section, to the 
sum of the amounts of remaining current-year business interest expense 
for all members of the consolidated group after applying the rule in 
paragraph (b)(3)(ii)(C)(2) of this section.
    (b) Treatment of disallowed business interest expense 
carryforwards--(1) In general. The amount of any business interest 
expense of a C corporation not allowed as a deduction for any taxable 
year as a result of the section 163(j) limitation is carried forward to 
the succeeding taxable year as a disallowed business interest expense 
carryforward under section 163(j)(2) and Sec.  1.163(j)-2(c).
    (2) Deduction of business interest expense. For a taxpayer that is a 
C corporation, current-year business interest expense is deducted in the 
current taxable year before any disallowed business interest expense 
carryforwards from a prior taxable year are deducted in that year. 
Disallowed business interest expense carryforwards are deducted in the 
order of the taxable years in which they arose, beginning with the 
earliest taxable year, subject to certain limitations (for example, the 
limitation under section 382). For purposes of section 163(j), 
disallowed disqualified interest is treated as carried forward from the 
taxable year in which a deduction was disallowed under old section 
163(j).
    (3) Consolidated groups--(i) In general. A consolidated group's 
disallowed business interest expense carryforwards for the current 
consolidated return year (the current year) are the carryforwards from 
the group's prior consolidated return years plus any carryforwards from 
separate return years.
    (ii) Deduction of business interest expense--(A) General rule. All 
current-year business interest expense of members of a consolidated 
group is deducted in the current year before any disallowed business 
interest expense carryforwards from prior taxable years are deducted in 
the current year. Disallowed business interest expense carryforwards 
from prior taxable years are deducted in the order of the taxable years 
in which they arose, beginning with the earliest taxable year, subject 
to the limitations described in this section.
    (B) Section 163(j) limitation equals or exceeds the current-year 
business interest expense and disallowed business interest expense 
carryforwards from prior taxable years. If a consolidated group's 
section 163(j) limitation for the current year equals or exceeds the 
aggregate amount of its members' current-year business interest expense 
and disallowed business interest expense carryforwards from prior 
taxable years that are available for deduction, then none of the 
current-year business interest expense or disallowed business interest 
expense carryforwards is subject to disallowance in the current year 
under section 163(j). However, a deduction for the members' business 
interest expense may be subject to limitation under other provisions of 
the Code or the Income Tax Regulations (see, for example, paragraphs 
(c), (d), (e), and (f) of this section).
    (C) Current-year business interest expense and disallowed business 
interest expense carryforwards exceed section 163(j) limitation. If the 
aggregate amount of members' current-year business interest expense and 
disallowed business interest expense carryforwards from prior taxable 
years exceeds the consolidated group's section 163(j) limitation for the 
current year, then the following rules apply in the order provided:
    (1) The group first determines whether its section 163(j) limitation 
for the current year equals or exceeds the aggregate amount of the 
members' current-year business interest expense.

[[Page 438]]

    (i) If the group's section 163(j) limitation for the current year 
equals or exceeds the aggregate amount of the members' current-year 
business interest expense, then no amount of the group's current-year 
business interest expense is subject to disallowance in the current year 
under section 163(j). Once the group has taken into account its members' 
current-year business interest expense, the group applies the rules of 
paragraph (b)(3)(ii)(C)(4) of this section.
    (ii) If the aggregate amount of members' current-year business 
interest expense exceeds the group's section 163(j) limitation for the 
current year, then the group applies the rule in paragraph 
(b)(3)(ii)(C)(2) of this section.
    (2) If this paragraph (b)(3)(ii)(C)(2) applies (see paragraph 
(b)(3)(ii)(C)(1)(ii) of this section), then each member with current-
year business interest expense and with current-year business interest 
income or floor plan financing interest expense deducts current-year 
business interest expense in an amount that does not exceed the sum of 
the member's business interest income and floor plan financing interest 
expense for the current year.
    (3) After applying the rule in paragraph (b)(3)(ii)(C)(2) of this 
section, if the group has any section 163(j) limitation remaining for 
the current year, then each member with remaining current-year business 
interest expense deducts a portion of its expense based on its allocable 
share of the consolidated group's remaining section 163(j) limitation.
    (4) If this paragraph (b)(3)(ii)(C)(4) applies (see paragraph 
(b)(3)(ii)(C)(1)(i) of this section), and if the group has any section 
163(j) limitation remaining for the current year after applying the 
rules in paragraph (b)(3)(ii)(C)(1) of this section, then disallowed 
business interest expense carryforwards permitted to be deducted 
(including under paragraph (d)(1)(A) of this section) in the current 
year are to be deducted in the order of the taxable years in which they 
arose, beginning with the earliest taxable year. Disallowed business 
interest expense carryforwards from taxable years ending on the same 
date that are available to offset tentative taxable income for the 
current year generally are to be deducted on a pro rata basis under the 
principles of paragraph (b)(3)(ii)(C)(3) of this section. For example, 
assume that P and S are the only members of a consolidated group with a 
section 163(j) limitation for the current year (Year 2) of $200x; the 
amount of current-year business interest expense deducted in Year 2 is 
$100x; and P and S, respectively, have $140x and $60x of disallowed 
business interest expense carryforwards from Year 1 that are not subject 
to limitation under paragraph (c), (d), or (e) of this section. Under 
these facts, P would be allowed to deduct $70x of its carryforwards from 
Year 1 ($100x x ($140x/($60x + $140x)) = $70x), and S would be allowed 
to deduct $30x of its carryforwards from Year 1 ($100x x ($60x/($60x + 
$140x)) = $30x). But see Sec.  1.383-1(d)(1)(ii), providing that, if 
losses subject to and not subject to the section 382 limitation are 
carried from the same taxable year, losses subject to the limitation are 
deducted before losses not subject to the limitation.
    (5) Each member with remaining business interest expense after 
applying the rules of this paragraph (b)(3)(ii), taking into account the 
limitations in paragraphs (c), (d), (e), and (f) of this section, 
carries the expense forward to the succeeding taxable year as a 
disallowed business interest expense carryforward under section 
163(j)(2) and Sec.  1.163(j)-2(c).
    (iii) Departure from group. If a corporation ceases to be a member 
during a consolidated return year, the corporation's current-year 
business interest expense from the taxable period ending on the day of 
the corporation's change in status as a member, as well as the 
corporation's disallowed business interest expense carryforwards from 
prior taxable years that are available to offset tentative taxable 
income in the consolidated return year, are first made available for 
deduction during that consolidated return year. See Sec.  1.1502-
76(b)(1)(i); see also Sec.  1.1502-36(d) (regarding reductions of 
deferred deductions on the transfer of loss shares of subsidiary stock). 
Only the amount that is neither deducted by the group in that 
consolidated return year nor otherwise reduced under the Code or

[[Page 439]]

regulations may be carried to the corporation's first separate return 
year after its change in status.
    (iv) Example: Deduction of interest expense--(A) Facts. (1) P wholly 
owns A, which is a member of the consolidated group of which P is the 
common parent. P and A each borrow money from Z, an unrelated third 
party. The business interest expense of P and A in Years 1, 2, and 3, 
and the P group's section 163(j) limitation for those years, are as 
follows:

                                      Table 1 To Paragraph (b)(3)(iv)(A)(1)
----------------------------------------------------------------------------------------------------------------
                                                                   P's business    A's business      P group's
                              Year                                   interest        interest     section 163(j)
                                                                      expense         expense        limitation
----------------------------------------------------------------------------------------------------------------
1...............................................................           $150x            $50x           $100x
2...............................................................             60x             90x            120x
3...............................................................             25x             50x            185x
----------------------------------------------------------------------------------------------------------------

    (2) P and A have neither business interest income nor floor plan 
financing interest expense in Years 1, 2, and 3. Additionally, the P 
group is neither eligible for the small business exemption in Sec.  
1.163(j)-2(d) nor engaged in an excepted trade or business.
    (B) Analysis--(1) Year 1. In Year 1, the aggregate amount of the P 
group members' current-year business interest expense ($150x + $50x) 
exceeds the P group's section 163(j) limitation ($100x). As a result, 
the rules of paragraph (b)(3)(ii)(C) of this section apply. Because the 
P group members' current-year business interest expense exceeds the 
group's section 163(j) limitation for Year 1, P and A must apply the 
rule in paragraph (b)(3)(ii)(C)(2) of this section. Pursuant to 
paragraph (b)(3)(ii)(C)(2) of this section, each of P and A must deduct 
its current-year business interest expense to the extent of its business 
interest income and floor plan financing interest expense. Neither P nor 
A has business interest income or floor plan financing interest expense 
in Year 1. Next, pursuant to paragraph (b)(3)(ii)(C)(3) of this section, 
each of P and A must deduct a portion of its current-year business 
interest expense based on its allocable share of the consolidated 
group's remaining section 163(j) limitation ($100x). P's allocable share 
is $75x ($100x x ($150x/$200x) = $75x), and A's allocable share is $25x 
($100x x ($50x/$200x) = $25x). Accordingly, in Year 1, P deducts $75x of 
its current-year business interest expense, and A deducts $25x of its 
current-year business interest expense. P has a disallowed business 
interest expense carryforward from Year 1 of $75x ($150x-$75x = $75x), 
and A has a disallowed business interest expense carryforward from Year 
1 of $25x ($50x-$25x = $25x).
    (2) Year 2. In Year 2, the aggregate amount of the P group members' 
current-year business interest expense ($60x + $90x) and disallowed 
business interest expense carryforwards ($75x + $25x) exceeds the P 
group's section 163(j) limitation ($120x). As a result, the rules of 
paragraph (b)(3)(ii)(C) of this section apply. Because the P group 
members' current-year business interest expense exceeds the group's 
section 163(j) limitation for Year 2, P and A must apply the rule in 
paragraph (b)(3)(ii)(C)(2) of this section. Pursuant to paragraph 
(b)(3)(ii)(C)(2) of this section, each of P and A must deduct its 
current-year business interest expense to the extent of its business 
interest income and floor plan financing interest expense. Neither P nor 
A has business interest income or floor plan financing interest expense 
in Year 2. Next, pursuant to paragraph (b)(3)(ii)(C)(3) of this section, 
each of P and A must deduct a portion of its current-year business 
interest expense based on its allocable share of the consolidated 
group's remaining section 163(j) limitation ($120x). P's allocable share 
is $48x (($120x x ($60x/$150x)) = $48x), and A's allocable share is $72x 
(($120x x ($90x/$150x)) = $72x). Accordingly, in Year 2, P deducts $48x 
of current-year business interest expense, and A deducts $72x of 
current-year business interest expense. P has a disallowed business 
interest expense

[[Page 440]]

carryforward from Year 2 of $12x ($60x-$48x = $12x), and A has a 
disallowed business interest expense carryforward from Year 2 of $18x 
($90x-$72x = $18x). Additionally, because the P group has no section 
163(j) limitation remaining after deducting current-year business 
interest expense in Year 2, the full amount of P and A's disallowed 
business interest expense carryforwards from Year 1 ($75x and $25x, 
respectively) also are carried forward to Year 3. As a result, at the 
beginning of Year 3, P and A's respective disallowed business interest 
expense carryforwards are as follows:

                                      Table 2 to Paragraph (b)(3)(iv)(B)(2)
----------------------------------------------------------------------------------------------------------------
                                                                      Year 1          Year 2           Total
                                                                    disallowed      disallowed      disallowed
                                                                     business        business        business
                                                                     interest        interest        interest
                                                                      expense         expense         expense
                                                                   carryforwards   carryforwards   carryforwards
----------------------------------------------------------------------------------------------------------------
P...............................................................            $75x            $12x            $87x
A...............................................................             25x             18x             43x
                                                                 -----------------------------------------------
    Total.......................................................            100x             30x            130x
----------------------------------------------------------------------------------------------------------------

    (3) Year 3. In Year 3, the aggregate amount of the P group members' 
current-year business interest expense ($25x + $50x = $75x) and 
disallowed business interest expense carryforwards ($130x) exceeds the P 
group's section 163(j) limitation ($185x). As a result, the rules of 
paragraph (b)(3)(ii)(C) of this section apply. Because the P group's 
section 163(j) limitation for Year 3 equals or exceeds the P group 
members' current-year business interest expense, no amount of the 
members' current-year business interest expense is subject to 
disallowance under section 163(j) (see paragraph (b)(3)(ii)(C)(1) of 
this section). After each of P and A deducts its current-year business 
interest expense, the P group has $110x of section 163(j) limitation 
remaining for Year 3 ($185x-$25x-$50x = $110x). Next, pursuant to 
paragraph (b)(3)(ii)(C)(4) of this section, $110x of disallowed business 
interest expense carryforwards are deducted on a pro rata basis, 
beginning with carryforwards from Year 1. Because the total amount of 
carryforwards from Year 1 ($100x) is less than the section 163(j) 
limitation remaining after the deduction of Year 3 business interest 
expense ($110x), all of the Year 1 carryforwards are deducted in Year 3. 
After current-year business interest expense and Year 1 carryforwards 
are deducted, the P group's remaining section 163(j) limitation in Year 
3 is $10x. Because the Year 2 carryforwards ($30x) exceed the remaining 
section 163(j) limitation ($10x), under paragraph (b)(3)(ii)(C)(4) of 
this section, each of P and A will deduct a portion of its Year 2 
carryforwards based on its allocable share of the consolidated group's 
remaining section 163(j) limitation. P's allocable share is $4x (($10x x 
($12x/$30x)) = $4x), and A's allocable share is $6x (($10x x ($18x/
$30x)) = $6x). Accordingly, P and A may deduct $4x and $6x, 
respectively, of their Year 2 carryforwards. For Year 4, P and A have 
$8x and $12x of disallowed business interest expense carryforwards from 
Year 2, respectively.
    (c) Disallowed business interest expense carryforwards in 
transactions to which section 381(a) applies. For rules governing the 
application of section 381(c)(20) to disallowed business interest 
expense carryforwards, including limitations on an acquiring 
corporation's use of the disallowed business interest expense 
carryforwards of the transferor or distributor corporation in the 
acquiring corporation's first taxable year ending after the date of 
distribution or transfer, see Sec.  1.381(c)(20)-1.
    (d) Limitations on disallowed business interest expense 
carryforwards from separate return limitation years--(1) General rule--
(A) Cumulative section 163(j) SRLY limitation. This paragraph (d) 
applies to disallowed business interest expense carryforwards of a 
member arising in a SRLY (see Sec.  1.1502-1(f))) or treated as arising 
in a SRLY under the principles of Sec.  1.1502-21(c) and (g). The amount 
of the carryforwards described in the preceding sentence that are 
included in the consolidated group's business interest expense deduction 
for any taxable year under paragraph (b) of this section may not exceed 
the aggregate section 163(j) limitation for all consolidated return 
years of the group, determined by reference only to the member's items 
of income, gain, deduction, and loss, and reduced (including below zero) 
by the member's business interest expense (including disallowed business 
interest

[[Page 441]]

expense carryforwards) absorbed by the group in all consolidated return 
years (cumulative section 163(j) SRLY limitation). For purposes of 
computing the member's cumulative section 163(j) SRLY limitation, 
intercompany items referred to in Sec.  1.163(j)-4(d)(2)(iv) are 
included, with the exception of interest items with regard to 
intercompany obligations. See Sec.  1.163(j)-4(d)(2)(v). Thus, for 
purposes of this paragraph (d), income and expense items arising from 
intercompany transactions (other than interest income and expense with 
regard to intercompany obligations) are included in the calculation of 
the cumulative section 163(j) SRLY limitation. In addition, items of 
interest expense with regard to intercompany obligations are not 
characterized as business interest expense for purposes of the reduction 
described in the second sentence of this paragraph (d)(1)(A).
    (B) Subgrouping. For purposes of this paragraph (d), the SRLY 
subgroup principles of Sec.  1.1502-21(c)(2)(i) (with regard to 
carryovers of SRLY losses) apply with appropriate adjustments.
    (2) Deduction of disallowed business interest expense carryforwards 
arising in a SRLY. Notwithstanding paragraph (d)(1) of this section, 
disallowed business interest expense carryforwards of a member arising 
in a SRLY are available for deduction by the consolidated group in the 
current year only to the extent the group has remaining section 163(j) 
limitation for the current year after the deduction of current-year 
business interest expense and disallowed business interest expense 
carryforwards from earlier taxable years that are permitted to be 
deducted in the current year (see paragraph (b)(3)(ii)(A) of this 
section). SRLY-limited disallowed business interest expense 
carryforwards are deducted on a pro rata basis (under the principles of 
paragraph (b)(3)(ii)(C)(3) of this section) with non-SRLY limited 
disallowed business interest expense carryforwards from taxable years 
ending on the same date. See also Sec.  1.1502-21(b)(1).
    (3) Examples. The principles of this paragraph (d) are illustrated 
by the following examples. For purposes of the examples in this 
paragraph (d)(3), unless otherwise stated, P, R, S, and T are taxable 
domestic C corporations that are not RICs or REITs and that file their 
tax returns on a calendar-year basis; none of P, R, S, or T qualifies 
for the small business exemption under section 163(j)(3) or is engaged 
in an excepted trade or business; all interest expense is deductible 
except for the potential application of section 163(j); and the facts 
set forth the only corporate activity.
    (i) Example 1: Determination of SRLY limitation--(A) Facts. 
Individual A owns P. In 2021, A forms T, which pays or accrues a $100x 
business interest expense for which a deduction is disallowed under 
section 163(j) and that is carried forward to 2022. P does not pay or 
accrue business interest expense in 2021, and P has no disallowed 
business interest expense carryforwards from prior taxable years. At the 
close of 2021, P acquires all of the stock of T, which joins with P in 
filing a consolidated return beginning in 2022. Neither P nor T pays or 
accrues business interest expense in 2022, and the P group has a section 
163(j) limitation of $300x in that year. This limitation would be $70x 
if determined by reference solely to T's items for all consolidated 
return years of the P group.
    (B) Analysis. T's $100x of disallowed business interest expense 
carryforwards from 2021 arose in a SRLY. P's acquisition of T was not an 
ownership change as defined by section 382(g); thus, T's disallowed 
business interest expense carryforwards are subject to the SRLY 
limitation in paragraph (d)(1) of this section. T's cumulative section 
163(j) SRLY limitation for 2022 is the P group's section 163(j) 
limitation, determined by reference solely to T's items for all 
consolidated return years of the P group ($70x). See paragraph (d)(1) of 
this section. Thus, $70x of T's disallowed business interest expense 
carryforwards are available to be deducted by the P group in 2022, and 
the remaining $30x of T's disallowed business interest expense 
carryforwards are carried forward to 2023. After the P group deducts 
$70x of T's disallowed business interest expense carryforwards, T's 
cumulative section 163(j) SRLY limitation is reduced by $70x to $0.

[[Page 442]]

    (C) Cumulative section 163(j) SRLY limitation of $0. The facts are 
the same as in Example 1 in paragraph (d)(3)(i)(A) of this section, 
except that T's cumulative section 163(j) SRLY limitation for 2022 is 
$0. Because the amount of T's disallowed business interest expense 
carryforwards that may be deducted by the P group in 2022 may not exceed 
T's cumulative section 163(j) SRLY limitation, none of T's carryforwards 
from 2021 may be deducted by the P group in 2022. Because none of T's 
disallowed business interest expense carryforwards are absorbed by the P 
group in 2022, T's cumulative section 163(j) SRLY limitation remains at 
$0 entering 2023.
    (ii) Example 2: Cumulative section 163(j) SRLY limitation less than 
zero--(A) Facts. P and S are the only members of a consolidated group. P 
has neither current-year business interest expense nor disallowed 
business interest expense carryforwards. For the current year, the P 
group has a section 163(j) limitation of $150x, $25x of which is 
attributable to P, and $125x of which is attributable to S. S has $100x 
of disallowed business interest expense carryforwards that arose in a 
SRLY and $150x of current-year business interest expense. S's cumulative 
section 163(j) SRLY limitation entering the current year (computed by 
reference solely to S's items for all consolidated return years of the P 
group) is $0.
    (B) Analysis. Under paragraph (d)(1) of this section, S's cumulative 
section 163(j) SRLY limitation is increased by $125x to reflect S's tax 
items for the current year. The P group's section 163(j) limitation 
permits the P group to deduct all $150x of S's current-year business 
interest expense. S's cumulative section 163(j) SRLY limitation is 
reduced by the $150x of S's business interest expense absorbed by the P 
group in the current year, which results in a -$25x balance. Thus, none 
of S's SRLY'd disallowed business interest expense carryforwards may be 
deducted by the P group in the current year. Entering the subsequent 
year, S's cumulative section 163(j) SRLY limitation remains -$25x.
    (iii) Example 3: Pro rata absorption of SRLY-limited disallowed 
business interest expense carryforwards--(A) Facts. P, R, and S are the 
only members of a consolidated group, and no member has floor plan 
financing or business interest income. P has $60x of current-year 
business interest expense and $40x of disallowed business interest 
expense carryforwards from the previous year, which was not a separate 
return year. R has $120x of current-year business interest expense and 
$80x of disallowed business interest expense carryforwards from the 
previous year, which was not a separate return year. S has $70x of 
current-year business interest expense and $30x of disallowed business 
interest expense carryforwards from the previous year, which was a 
separate return year. The P group has a section 163(j) limitation of 
$300x, $50x of which is attributable to P, $90x to R, and $160x to S. 
S's cumulative section 163(j) SRLY limitation entering the current year 
(computed by reference solely to S's items for all consolidated return 
years of the P group) is $0.

                                       Table 3 to Paragraph (d)(3)(iii)(A)
----------------------------------------------------------------------------------------------------------------
                                                                                    Disallowed
                                                                                     business
                                                                   Current-year      interest
                                                                     business         expense     Section 163(j)
                                                                     interest      carryforwards     limitation
                                                                      expense       from prior
                                                                                   taxable year
----------------------------------------------------------------------------------------------------------------
P...............................................................            $60x            $40x            $50x
R...............................................................            120x             80x             90x
S...............................................................             70x      (SRLY) 30x            160x
                                                                 -----------------------------------------------
    Total.......................................................            250x            150x            300x
----------------------------------------------------------------------------------------------------------------

    (B) Analysis. Under paragraph (d)(1) of this section, S's cumulative 
section 163(j) SRLY limitation is increased in the current year by 
$160x. The P group's section 163(j) limitation permits the P group to 
deduct all $70x of S's current-year business interest expense (and all 
$180x of P and R's current-year business interest expense). S's 
cumulative section 163(j) SRLY limitation is reduced by the $70x of S's 
business interest expense absorbed by the P group in the current year, 
resulting in a $90x balance. Because the P group has $50x of section 
163(j) limitation remaining after the absorption of current-year 
business interest expense, the P group can absorb $50x of its members' 
disallowed business interest expense carryforwards. Under paragraph

[[Page 443]]

(d)(2) of this section, SRLY-limited disallowed business interest 
expense carryforwards are deducted on a pro rata basis with other 
disallowed business interest expense carryforwards from the same taxable 
year. Accordingly, the P group can deduct $10x ($50x x ($30x/$150x)) of 
S's SRLY-limited disallowed business interest expense carryforwards. S's 
cumulative section 163(j) SRLY limitation is reduced (to $80x) by the 
$10x of SRLY-limited disallowed business interest carryforwards absorbed 
by the P group in the current year.
    (C) Cumulative section 163(j) SRLY limitation of -$75x. The facts 
are the same as in Example 3 in paragraph (d)(3)(iii)(A) of this 
section, except that S's cumulative section 163(j) SRLY limitation 
entering the current year is -$75x. After adjusting for S's tax items 
for the current year ($160x) and the P group's absorption of S's 
current-year business interest expense ($70x), S's cumulative section 
163(j) SRLY limitation is $15x (-$75x + $160x-$70x). Because S's 
cumulative section 163(j) SRLY limitation ($15x) is less than the amount 
of S's SRLY-limited disallowed business interest expense carryforwards 
($30x), the pro rata calculation under paragraph (d)(2) of this section 
is applied to $15x (rather than $30x) of S's carryforwards. Accordingly, 
the P group can deduct $5.56x ($50x x ($15x/$135x)) of S's SRLY-limited 
disallowed business interest expense carryforwards. S's cumulative 
section 163(j) SRLY limitation is reduced (to $9.44x) by the $5.56x of 
SRLY-limited disallowed business interest carryforwards absorbed by the 
P group in the current year.
    (e) Application of section 382--(1) Pre-change loss. For rules 
governing the treatment of a disallowed business interest expense as a 
pre-change loss for purposes of section 382, see Sec. Sec.  1.382-2(a) 
and 1.382-6. For rules governing the application of section 382 to 
disallowed disqualified interest carryforwards, see Sec.  1.163(j)-
11(c)(4).
    (2) Loss corporation. For rules governing when a disallowed business 
interest expense causes a corporation to be a loss corporation within 
the meaning of section 382(k)(1), see Sec.  1.382-2(a). For the 
application of section 382 to disallowed disqualified interest 
carryforwards, see Sec.  1.163(j)-11(c)(4).
    (3) Ordering rules for utilization of pre-change losses and for 
absorption of the section 382 limitation. For ordering rules for the 
utilization of disallowed business interest expense, net operating 
losses, and other pre-change losses, and for the absorption of the 
section 382 limitation, see Sec.  1.383-1(d).
    (4) Disallowed business interest expense from the pre-change period 
in the year of a testing date. For rules governing the treatment of 
disallowed business interest expense from the pre-change period (within 
the meaning of Sec.  1.382-6(g)(2)) in the year of a testing date, see 
Sec.  1.382-2.
    (5) Recognized built-in loss. For a rule providing that a section 
382 disallowed business interest carryforward (as defined in Sec.  
1.382-2(a)(7)) is not treated as a recognized built-in loss for purposes 
of section 382, see Sec.  1.382-7(d)(5).
    (f) Overlap of SRLY limitation with section 382. For rules governing 
the overlap of the application of section 382 and the application of the 
SRLY rules, see Sec.  1.1502-21(g).
    (g) Additional limitations. Additional rules provided under the Code 
or regulations also apply to limit the use of disallowed business 
interest expense carryforwards. For rules governing the relationship 
between section 163(j) and other provisions affecting the deductibility 
of interest, see Sec.  1.163(j)-3.
    (h) Applicability date. This section applies to taxable years 
beginning on or after November 13, 2020. However, taxpayers and their 
related parties, within the meaning of sections 267(b) and 707(b)(1), 
may choose to apply the rules of this section to a taxable year 
beginning after December 31, 2017, so long as the taxpayers and their 
related parties consistently apply the rules of the section 163(j) 
regulations, and, if applicable, Sec. Sec.  1.263A-9, 1.263A-15, 
1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 
1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 
1.1377-1, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 
1.1502-99 (to the extent they effectuate the rules of Sec. Sec.  1.382-
2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4, to that taxable year.

[T.D. 9905, 85 FR 56760, Sept. 14, 2020]

[[Page 444]]



Sec.  1.163(j)-6  Application of the section 163(j) limitation 
to partnerships and subchapter S corporations.

    (a) Overview. If a deduction for business interest expense of a 
partnership or an S corporation is subject to the section 163(j) 
limitation, section 163(j)(4) provides that the section 163(j) 
limitation applies at the partnership or S corporation level and any 
deduction for business interest expense is taken into account in 
determining the nonseparately stated taxable income or loss of the 
partnership or S corporation. Once a partnership or an S corporation 
determines its business interest expense, business interest income, ATI, 
and floor plan financing interest expense, the partnership or S 
corporation calculates its section 163(j) limitation by applying the 
rules of Sec.  1.163(j)-2(b) and this section. Paragraph (b) of this 
section provides definitions used in this section. Paragraph (c) of this 
section provides rules regarding the character of a partnership's 
deductible business interest expense and excess business interest 
expense. Paragraph (d) of this section provides rules regarding the 
calculation of a partnership's ATI and floor plan financing interest 
expense. Paragraph (e) of this section provides rules regarding a 
partner's ATI and business interest income. Paragraph (f) of this 
section provides an eleven-step computation necessary for properly 
allocating a partnership's deductible business interest expense and 
section 163(j) excess items to its partners. Paragraph (g) of this 
section applies carryforward rules at the partner level if a partnership 
has excess business interest expense. Paragraph (h) of this section 
provides basis adjustment rules, and paragraph (k) of this section 
provides rules regarding investment items of a partnership. Paragraph 
(l) of this section provides rules regarding S corporations. Paragraph 
(m) of this section provides rules for partnerships and S corporations 
not subject to section 163(j). Paragraph (o) of this section provides 
examples illustrating the rules of this section.
    (b) Definitions. In addition to the definitions contained in Sec.  
1.163(j)-1, the following definitions apply for purposes of this 
section.
    (1) Section 163(j) items. The term section 163(j) items means the 
partnership or S corporation's business interest expense, business 
interest income, and items comprising ATI.
    (2) Partner basis items. The term partner basis items means any 
items of income, gain, loss, or deduction resulting from either an 
adjustment to the basis of partnership property used in a non-excepted 
trade or business made pursuant to section 743(b) or the operation of 
section 704(c)(1)(C)(i) with respect to such property. Partner basis 
items also include section 743(b) basis adjustments used to increase or 
decrease a partner's share of partnership gain or loss on the sale of 
partnership property used in a non-excepted trade or business (as 
described in Sec.  1.743-1(j)(3)(i)) and amounts resulting from the 
operation of section 704(c)(1)(C)(i) used to decrease a partner's share 
of partnership gain or increase a partner's share of partnership loss on 
the sale of such property.
    (3) Remedial items. The term remedial items means any allocation to 
a partner of remedial items of income, gain, loss, or deduction pursuant 
to section 704(c) and Sec.  1.704-3(d).
    (4) Excess business interest income. The term excess business 
interest income means the amount by which a partnership's or S 
corporation's business interest income exceeds its business interest 
expense in a taxable year.
    (5) Deductible business interest expense. The term deductible 
business interest expense means the amount of a partnership's or S 
corporation's business interest expense that is deductible under section 
163(j) in the current taxable year following the application of the 
limitation contained in Sec.  1.163(j)-2(b).
    (6) Section 163(j) excess items. The term section 163(j) excess 
items means the partnership's excess business interest expense, excess 
taxable income, and excess business interest income.
    (7) Non-excepted assets. The term non-excepted assets means assets 
from a non-excepted trade or business.
    (8) Excepted assets. The term excepted assets means assets from an 
excepted trade or business.
    (c) Business interest income and business interest expense of a 
partnership--

[[Page 445]]

    (1) Modification of business interest income for partnerships. The 
business interest income of a partnership generally is determined in 
accordance with Sec.  1.163(j)-1(b)(4). However, to the extent that 
interest income of a partnership that is properly allocable to trades or 
businesses that are per se non-passive activities is allocated to 
partners that do not materially participate (within the meaning of 
section 469), as described in Sec.  1.469-1T(e)(6) and subject to 
section 163(d)(5)(A)(ii), such interest income shall not be considered 
business interest income for purposes of determining the section 163(j) 
limitation of a partnership pursuant to Sec.  1.163(j)-2(b). A per se 
non-passive activity is an activity that is not treated as a passive 
activity for purposes of section 469 regardless of whether the owners of 
the activity materially participate in the activity.
    (2) Modification of business interest expense for partnerships. The 
business interest expense of a partnership generally is determined in 
accordance with Sec.  1.163(j)-1(b)(3). However, to the extent that 
interest expense of a partnership that is properly allocable to trades 
or businesses that are per se non-passive activities is allocated to 
partners that do not materially participate (within the meaning of 
section 469), as described in Sec.  1.469-1T(e)(6) and subject to 
section 163(d)(5)(A)(ii), such interest expense shall not be considered 
business interest expense for purposes of determining the section 163(j) 
limitation of a partnership pursuant to Sec.  1.163(j)-2(b).
    (3) Transition rule. With respect to a partner in a partnership 
engaged in a trade or business described in Sec.  1.469-1T(e)(6) and 
subject to section 163(d)(5)(A)(ii), if such partner had been allocated 
EBIE from the partnership with respect to the trade or business 
described in Sec.  1.469-1T(e)(6) and subject to section 
163(d)(5)(A)(ii) in any prior taxable year in which the partner did not 
materially participate, such partner may treat such excess business 
interest expense not previously treated as paid or accrued under Sec.  
1.163(j)-6(g)(2) as paid or accrued by the partner in the first taxable 
year ending on or after the effective date of the final regulations and 
not subject to further limitation under section 163(j) or 163(d).
    (4) Character of business interest expense. If a partnership has 
deductible business interest expense, such deductible business interest 
expense is not subject to any additional application of section 163(j) 
at the partner-level because it is taken into account in determining the 
nonseparately stated taxable income or loss of the partnership. However, 
for all other purposes of the Code, deductible business interest expense 
and excess business interest expense retain their character as business 
interest expense at the partner-level. For example, for purposes of 
section 469, such business interest expense retains its character as 
either passive or non-passive in the hands of the partner. Additionally, 
for purposes of section 469, deductible business interest expense and 
excess business interest expense from a partnership remain interest 
derived from a trade or business in the hands of a partner even if the 
partner does not materially participate in the partnership's trade or 
business activity. For additional rules regarding the interaction 
between sections 465, 469, and 163(j), see Sec.  1.163(j)-3.
    (d) Adjusted taxable income of a partnership--(1) Tentative taxable 
income of a partnership. For purposes of computing a partnership's ATI 
under Sec.  1.163(j)-1(b)(1), the tentative taxable income of a 
partnership is the partnership's taxable income determined under section 
703(a), but computed without regard to the application of the section 
163(j) limitation.
    (2) Section 734(b), partner basis items, and remedial items. A 
partnership takes into account items resulting from adjustments made to 
the basis of its property pursuant to section 734(b) for purposes of 
calculating its ATI pursuant to Sec.  1.163(j)-1(b)(1). However, partner 
basis items and remedial items are not taken into account in determining 
a partnership's ATI under Sec.  1.163(j)-1(b)(1). Instead, partner basis 
items and remedial items are taken into account by the partner in 
determining the partner's ATI pursuant to Sec.  1.163(j)-1(b)(1). See 
Example 6 in paragraph (o)(6) of this section.

[[Page 446]]

    (3) Section 743(b) adjustments and publicly traded partnerships. 
Solely for purposes of Sec.  1.163(j)-6, a publicly traded partnership, 
as defined in Sec.  1.7704-1, shall treat the amount of any section 
743(b) adjustment of a purchaser of a partnership unit that relates to a 
remedial item that the purchaser inherits from the seller as an offset 
to the related section 704(c) remedial item. For this purpose, Sec.  
1.163(j)-6(e)(2)(ii) applies. See Example 25 in paragraph (o)(25) of 
this section.
    (4) Modification of adjusted taxable income for partnerships. The 
adjusted taxable income of a partnership generally is determined in 
accordance with Sec.  1.163(j)-1(b)(1). However, to the extent that the 
items comprising the adjusted taxable income of a partnership that are 
properly allocable to trades or businesses that are per se non-passive 
activities are allocated to partners that do not materially participate 
(within the meaning of section 469), as described in section 
163(d)(5)(A)(ii), such partnership items shall not be considered 
adjusted taxable income for purposes of determining the section 163(j) 
limitation of a partnership pursuant to Sec.  1.163(j)-2(b).
    (5) Election to use 2019 adjusted taxable income for taxable years 
beginning in 2020. In the case of any taxable year beginning in 2020, a 
partnership may elect to apply this section by substituting its adjusted 
taxable income for the last taxable year beginning in 2019 for the 
adjusted taxable income for such taxable year (post-election ATI or 2019 
ATI). See Sec.  1.163(j)-2(b)(4) for the time and manner of making or 
revoking this election. An electing partnership determines each 
partner's allocable ATI (as defined in paragraph (f)(2)(ii) of this 
section) by using the partnership's 2019 section 704 income, gain, loss, 
and deduction as though such amounts were recognized by the partnership 
in 2020. See Example 34 in paragraph (o)(34) of this section.
    (e) Adjusted taxable income and business interest income of 
partners--(1) Modification of adjusted taxable income for partners. The 
ATI of a partner in a partnership generally is determined in accordance 
with Sec.  1.163(j)-1(b)(1), without regard to such partner's 
distributive share of any items of income, gain, deduction, or loss of 
such partnership, except as provided for in paragraph (m) of this 
section, and is increased by such partner's distributive share of such 
partnership's excess taxable income determined under paragraph (f) of 
this section. For rules regarding corporate partners, see Sec.  
1.163(j)-4(b)(3).
    (2) Partner basis items and remedial items. Partner basis items and 
remedial items are taken into account as items derived directly by the 
partner in determining the partner's ATI for purposes of the partner's 
section 163(j) limitation. If a partner is allocated remedial items, 
such partner's ATI is increased or decreased by the amount of such 
items. Additionally, to the extent a partner is allocated partner basis 
items, such partner's ATI is increased or decreased by the amount of 
such items. See Example 6 in paragraph (o)(6) of this section.
    (3) Disposition of partnership interests. If a partner recognizes 
gain or loss upon the disposition of interests in a partnership, and the 
partnership in which the interest is being disposed owns only non-
excepted trade or business assets, the gain or loss on the disposition 
of the partnership interest is included in the partner's ATI. See Sec.  
1.163(j)-10(b)(4)(ii) for dispositions of interests in partnerships that 
own--
    (i) Non-excepted assets and excepted assets; or
    (ii) Investment assets; or
    (iii) Both.
    (4) Double counting of business interest income and floor plan 
financing interest expense prohibited. For purposes of calculating a 
partner's section 163(j) limitation, the partner does not include--
    (i) Business interest income from a partnership that is subject to 
section 163(j), except to the extent the partner is allocated excess 
business interest income from that partnership pursuant to paragraph 
(f)(2) of this section; and
    (ii) The partner's allocable share of the partnership's floor plan 
financing interest expense, because such floor plan financing interest 
expense already has been taken into account by the partnership in 
determining its nonseparately stated taxable income or loss for purposes 
of section 163(j).
    (5) Partner basis items, remedial items, and publicly traded 
partnerships. Solely

[[Page 447]]

for purposes of Sec.  1.163(j)-6, a publicly traded partnership, as 
defined in Sec.  1.7704-1, shall either allocate gain that would 
otherwise be allocated under section 704(c) based on a partner's section 
704(b) sharing ratios, or, for purposes of allocating cost recovery 
deductions under section 704(c), determine a partner's remedial items, 
as defined in Sec.  1.163(j)-6(b)(3), based on an allocation of the 
partnership's asset basis (inside basis) items among its partners in 
proportion to their share of corresponding section 704(b) items (rather 
than applying the traditional method, described in Sec.  1.704-3(b)). 
See Example 24 in paragraph (o)(24) of this section.
    (f) Allocation and determination of section 163(j) excess items made 
in the same manner as nonseparately stated taxable income or loss of the 
partnership--(1) Overview--(i) In general. The purpose of this paragraph 
is to provide guidance regarding how a partnership must allocate its 
deductible business interest expense and section 163(j) excess items, if 
any, among its partners. For purposes of section 163(j)(4) and this 
section, allocations and determinations of deductible business interest 
expense and section 163(j) excess items are considered made in the same 
manner as the nonseparately stated taxable income or loss of the 
partnership if, and only if, such allocations and determinations are 
made in accordance with the eleven-step computation set forth in 
paragraphs (f)(2)(i) through (xi) of this section. A partnership first 
determines its section 163(j) limitation, total amount of deductible 
business interest expense, and section 163(j) excess items under 
paragraph (f)(2)(i) of this section. The partnership then applies 
paragraphs (f)(2)(ii) through (xi) of this section, in that order, to 
determine how those items of the partnership are allocated among its 
partners. At the conclusion of the eleven-step computation set forth in 
paragraphs (f)(2)(i) through (xi) of this section, the total amount of 
deductible business interest expense and section 163(j) excess items 
allocated to each partner will equal the partnership's total amount of 
deductible business interest expense and section 163(j) excess items.
    (ii) Relevance solely for purposes of section 163(j). No rule set 
forth in paragraph (f)(2) of this section prohibits a partnership from 
making an allocation to a partner of any item of partnership income, 
gain, loss, or deduction that is otherwise permitted under section 704 
and the regulations under section 704 of the Code. Accordingly, any 
calculations in paragraphs (f)(2)(i) through (xi) of this section are 
solely for the purpose of determining each partner's deductible business 
interest expense and section 163(j) excess items and do not otherwise 
affect any other provision under the Code, such as section 704(b). 
Additionally, floor plan financing interest expense is not allocated in 
accordance with paragraph (f)(2) of this section. Instead, floor plan 
financing interest expense of a partnership is allocated to its partners 
under section 704(b) and is taken into account as a nonseparately stated 
item of loss for purposes of section 163(j).
    (iii) Exception applicable to publicly traded partnerships. Publicly 
traded partnerships, as defined in Sec.  1.7704-1, do not apply the 
rules in paragraph (f)(2) of this section to determine a partner's share 
of section 163(j) excess items. Rather, publicly traded partnerships 
determine a partner's share of section 163(j) excess items by applying 
the same percentage used to determine the partner's share of the 
corresponding section 704(b) items that comprise ATI.
    (2) Steps for allocating deductible business interest expense and 
section 163(j) excess items--(i) Partnership-level calculation required 
by section 163(j)(4)(A). First, a partnership must determine its section 
163(j) limitation pursuant to Sec.  1.163(j)-2(b). This calculation 
determines a partnership's total amounts of excess business interest 
income, excess taxable income, excess business interest expense (that 
is, the partnership's section 163(j) excess items), and deductible 
business interest expense under section 163(j) for a taxable year.
    (ii) Determination of each partner's relevant section 163(j) items. 
Second, a partnership must determine each partner's allocable share of 
each section 163(j) item under section 704(b) and the regulations under 
section 704 of the Code, including any allocations under section 704(c), 
other than remedial items. Only

[[Page 448]]

section 163(j) items that were actually taken into account in the 
partnership's section 163(j) calculation under paragraph (f)(2)(i) of 
this section are taken into account for purposes of this paragraph 
(f)(2)(ii). Partner basis items, allocations of investment income and 
expense, remedial items, and amounts determined for the partner under 
Sec.  1.163-8T are not taken into account for purposes of this paragraph 
(f)(2)(ii). For purposes of paragraphs (f)(2)(ii) through (xi) of this 
section, the term allocable ATI means a partner's distributive share of 
the partnership's ATI (that is, a partner's distributive share of gross 
income and gain items comprising ATI less such partner's distributive 
share of gross loss and deduction items comprising ATI), the term 
allocable business interest income means a partner's distributive share 
of the partnership's business interest income, and the term allocable 
business interest expense means a partner's distributive share of the 
partnership's business interest expense that is not floor plan financing 
interest expense. If the partnership determines that each partner has a 
pro rata share of allocable ATI, allocable business interest income, and 
allocable business interest expense, then the partnership may bypass 
paragraphs (f)(2)(iii) through (xi) of this section and allocate its 
section 163(j) excess items in the same proportion. See Example 1 
through Example 16 in paragraphs (o)(1) through (16), respectively. This 
pro-rata exception does not result in allocations of section 163(j) 
excess items that vary from the array of allocations of section 163(j) 
excess items that would have resulted had paragraphs (f)(2)(iii) through 
(xi) been applied.
    (iii) Partner-level comparison of business interest income and 
business interest expense. Third, a partnership must compare each 
partner's allocable business interest income to such partner's allocable 
business interest expense. Paragraphs (f)(2)(iii) through (v) of this 
section determine how a partnership must allocate its excess business 
interest income among its partners, as well as the amount of each 
partner's allocable business interest expense that is not deductible 
business interest expense after taking the partnership's business 
interest income into account. To the extent a partner's allocable 
business interest income exceeds its allocable business interest 
expense, the partner has an allocable business interest income excess. 
The aggregate of all the partners' allocable business interest income 
excess amounts is the total allocable business interest income excess. 
To the extent a partner's allocable business interest expense exceeds 
its allocable business interest income, the partner has an allocable 
business interest income deficit. The aggregate of all the partners' 
allocable business interest income deficit amounts is the total 
allocable business interest income deficit. These amounts are required 
to perform calculations in paragraphs (f)(2)(iv) and (v) of this 
section, which appropriately reallocate allocable business interest 
income excess to partners with allocable business interest income 
deficits in order to reconcile the partner-level calculation under 
paragraph (f)(2)(iii) of this section with the partnership-level result 
under paragraph (f)(2)(i) of this section.
    (iv) Matching partnership and aggregate partner excess business 
interest income. Fourth, a partnership must determine each partner's 
final allocable business interest income excess. A partner's final 
allocable business interest income excess is determined by reducing, but 
not below zero, such partner's allocable business interest income excess 
(if any) by the partner's step four adjustment amount. A partner's step 
four adjustment amount is the product of the total allocable business 
interest income deficit and the ratio of such partner's allocable 
business interest income excess to the total allocable business interest 
income excess. The rules of this paragraph (f)(2)(iv) ensure that, 
following the application of paragraph (f)(2)(xi) of this section, the 
aggregate of all the partners' allocations of excess business interest 
income equals the total amount of the partnership's excess business 
interest income as determined in paragraph (f)(2)(i) of this section.
    (v) Remaining business interest expense determination. Fifth, a 
partnership must determine each partner's remaining business interest 
expense. A partner's remaining business interest expense

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is determined by reducing, but not below zero, such partner's allocable 
business interest income deficit (if any) by such partner's step five 
adjustment amount. A partner's step five adjustment amount is the 
product of the total allocable business interest income excess and the 
ratio of such partner's allocable business interest income deficit to 
the total allocable business interest income deficit. Generally, a 
partner's remaining business interest expense is a partner's allocable 
business interest income deficit adjusted to reflect a reallocation of 
allocable business interest income excess from other partners. 
Determining a partner's remaining business interest expense is necessary 
to perform an ATI calculation that begins in paragraph (f)(2)(vii) of 
this section.
    (vi) Determination of final allocable ATI. Sixth, a partnership must 
determine each partner's final allocable ATI. Paragraphs (f)(2)(vi) 
through (x) of this section determine how a partnership must allocate 
its excess taxable income and excess business interest expense among its 
partners.
    (A) Positive allocable ATI. To the extent a partner's income and 
gain items comprising its allocable ATI exceed its deduction and loss 
items comprising its allocable ATI, the partner has positive allocable 
ATI. The aggregate of all the partners' positive allocable ATI amounts 
is the total positive allocable ATI.
    (B) Negative allocable ATI. To the extent a partner's deduction and 
loss items comprising its allocable ATI exceed its income and gain items 
comprising its allocable ATI, the partner has negative allocable ATI. 
The aggregate of all the partners' negative allocable ATI amounts is the 
total negative allocable ATI.
    (C) Final allocable ATI. Any partner with a negative allocable ATI, 
or an allocable ATI of $0, has a positive allocable ATI of $0. Any 
partner with a positive allocable ATI of $0 has a final allocable ATI of 
$0. The final allocable ATI of any partner with a positive allocable ATI 
greater than $0 is such partner's positive allocable ATI reduced, but 
not below zero, by the partner's step six adjustment amount. A partner's 
step six adjustment amount is the product of the total negative 
allocable ATI and the ratio of such partner's positive allocable ATI to 
the total positive allocable ATI. The total of the partners' final 
allocable ATI amounts must equal the partnership's ATI amount used to 
compute its section 163(j) limitation pursuant to Sec.  1.163(j)-2(b).
    (vii) Partner-level comparison of 30 percent of adjusted taxable 
income and remaining business interest expense. Seventh, a partnership 
must compare each partner's ATI capacity to such partner's remaining 
business interest expense as determined under paragraph (f)(2)(v) of 
this section. A partner's ATI capacity is the amount that is 30 percent 
of such partner's final allocable ATI as determined under paragraph 
(f)(2)(vi) of this section. A partner's final allocable ATI is grossed 
down to 30 percent prior to being compared to its remaining business 
interest expense in this calculation to parallel the partnership's 
adjustment to its ATI under section 163(j)(1)(B). To the extent a 
partner's ATI capacity exceeds its remaining business interest expense, 
the partner has an ATI capacity excess. The aggregate of all the 
partners' ATI capacity excess amounts is the total ATI capacity excess. 
To the extent a partner's remaining business interest expense exceeds 
its ATI capacity, the partner has an ATI capacity deficit. The aggregate 
of all the partners' ATI capacity deficit amounts is the total ATI 
capacity deficit. These amounts (which may be subject to adjustment 
under paragraph (f)(2)(viii) of this section) are required to perform 
calculations in paragraphs (f)(2)(ix) and (x) of this section, which 
appropriately reallocate ATI capacity excess to partners with ATI 
capacity deficits in order to reconcile the partner-level calculation 
under paragraph (f)(2)(vii) of this section with the partnership-level 
result under paragraph (f)(2)(i) of this section.
    (viii) Partner priority right to ATI capacity excess determination. 
(A) Eighth, the partnership must determine whether it is required to 
make any adjustments described in this paragraph (f)(2)(viii) and, if it 
is, make such adjustments. The rules of this paragraph (f)(2)(viii) are 
necessary to account for

[[Page 450]]

adjustments made to a partner's allocable ATI in paragraph (f)(2)(vi) of 
this section to ensure that the partners who had a negative allocable 
ATI do not inappropriately benefit under the rules of paragraphs 
(f)(2)(ix) through (xi) of this section to the detriment of the partners 
who had positive allocable ATI. The partnership must perform the 
calculations and make the necessary adjustments described under 
paragraphs (f)(2)(viii)(B) and (C) or paragraph (f)(2)(viii)(D) of this 
section if, and only if, there is--
    (1) An excess business interest expense amount greater than $0 under 
paragraph (f)(2)(i) of this section;
    (2) A total negative allocable ATI amount greater than $0 under 
paragraph (f)(2)(vi) of this section; and
    (3) A total ATI capacity excess amount greater than $0 under 
paragraph (f)(2)(vii) of this section.
    (B) A partnership must determine each partner's priority amount and 
usable priority amount. A partner's priority amount is 30 percent of the 
amount by which a partner's positive allocable ATI under paragraph 
(f)(2)(vi)(A) of this section exceeds such partner's final allocable ATI 
under paragraph (f)(2)(vi)(C) of this section. However, only partners 
with an ATI capacity deficit as determined under paragraph (f)(2)(vii) 
of this section can have a priority amount greater than $0. The 
aggregate of all the partners' priority amounts is the total priority 
amount. A partner's usable priority amount is the lesser of such 
partner's priority amount or such partner's ATI capacity deficit as 
determined under paragraph (f)(2)(vii) of this section. The aggregate of 
all the partners' usable priority amounts is the total usable priority 
amount. If the total ATI capacity excess amount, as determined under 
paragraph (f)(2)(vii) of this section, is greater than or equal to the 
total usable priority amount, then the partnership must perform the 
adjustments described in paragraph (f)(2)(viii)(C) of this section. If 
the total usable priority amount is greater than the total ATI capacity 
excess amount, as determined under paragraph (f)(2)(vii) of this 
section, then the partnership must perform the adjustments described in 
paragraph (f)(2)(viii)(D) of this section.
    (C) For purposes of paragraph (f)(2)(ix) of this section, each 
partner's final ATI capacity excess amount is $0. For purposes of 
paragraph (f)(2)(x) of this section, the following terms have the 
following meanings for each partner:
    (1) Each partner's ATI capacity deficit is such partner's ATI 
capacity deficit as determined under paragraph (f)(2)(vii) of this 
section, reduced by such partner's usable priority amount.
    (2) The total ATI capacity deficit is the total ATI capacity deficit 
as determined under paragraph (f)(2)(vii) of this section, reduced by 
the total usable priority amount.
    (3) The total ATI capacity excess is the total ATI capacity excess 
as determined under paragraph (f)(2)(vii) of this section, reduced by 
the total usable priority amount.
    (D) Any partner with a priority amount greater than $0 is a priority 
partner. Any partner that is not a priority partner is a non-priority 
partner. For purposes of paragraph (f)(2)(ix) of this section, each 
partner's final ATI capacity excess amount is $0. For purposes of 
paragraph (f)(2)(x) of this section, each non-priority partner's final 
ATI capacity deficit amount is such partner's ATI capacity deficit as 
determined under paragraph (f)(2)(vii) of this section. For purposes of 
paragraph (f)(2)(x) of this section, the following terms have the 
following meanings for priority partners.
    (1) Each priority partner must determine its step eight excess 
share. A partner's step eight excess share is the product of the total 
ATI capacity excess as determined under paragraph (f)(2)(vii) of this 
section and the ratio of the partner's priority amount to the total 
priority amount.
    (2) To the extent a priority partner's step eight excess share 
exceeds its ATI capacity deficit as determined under paragraph 
(f)(2)(vii) of this section, such excess amount is the priority 
partner's ATI capacity excess for purposes of paragraph (f)(2)(x) of 
this section. The total ATI capacity excess is the aggregate of the 
priority partners' ATI capacity excess amounts as determined under this 
paragraph (f)(2)(viii)(D)(2).
    (3) To the extent a priority partner's ATI capacity deficit as 
determined

[[Page 451]]

under paragraph (f)(2)(vii) of this section exceeds its step eight 
excess share, such excess amount is the priority partner's ATI capacity 
deficit for purposes of paragraph (f)(2)(x) of this section. The total 
ATI capacity deficit is the aggregate of the priority partners' ATI 
capacity deficit amounts as determined under this paragraph 
(f)(2)(viii)(D)(3).
    (ix) Matching partnership and aggregate partner excess taxable 
income. Ninth, a partnership must determine each partner's final ATI 
capacity excess. A partner's final ATI capacity excess amount is 
determined by reducing, but not below zero, such partner's ATI capacity 
excess (if any) by the partner's step nine adjustment amount. A 
partner's step nine adjustment amount is the product of the total ATI 
capacity deficit and the ratio of such partner's ATI capacity excess to 
the total ATI capacity excess. The rules of this paragraph (f)(2)(ix) 
ensure that, following the application of paragraph (f)(2)(xi) of this 
section, the aggregate of all the partners' allocations of excess 
taxable income equals the total amount of the partnership's excess 
taxable income as determined in paragraph (f)(2)(i) of this section.
    (x) Matching partnership and aggregate partner excess business 
interest expense. Tenth, a partnership must determine each partner's 
final ATI capacity deficit. A partner's final ATI capacity deficit 
amount is determined by reducing, but not below zero, such partner's ATI 
capacity deficit (if any) by the partner's step ten adjustment amount. A 
partner's step ten adjustment amount is the product of the total ATI 
capacity excess and the ratio of such partner's ATI capacity deficit to 
the total ATI capacity deficit. Generally, a partner's final ATI 
capacity deficit is a partner's ATI capacity deficit adjusted to reflect 
a reallocation of ATI capacity excess from other partners. The rules of 
this paragraph (f)(2)(x) ensure that, following the application of 
paragraph (f)(2)(xi) of this section, the aggregate of all the partners' 
allocations of excess business interest expense equals the total amount 
of the partnership's excess business interest expense as determined in 
paragraph (f)(2)(i) of this section.
    (xi) Final section 163(j) excess item and deductible business 
interest expense allocation. Eleventh, a partnership must allocate 
section 163(j) excess items and deductible business interest expense to 
its partners. Excess business interest income calculated under paragraph 
(f)(2)(i) of this section, if any, is allocated dollar for dollar by the 
partnership to its partners with final allocable business interest 
income excess amounts. Excess business interest expense calculated under 
paragraph (f)(2)(i) of this section, if any, is allocated dollar for 
dollar to partners with final ATI capacity deficit amounts. After 
grossing up each partner's final ATI capacity excess amount by ten-
thirds, excess taxable income calculated under paragraph (f)(2)(i) of 
this section, if any, is allocated dollar for dollar to partners with 
final ATI capacity excess amounts. A partner's allocable business 
interest expense is deductible business interest expense to the extent 
it exceeds such partner's share of excess business interest expense. See 
Example 17 through Example 21 in paragraphs (o)(17) through (21) of this 
section, respectively.
    (g) Carryforwards--(1) In general. The amount of any business 
interest expense not allowed as a deduction to a partnership by reason 
of Sec.  1.163(j)-2(b) and paragraph (f)(2) of this section for any 
taxable year is--
    (i) Not treated as business interest expense of the partnership in 
the succeeding taxable year; and
    (ii) Subject to paragraph (g)(2) of this section, treated as excess 
business interest expense, which is allocated to each partner pursuant 
to paragraph (f)(2) of this section.
    (2) Treatment of excess business interest expense allocated to 
partners. If a partner is allocated excess business interest expense 
from a partnership under paragraph (f)(2) of this section for any 
taxable year and the excess business interest expense is treated as such 
under paragraph (h)(2) of this section--
    (i) Solely for purposes of section 163(j), such excess business 
interest expense is treated as business interest expense paid or accrued 
by the partner in the next succeeding taxable year in which the partner 
is allocated excess

[[Page 452]]

taxable income or excess business interest income from such partnership, 
but only to the extent of such excess taxable income or excess business 
interest income; and
    (ii) Any portion of such excess business interest expense remaining 
after the application of paragraph (g)(2)(i) of this section is excess 
business interest expense that is subject to the limitations of 
paragraph (g)(2)(i) of this section in succeeding taxable years, unless 
paragraph (m)(3) of this section applies. See Example 1 through Example 
16 in paragraphs (o)(1) through (16) of this section, respectively.
    (3) Excess taxable income and excess business interest income 
ordering rule. In the event a partner has excess business interest 
expense from a prior taxable year and is allocated excess taxable income 
or excess business interest income from the same partnership in a 
succeeding taxable year, the partner must treat, for purposes of section 
163(j), the excess business interest expense as business interest 
expense paid or accrued by the partner in an amount equal to the 
partner's share of the partnership's excess taxable income or excess 
business interest income in such succeeding taxable year. See Example 2 
through Example 16 in paragraphs (o)(2) through (16) of this section, 
respectively.
    (4) Special rule for taxable years beginning in 2019 and 2020. In 
the case of any excess business interest expense of a partnership for 
any taxable year beginning in 2019 that is allocated to a partner under 
paragraph (f)(2) of this section, 50 percent of such excess business 
interest expense (Sec.  1.163(j)-6(g)(4) business interest expense) is 
treated as business interest expense that, notwithstanding paragraph 
(g)(2) of this section, is paid or accrued by the partner in the 
partner's first taxable year beginning in 2020. Additionally, Sec.  
1.163(j)-6(g)(4) business interest expense is not subject to the section 
163(j) limitation at the level of the partner. For purposes of paragraph 
(h)(1) of this section, any Sec.  1.163(j)-6(g)(4) business interest 
expense is, similar to deductible business interest expense, taken into 
account before any excess business interest expense. This paragraph 
applies after paragraph (n) of this section. If a partner disposes of a 
partnership interest in the partnership's 2019 or 2020 taxable year, 
Sec.  1.163(j)-6(g)(4) business interest expense is deductible by the 
partner (except to the extent that the business interest expense is 
negative section 163(j) expense as defined in Sec.  1.163(j)-6(h)(1) 
immediately prior to the disposition) and thus does not result in a 
basis increase under paragraph (h)(3) of this section. See Example 35 
and Example 36 in paragraphs (o)(35) and (o)(36), respectively, of this 
section. A partner may elect to not have this provision apply with 
respect to each partnership interest held by the partner on an interest 
by interest basis. The rules and procedures regarding the time and 
manner of making, or revoking, such an election are provided in Revenue 
Procedure 2020-22, 2020-18 I.R.B. 745, and may be further modified 
through other guidance (see Sec. Sec.  601.601(d) and 601.602 of this 
chapter).
    (h) Basis adjustments--(1) Section 704(d) ordering. Deductible 
business interest expense and excess business interest expense are 
subject to section 704(d). If a partner is subject to a limitation on 
loss under section 704(d) and a partner is allocated losses from a 
partnership in a taxable year, Sec.  1.704-1(d)(2) requires that the 
limitation on losses under section 704(d) be apportioned amongst these 
losses based on the character of each loss (each grouping of losses 
based on character being a section 704(d) loss class). If there are 
multiple section 704(d) loss classes in a given year, Sec.  1.704-
1(d)(2) requires the partner to apportion the limitation on losses under 
section 704(d) to each section 704(d) loss class proportionately. For 
purposes of applying this proportionate rule, any deductible business 
interest expense and business interest expense of an exempt entity 
(whether allocated to the partner in the current taxable year or 
suspended under section 704(d) in a prior taxable year), any excess 
business interest expense allocated to the partner in the current 
taxable year, and any excess business interest expense from a prior 
taxable year that was suspended under section 704(d) (negative section 
163(j) expense) shall comprise the same section 704(d) loss class. Once 
the partner determines

[[Page 453]]

the amount of limitation on losses apportioned to this section 704(d) 
loss class, any deductible business interest expense is taken into 
account before any excess business interest expense or negative section 
163(j) expense. See Example 7 in paragraph (o)(7) of this section.
    (2) Excess business interest expense basis adjustments. The adjusted 
basis of a partner in a partnership interest is reduced, but not below 
zero, by the amount of excess business interest expense allocated to the 
partner pursuant to paragraph (f)(2) of this section. Negative section 
163(j) expense is not treated as excess business interest expense in any 
subsequent year until such negative section 163(j) expense is no longer 
suspended under section 704(d). Therefore, negative section 163(j) 
expense does not affect, and is not affected by, any allocation of 
excess taxable income to the partner. Accordingly, any excess taxable 
income allocated to a partner from a partnership while the partner still 
has negative section 163(j) expense will be included in the partner's 
ATI. However, once the negative section 163(j) expense is no longer 
suspended under section 704(d), it becomes excess business interest 
expense, which is subject to the general rules in paragraph (g) of this 
section. See Example 8 in paragraph (o)(8) of this section.
    (3) Partner basis adjustment upon disposition of partnership 
interest. If a partner (transferor) disposes of an interest in a 
partnership, the adjusted basis of the partnership interest being 
disposed of (transferred interest) is increased immediately before the 
disposition by the amount of the excess (if any) of the amount of the 
basis reduction under paragraph (h)(2) of this section over the portion 
of any excess business interest expense allocated to the transferor 
under paragraph (f)(2) of this section which has previously been treated 
under paragraph (g) of this section as business interest expense paid or 
accrued by the transferor, multiplied by the ratio of the fair market 
value of the transferred interest to the total fair market value of the 
transferor's partnership interest immediately prior to the disposition. 
Therefore, the adjusted basis of the transferred interest is not 
increased immediately before the disposition by any allocation of excess 
business interest expense from the partnership that did not reduce the 
transferor's adjusted basis in its partnership interest pursuant to 
paragraph (h) of this section prior to the disposition, or by any excess 
business interest expense that was treated under paragraph (g) of this 
section as business interest expense paid or accrued by the transferor 
prior to the disposition. If the transferor disposes of all of its 
partnership interest, no deduction under section 163(j) is allowed to 
the transferor or transferee under chapter 1 of subtitle A of the Code 
for any excess business interest expense or negative section 163(j) 
expense. If the transferor disposes of a portion of its partnership 
interest, no deduction under section 163(j) is allowed to the transferor 
or transferee under chapter 1 of subtitle A of the Code for the amount 
of excess business interest expense proportionate to the transferred 
interest. The amount of excess business interest expense proportionate 
to the partnership interest retained by the transferor shall remain as 
excess business interest expense of the transferor until such time as 
such excess business interest expense is treated as business interest 
expense paid or accrued by the transferor pursuant to paragraph (g) of 
this section. Further, if the transferor disposes of a portion of its 
partnership interest, any negative section 163(j) expense shall remain 
negative section 163(j) expense of the transferor partner until such 
negative section 163(j) expense is no longer suspended under section 
704(d). For purposes of this paragraph, a disposition includes a 
distribution of money or other property by the partnership to a partner 
in complete liquidation of its interest in the partnership. Further, 
solely for purposes of this section, each partner is considered to have 
disposed of its partnership interest if the partnership terminates under 
section 708(b)(1). See Example 9 and Example 10 in paragraphs (o)(9) and 
(o)(10) of this section, respectively.
    (i)-(j) [Reserved]
    (k) Investment items and certain other items. Any item of a 
partnership's income, gain, deduction, or loss that is investment 
interest income or expense pursuant to Sec.  1.163-8T, and any other

[[Page 454]]

tax item of a partnership that is neither properly allocable to a trade 
or business of the partnership nor described in section 163(d), is 
allocated to each partner in accordance with section 704(b) and the 
regulations under section 704 of the Code, and the effect of such 
allocation for purposes of section 163 is determined at the partner-
level. See Sec.  1.163(j)-4(b)(3), section 163(d), and Sec.  1.163-8T.
    (l) S corporations--(1) In general--(i) Corporate level limitation. 
In the case of any S corporation, the section 163(j) limitation is 
applied at the S corporation level, and any deduction allowed for 
business interest expense is taken into account in determining the 
nonseparately stated taxable income or loss of the S corporation. An S 
corporation determines its section 163(j) limitation in the same manner 
as set forth in Sec.  1.163(j)-2(b). Allocations of excess taxable 
income and excess business interest income are made in accordance with 
the shareholders' pro rata interests in the S corporation pursuant to 
section 1366(a)(1) after determining the S corporation's section 163(j) 
limitation pursuant to Sec.  1.163(j)-2(b). See Example 22 and Example 
23 in paragraphs (o)(22) and (23) of this section, respectively.
    (ii) Short taxable periods. For rules on applying the section 163(j) 
limitation where an S corporation has a two short taxable periods or 
where its taxable year consists of two separate taxable years see 
Sec. Sec.  1.1362-3(c), 1.1368-1(g), and 1.1377-1(b).
    (2) Character of deductible business interest expense. If an S 
corporation has deductible business interest expense, such deductible 
business interest expense is not subject to any additional application 
of section 163(j) at the shareholder-level because such deductible 
business interest expense is taken into account in determining the 
nonseparately stated taxable income or loss of the S corporation. 
However, for all other purposes of the Code, deductible business 
interest expense retains its character as business interest expense at 
the shareholder-level. For example, for purposes of section 469, such 
deductible business interest expense retains its character as either 
passive or non-passive in the hands of the shareholder. Additionally, 
for purposes of section 469, deductible business interest expense from 
an S corporation remains interest derived from a trade or business in 
the hands of a shareholder even if the shareholder does not materially 
participate in the S corporation's trade or business activity. For 
additional rules regarding the interaction between sections 465, 469, 
and 163(j), see Sec.  1.163(j)-3.
    (3) Adjusted taxable income of an S corporation. The ATI of an S 
corporation generally is determined in accordance with Sec.  1.163(j)-
1(b)(1). For purposes of computing the S corporation's ATI, the 
tentative taxable income of the S corporation is determined under 
section 1363(b) and includes--
    (i) Any item described in section 1363(b)(1); and
    (ii) Any item described in Sec.  1.163(j)-1(b)(1), to the extent 
such item is consistent with subchapter S of the Code.
    (4) Adjusted taxable income and business interest income of S 
corporation shareholders--(i) Adjusted taxable income of S corporation 
shareholders. The ATI of an S corporation shareholder is determined in 
accordance with Sec.  1.163(j)-1(b)(1) without regard to such 
shareholder's distributive share of any items of income, gain, 
deduction, or loss of such S corporation, except as provided in 
paragraph (m), and is increased by such shareholder's distributive share 
of such S corporation's excess taxable income.
    (ii) Disposition of S corporation stock. If a shareholder of an S 
corporation recognizes gain or loss upon the disposition of stock of the 
S corporation, and the corporation the stock of which is being disposed 
of only owns non-excepted trade or business assets, the gain or loss on 
the disposition of the stock is included in the shareholder's ATI. See 
Sec.  1.163(j)-10(b)(4)(ii) for dispositions of stock of S corporations 
that own--
    (A) Non-excepted assets and excepted assets; or
    (B) Investment assets; or
    (C) Both.
    (iii) Double counting of business interest income and floor plan 
financing interest expense prohibited. For purposes of

[[Page 455]]

calculating an S corporation shareholder's section 163(j) limitation, 
the shareholder does not include--
    (A) Business interest income from an S corporation that is subject 
to section 163(j), except to the extent the shareholder is allocated 
excess business interest income from that S corporation pursuant to 
paragraph (l)(1) of this section; and
    (B) The shareholder's share of the S corporation's floor plan 
financing interest expense, because such floor plan financing interest 
expense already has been taken into account by the S corporation in 
determining its nonseparately stated taxable income or loss for purposes 
of section 163(j).
    (5) Carryforwards. The amount of any business interest expense not 
allowed as a deduction for any taxable year by reason of the limitation 
contained in Sec.  1.163(j)-2(b) is carried forward in the succeeding 
taxable year as a disallowed business interest expense carryforward 
under the rules set forth in Sec.  1.163(j)-2(c) (whether to an S 
corporation taxable year or a C corporation taxable year). For purposes 
of applying section 163(j), S corporations are subject to the same 
ordering rules as a C corporation that is not a member of a consolidated 
group. See Sec.  1.163(j)-5(b)(2).
    (6) Basis adjustments and disallowed business interest expense 
carryforwards. An S corporation shareholder's adjusted basis in its S 
corporation stock is reduced, but not below zero, when a disallowed 
business interest expense carryforward becomes deductible under section 
163(j).
    (7) Accumulated adjustment accounts. The accumulated adjustment 
account of an S corporation is adjusted to take into account business 
interest expense in the year in which the S corporation treats such 
business interest expense as deductible under the section 163(j) 
limitation. See section 1368(e)(1).
    (8) Termination of qualified subchapter S subsidiary election. If a 
corporation's qualified subchapter S subsidiary election terminates and 
any disallowed business interest expense carryforward is attributable to 
the activities of the qualified subchapter S subsidiary at the time of 
termination, such disallowed business interest expense carryforward 
remains with the parent S corporation, and no portion of these items is 
allocable to the former qualified subchapter S subsidiary.
    (9) Investment items. Any item of an S corporation's income, gain, 
deduction, or loss that is investment interest income or expense 
pursuant to Sec.  1.163-8T is allocated to each shareholder in 
accordance with the shareholders' pro rata interests in the S 
corporation pursuant to section 1366(a)(1). See section 163(d) and Sec.  
1.163-8T.
    (10) Application of section 382. In the event of an ownership 
change, within the meaning of section 382(g), the S corporation's 
business interest expense is subject to section 382. Therefore, the 
allocation of the S corporation's business interest expense between the 
pre-change period (as defined in Sec.  1.382-6(g)(2)) and the post-
change period (as defined in Sec.  1.382-6(g)(3)), and the determination 
of the amount that is deducted and carried forward, is determined 
pursuant to Sec.  1.382-6. If the date of the ownership change is also 
the date of a qualifying disposition (as defined in Sec.  1.1368-
1(g)(2)) or the date for a termination of shareholder interest (as 
defined in Sec.  1.1377-1(b)(4)), then--
    (i) The rules of this paragraph govern the S corporation's business 
interest expense;
    (ii) The S corporation must make an election under Sec.  1.382-6(b) 
with respect to such date if it also makes an election under Sec.  
1.1368-1(g)(2) or a shareholder termination election to apply normal tax 
accounting rules, as applicable, with respect to such date; and
    (iii) The S corporation may not make an election under Sec.  1.382-
6(b) with respect to such date if it does not make an election under 
Sec.  1.1368-1(g)(2) or a termination election under Sec.  1.1377-
1(b)(1), as applicable, with respect to such date.
    (m) Partnerships and S corporations not subject to section 163(j)--
(1) Exempt partnerships and S corporations. If the small business 
exemption in Sec.  1.163(j)-2(d) applies to a partnership or an S 
corporation in a taxable year (exempt entity), the general rule in Sec.  
1.163(j)-2 and this section does not apply to limit the deduction for 
business interest expense of the exempt entity in that taxable year. 
Additionally, if a partner or S corporation shareholder is allocated

[[Page 456]]

business interest expense from an exempt entity, such business interest 
expense is not subject to the section 163(j) limitation at the partner's 
or S corporation shareholder's level. However, see paragraph (h)(1) of 
this section. Further, a partner or S corporation shareholder of an 
exempt entity includes its share of non-excepted trade or business items 
of income, gain, loss, and deduction (including business interest 
expense and business interest income) of such exempt entity when 
calculating its ATI. However, if a partner's or S corporation 
shareholder's allocations of non-excepted trade or business items of 
loss and deduction from an exempt entity exceed its allocations of non-
excepted trade or business items of income and gain from such exempt 
entity (net loss allocation), then such net loss allocation will not 
reduce a partner's or S corporation shareholder's ATI. See Example 11 
and Example 12 in paragraphs (o)(11) and (12) of this section, 
respectively.
    (2) Partnerships and S corporations engaged in excepted trades or 
businesses. To the extent a partnership or an S corporation is engaged 
in an excepted trade or business, the general rule in Sec.  1.163(j)-2 
and this section does not apply to limit the deduction for business 
interest expense that is allocable to such excepted trade or business. 
If a partner or S corporation shareholder is allocated any section 
163(j) item that is allocable to an excepted trade or business of the 
partnership or S corporation (excepted 163(j) items), such excepted 
163(j) items are excluded from the partner's or shareholder's section 
163(j) deduction calculation. See Sec.  1.163(j)-10(c) (regarding the 
allocation of items between excepted and non-excepted trades or 
businesses). See also Example 13 in paragraph (o)(13) of this section.
    (3) Treatment of excess business interest expense from partnerships 
that are exempt entities in a succeeding taxable year. If a partner is 
allocated excess business interest expense from a partnership and, in a 
succeeding taxable year, such partnership is an exempt entity, then the 
partner shall treat any of its excess business interest expense that was 
previously allocated from such partnership as business interest expense 
paid or accrued by the partner in such succeeding taxable year, which is 
potentially subject to limitation at the partner level under section 
163(j). However, if a partner is allocated excess business interest 
expense from a partnership and, in a succeeding taxable year, such 
partnership engages in excepted trades or businesses, then the partner 
shall not treat any of its excess business interest expense that was 
previously allocated from such partnership as business interest expense 
paid or accrued by the partner in such succeeding taxable year by reason 
of the partnership engaging in excepted trades or businesses. See 
Example 14 through Example 16 in paragraphs (o)(14) through (o)(16) of 
this section, respectively. For rules regarding the treatment of excess 
business interest expense from a partnership that terminates under 
section 708(b)(1), see paragraph (h)(3) of this section.
    (4) S corporations with disallowed business interest expense 
carryforwards prior to becoming exempt entities. If an S corporation has 
a disallowed business interest expense carryforward for a taxable year 
and, in a succeeding taxable year, such S corporation is an exempt 
entity, then such disallowed business interest expense carryforward--
    (i) Continues to be carried forward at the S corporation level;
    (ii) Is no longer subject to the section 163(j) limitation; and
    (iii) Is taken into account in determining the nonseparately stated 
taxable income or loss of the S corporation.
    (n) Treatment of self-charged lending transactions between 
partnerships and partners. In the case of a lending transaction between 
a partner (lending partner) and partnership (borrowing partnership) in 
which the lending partner owns a direct interest (self-charged lending 
transaction), any business interest expense of the borrowing partnership 
attributable to the self-charged lending transaction is business 
interest expense of the borrowing partnership for purposes of this 
section. If in a given taxable year the lending partner is allocated 
excess business interest expense from the borrowing partnership and has 
interest income attributable to the self-charged lending transaction

[[Page 457]]

(interest income), the lending partner is deemed to receive an 
allocation of excess business interest income from the borrowing 
partnership in such taxable year. The amount of the lending partner's 
deemed allocation of excess business interest income is the lesser of 
such lending partner's allocation of excess business interest expense 
from the borrowing partnership in such taxable year or the interest 
income attributable to the self-charged lending transaction in such 
taxable year. To prevent the double counting of business interest 
income, the lending partner includes interest income that was treated as 
excess business interest income pursuant to this paragraph (n) only once 
when calculating its own section 163(j) limitation. To the extent an 
amount of interest income received by a lending partner is attributable 
to a self-charged lending transaction, and is deemed to be an allocation 
of excess business interest income from the borrowing partnership 
pursuant to this paragraph (n), such an amount of interest income will 
not be treated as investment income for purposes of section 163(d). In 
cases where the lending partner is not a C corporation, to the extent 
that any interest income exceeds the lending partner's allocation of 
excess business interest expense from the borrowing partnership for the 
taxable year, and such interest income otherwise would be properly 
treated as investment income of the lending partner for purposes of 
section 163(d) for that year, such excess amount of interest income will 
continue to be treated as investment income of the lending partner for 
that year for purposes of section 163(d). See Example 26 in paragraph 
(o)(26) of this section.
    (o) Examples. The examples in this paragraph illustrate the 
provisions of section 163(j) as applied to partnerships and subchapter S 
corporations. For purposes of these examples, unless stated otherwise, 
each partnership and S corporation is subject to the provisions of 
section 163(j), is only engaged in non-excepted trades or businesses, 
was created or organized in the United States, and uses the calendar 
year for its annual accounting period. Unless stated otherwise, all 
partners and shareholders are subject to the provisions of section 
163(j), are not subject to a limitation under section 704(d) or 1366(d), 
have no tax items other than those listed in the example, are U.S. 
citizens, and use the calendar year for their annual accounting period. 
The phrase ``section 163(j) limit'' shall equal the maximum potential 
deduction allowed under section 163(j)(1). Unless stated otherwise, 
business interest expense means business interest expense that is not 
floor plan financing interest expense. With respect to partnerships, all 
allocations are in accordance with section 704(b) and the regulations in 
this part under section 704 of the Code.
    (1) Example 1--(i) Facts. X and Y are equal partners in partnership 
PRS. In Year 1, PRS has $100 of ATI and $40 of business interest 
expense. PRS allocates the items comprising its $100 of ATI $50 to X and 
$50 to Y. PRS allocates its $40 of business interest expense $20 to X 
and $20 to Y. X has $100 of ATI and $20 of business interest expense 
from its sole proprietorship. Y has $0 of ATI and $20 of business 
interest expense from its sole proprietorship.
    (ii) Partnership-level. In Year 1, PRS's section 163(j) limit is 30 
percent of its ATI, or $30 ($100 x 30 percent). Thus, PRS has $30 of 
deductible business interest expense and $10 of excess business interest 
expense. Such $30 of deductible business interest expense is includable 
in PRS's nonseparately stated income or loss, and is not subject to 
further limitation under section 163(j) at the partners' level.
    (iii) Partner-level allocations. Pursuant to Sec.  1.163(j)-6(f)(2), 
X and Y are each allocated $15 of deductible business interest expense 
and $5 of excess business interest expense. At the end of Year 1, X and 
Y each have $5 of excess business interest expense from PRS, which is 
not treated as paid or accrued by the partner until such partner is 
allocated excess taxable income or excess business interest income from 
PRS in a succeeding taxable year. Pursuant to Sec.  1.163(j)-6(e)(1), X 
and Y, in computing their limit under section 163(j), do not increase 
any of their section 163(j) items by any of PRS's section 163(j) items. 
X and Y each increase their outside basis in PRS by $30 ($50-$20).

[[Page 458]]

    (iv) Partner-level computations. X, in computing its limit under 
section 163(j), has $100 of ATI and $20 of business interest expense 
from its sole proprietorship. X's section 163(j) limit is $30 ($100 x 30 
percent). Thus, X's $20 of business interest expense is deductible 
business interest expense. Y, in computing its limit under section 
163(j), has $20 of business interest expense from its sole 
proprietorship. Y's section 163(j) limit is $0 ($0 x 30 percent). Thus, 
Y's $20 of business interest expense is not allowed as a deduction and 
is treated as business interest expense paid or accrued by Y in Year 2.
    (2) Example 2--(i) Facts. The facts are the same as in Example 1 in 
paragraph (o)(1)(i) of this section. In Year 2, PRS has $200 of ATI, $0 
of business interest income, and $30 of business interest expense. PRS 
allocates the items comprising its $200 of ATI $100 to X and $100 to Y. 
PRS allocates its $30 of business interest expense $15 to X and $15 to 
Y. X has $100 of ATI and $20 of business interest expense from its sole 
proprietorship. Y has $0 of ATI and $20 of business interest expense 
from its sole proprietorship.
    (ii) Partnership-level. In Year 2, PRS's section 163(j) limit is 30 
percent of its ATI plus its business interest income, or $60 ($200 x 30 
percent). Thus, PRS has $100 of excess taxable income, $30 of deductible 
business interest expense, and $0 of excess business interest expense. 
Such $30 of deductible business interest expense is includable in PRS's 
nonseparately stated income or loss, and is not subject to further 
limitation under section 163(j) at the partners' level.
    (iii) Partner-level allocations. Pursuant to Sec.  1.163(j)-6(f)(2), 
X and Y are each allocated $50 of excess taxable income, $15 of 
deductible business interest expense, and $0 of excess business interest 
expense. As a result, X and Y each increase their ATI by $50. Because X 
and Y are each allocated $50 of excess taxable income from PRS, and 
excess business interest expense from a partnership is treated as paid 
or accrued by a partner to the extent excess taxable income and excess 
business interest income are allocated from such partnership to a 
partner, X and Y each treat $5 of excess business interest expense (the 
carryforward from Year 1) as paid or accrued in Year 2. X and Y each 
increase their outside basis in PRS by $85 ($100-$15).
    (iv) Partner-level computations. X, in computing its limit under 
section 163(j), has $150 of ATI ($100 from its sole proprietorship, plus 
$50 excess taxable income) and $25 of business interest expense ($20 
from its sole proprietorship, plus $5 excess business interest expense 
treated as paid or accrued in Year 2). X's section 163(j) limit is $45 
($150 x 30 percent). Thus, X's $25 of business interest expense is 
deductible business interest expense. At the end of Year 2, X has $0 of 
excess business interest expense from PRS ($5 from Year 1, less $5 
treated as paid or accrued in Year 2). Y, in computing its limit under 
section 163(j), has $50 of ATI ($0 from its sole proprietorship, plus 
$50 excess taxable income) and $45 of business interest expense ($20 
from its sole proprietorship, plus $20 disallowed business interest 
expense from Year 1, plus $5 excess business interest expense treated as 
paid or accrued in Year 2). Y's section 163(j) limit is $15 ($50 x 30 
percent). Thus, $15 of Y's business interest expense is deductible 
business interest expense. The $30 of Y's business interest expense not 
allowed as a deduction ($45 business interest expense, less $15 section 
163(j) limit) is treated as business interest expense paid or accrued by 
Y in Year 3. At the end of Year 2, Y has $0 of excess business interest 
expense from PRS ($5 from Year 1, less $5 treated as paid or accrued in 
Year 2).
    (3) Example 3--(i) Facts. The facts are the same as in Example 1 in 
paragraph (o)(1)(i) of this section. In Year 2, PRS has $0 of ATI, $60 
of business interest income, and $40 of business interest expense. PRS 
allocates its $60 of business interest income $30 to X and $30 to Y. PRS 
allocates its $40 of business interest expense $20 to X and $20 to Y. X 
has $100 of ATI and $20 of business interest expense from its sole 
proprietorship. Y has $0 of ATI and $20 of business interest expense 
from its sole proprietorship.
    (ii) Partnership-level. In Year 2, PRS's section 163(j) limit is 30 
percent of its ATI plus its business interest income, or $60 (($0 x 30 
percent) + $60). Thus, PRS has $20 of excess business interest income, 
$0 of excess taxable income, $40

[[Page 459]]

of deductible business interest expense, and $0 of excess business 
interest expense. Such $40 of deductible business interest expense is 
includable in PRS's nonseparately stated income or loss, and is not 
subject to further limitation under section 163(j) at the partners' 
level.
    (iii) Partner-level allocations. Pursuant to Sec.  1.163(j)-6(f)(2), 
X and Y are each allocated $10 of excess business interest income, and 
$20 of deductible business interest expense. As a result, X and Y each 
increase their business interest income by $10. Because X and Y are each 
allocated $10 of excess business interest income from PRS, and excess 
business interest expense from a partnership is treated as paid or 
accrued by a partner to the extent excess taxable income and excess 
business interest income are allocated from such partnership to a 
partner, X and Y each treat $5 of excess business interest expense (the 
carryforward from Year 1) as paid or accrued in Year 2. X and Y each 
increase their outside basis in PRS by $10 ($30-$20).
    (iv) Partner-level computations. X, in computing its limit under 
section 163(j), has $100 of ATI (from its sole proprietorship), $10 of 
business interest income (from the allocation of $10 of excess business 
interest income from PRS), and $25 of business interest expense ($20 
from its sole proprietorship, plus $5 excess business interest expense 
treated as paid or accrued in Year 2). X's section 163(j) limit is $40 
(($100 x 30 percent) + $10). Thus, X's $25 of business interest expense 
is deductible business interest expense. At the end of Year 2, X has $0 
of excess business interest expense from PRS ($5 from Year 1, less $5 
treated as paid or accrued in Year 2). Y, in computing its limit under 
section 163(j), has $0 of ATI (from its sole proprietorship), $10 of 
business interest income, and $45 of business interest expense ($20 from 
its sole proprietorship, plus $20 disallowed business interest expense 
from Year 1, plus $5 excess business interest expense treated as paid or 
accrued in Year 2). Y's section 163(j) limit is $10 (($0 x 30 percent) + 
$10). Thus, $10 of Y's business interest expense is deductible business 
interest expense. The $35 of Y's business interest expense not allowed 
as a deduction ($45 business interest expense, less $10 section 163(j) 
limit) is treated as business interest expense paid or accrued by Y in 
Year 3. At the end of Year 2, Y has $0 of excess business interest 
expense from PRS ($5 from Year 1, less $5 treated as paid or accrued in 
Year 2).
    (4) Example 4--(i) Facts. The facts are the same as in Example 1 in 
paragraph (o)(1)(i) of this section. In Year 2, PRS has $100 of ATI, $60 
of business interest income, and $40 of business interest expense. PRS 
allocates the items comprising its $100 of ATI $50 to X and $50 to Y. 
PRS allocates its $60 of business interest income $30 to X and $30 to Y. 
PRS allocates its $40 of business interest expense $20 to X and $20 to 
Y. X has $100 of ATI and $20 of business interest expense from its sole 
proprietorship. Y has $0 of ATI and $20 of business interest expense 
from its sole proprietorship.
    (ii) Partnership-level. In Year 2, PRS's section 163(j) limit is 30 
percent of its ATI plus its business interest income, or $90 (($100 x 30 
percent)) + $60). Thus, PRS has $20 of excess business interest income, 
$100 of excess taxable income, $40 of deductible business interest 
expense, and $0 of excess business interest expense. Such $40 of 
deductible business interest expense is includable in PRS's 
nonseparately stated income or loss, and is not subject to further 
limitation under section 163(j) at the partners' level.
    (iii) Partner-level allocations. Pursuant to Sec.  1.163(j)-6(f)(2), 
X and Y are each allocated $10 of excess business interest income, $50 
of excess taxable income, and $20 of deductible business interest 
expense. As a result, X and Y each increase their business interest 
income by $10 and ATI by $50. Because X and Y are each allocated $10 of 
excess business interest income and $50 of excess taxable income from 
PRS, and excess business interest expense from a partnership is treated 
as paid or accrued by a partner to the extent excess taxable income and 
excess business interest income are allocated from such partnership to a 
partner, X and Y each treat $5 of excess business interest expense (the 
carryforward from Year 1) as paid or

[[Page 460]]

accrued in Year 2. X and Y each increase their outside basis in PRS by 
$60 ($80-$20).
    (iv) Partner-level computations. X, in computing its limit under 
section 163(j), has $150 of ATI ($100 from its sole proprietorship, plus 
$50 excess taxable income), $10 of business interest income, and $25 of 
business interest expense ($20 from its sole proprietorship, plus $5 
excess business interest expense treated as paid or accrued in Year 2). 
X's section 163(j) limit is $55 (($150 x 30 percent) + $10). Thus, $25 
of X's business interest expense is deductible business interest 
expense. At the end of Year 2, X has $0 of excess business interest 
expense from PRS ($5 from Year 1, less $5 treated as paid or accrued in 
Year 2). Y, in computing its limit under section 163(j), has $50 of ATI 
($0 from its sole proprietorship, plus $50 excess taxable income), $10 
of business interest income, and $45 of business interest expense ($20 
from its sole proprietorship, plus $20 disallowed business interest 
expense from Year 1, plus $5 excess business interest expense treated as 
paid or accrued in Year 2). Y's section 163(j) limit is $25 (($50 x 30 
percent) + $10). Thus, $25 of Y's business interest expense is 
deductible business interest expense. Y's $20 of business interest 
expense not allowed as a deduction ($45 business interest expense, less 
$25 section 163(j) limit) is treated as business interest expense paid 
or accrued by Y in Year 3. At the end of Year 2, Y has $0 of excess 
business interest expense from PRS ($5 from Year 1, less $5 treated as 
paid or accrued in Year 2).
    (5) Example 5--(i) Facts. The facts are the same as in Example 1 in 
paragraph (o)(1)(i) of this section. In Year 2, PRS has $100 of ATI, 
$11.20 of business interest income, and $40 of business interest 
expense. PRS allocates the items comprising its $100 of ATI $50 to X and 
$50 to Y. PRS allocates its $11.20 of business interest income $5.60 to 
X and $5.60 to Y. PRS allocates its $40 of business interest expense $20 
to X and $20 to Y. X has $100 of ATI and $20 of business interest 
expense from its sole proprietorship. Y has $0 of ATI and $20 of 
business interest expense from its sole proprietorship.
    (ii) Partnership-level. In Year 2, PRS's section 163(j) limit is 30 
percent of its ATI plus its business interest income, or $41.20 (($100 x 
30 percent) + $11.20). Thus, PRS has $0 of excess business interest 
income, $4 of excess taxable income, and $40 of deductible business 
interest expense. Such $40 of deductible business interest expense is 
includable in PRS's nonseparately stated income or loss, and is not 
subject to further limitation under section 163(j) at the partners' 
level.
    (iii) Partner-level allocations. Pursuant to Sec.  1.163(j)-6(f)(2), 
X and Y are each allocated $2 of excess taxable income, $20 of 
deductible business interest expense, and $0 of excess business interest 
expense. As a result, X and Y each increase their ATI by $2. Because X 
and Y are each allocated $2 of excess taxable income from PRS, and 
excess business interest expense from a partnership is treated as paid 
or accrued by a partner to the extent excess taxable income and excess 
business interest income are allocated from such partnership to a 
partner, X and Y each treat $2 of excess business interest expense (a 
portion of the carryforward from Year 1) as paid or accrued in Year 2. X 
and Y each increase their outside basis in PRS by $35.60 ($55.60-$20).
    (iv) Partner-level computations. X, in computing its limit under 
section 163(j), has $102 of ATI ($100 from its sole proprietorship, plus 
$2 excess taxable income), $0 of business interest income, and $22 of 
business interest expense ($20 from its sole proprietorship, plus $2 
excess business interest expense treated as paid or accrued). X's 
section 163(j) limit is $30.60 ($102 x 30 percent). Thus, X's $22 of 
business interest expense is deductible business interest expense. At 
the end of Year 2, X has $3 of excess business interest expense from PRS 
($5 from Year 1, less $2 treated as paid or accrued in Year 2). Y, in 
computing its limit under section 163(j), has $2 of ATI ($0 from its 
sole proprietorship, plus $2 excess taxable income), $0 of business 
interest income, and $42 of business interest expense ($20 from its sole 
proprietorship, plus $20 disallowed business interest expense from Year 
1, plus $2 excess business interest expense treated as paid or accrued 
in Year 2). Y's

[[Page 461]]

section 163(j) limit is $0.60 ($2 x 30 percent). Thus, $0.60 of Y's 
business interest expense is deductible business interest expense. Y's 
$41.40 of business interest expense not allowed as a deduction ($42 
business interest expense, less $0.60 section 163(j) limit) is treated 
as business interest expense paid or accrued by Y in Year 3. At the end 
of Year 2, Y has $3 of excess business interest expense from PRS ($5 
from Year 1, less $2 treated as paid or accrued in Year 2).
    (6) Example 6--(i) Facts. In Year 1, X, Y, and Z formed partnership 
PRS. Upon formation, X and Y each contributed $100, and Z contributed 
non-excepted and non-depreciable trade or business property with a basis 
of $0 and fair market value of $100 (Blackacre). PRS allocates all items 
pro rata between its partners. Immediately after the formation of PRS, Z 
sold all of its interest in PRS to A for $100 (assume the interest sale 
is respected for U.S. Federal income tax purposes). In connection with 
the interest transfer, PRS made a valid election under section 754. 
Therefore, after the interest sale, A had a $100 positive section 743(b) 
adjustment in Blackacre. In Year 1, PRS had $0 of ATI, $15 of business 
interest expense, and $0 of business interest income. Pursuant to Sec.  
1.163(j)-6(f)(2), PRS allocated each of the partners $5 of excess 
business interest expense. In Year 2, PRS sells Blackacre for $100 which 
generated $100 of ATI. The sale of Blackacre was PRS's only item of 
income in Year 2. In accordance with section 704(c), PRS allocates all 
$100 of gain resulting from the sale of Blackacre to A. Additionally, 
PRS has $15 of business interest expense, all of which it allocates to 
X. A has $50 of ATI and $20 of business interest expense from its sole 
proprietorship.
    (ii) Partnership-level. In Year 2, PRS's section 163(j) limit is 30 
percent of its ATI, or $30 ($100 x 30 percent). Thus, PRS has $15 of 
deductible business interest expense and $50 of excess taxable income. 
Such $15 of deductible business interest expense is includable in PRS's 
nonseparately stated income or loss, and is not subject to further 
limitation under section 163(j) at X's level.
    (iii) Partner-level allocations. Pursuant to Sec.  1.163(j)-6(f)(2), 
X is allocated $15 of deductible business interest expense and X's 
outside basis in PRS is reduced by $15. A is allocated $50 of excess 
taxable income and, as a result, A increases its ATI by $50. Because A 
is allocated $50 of excess taxable income, and excess business interest 
expense from a partnership is treated as paid or accrued by a partner to 
the extent excess taxable income and excess business interest income are 
allocated from such partnership to a partner, A treats $5 of excess 
business interest expense (the carryforward from Year 1) as paid or 
accrued in Year 2. PRS's $100 of gain allocated to A in Year 2 is fully 
reduced by A's $100 section 743(b) adjustment. Therefore, at the end of 
Year 2, there is no change to A's outside basis in PRS.
    (iv) Partner-level. A, in computing its limit under section 163(j), 
has $0 of ATI ($50 from its sole proprietorship, plus $50 excess taxable 
income, less $100 ATI reduction as a result of A's section 743(b) 
adjustment under Sec.  1.163(j)-6(e)(2)) and $25 of business interest 
expense ($20 from its sole proprietorship, plus $5 excess business 
interest expense treated as paid or accrued in Year 2). A's section 
163(j) limit is $0 ($0 x 30 percent). Thus, all $25 of A's business 
interest expense is not allowed as a deduction and is treated as 
business interest expense paid or accrued by A in Year 3.
    (7) Example 7--(i) Facts. X and Y are equal partners in partnership 
PRS. At the beginning of Year 1, X and Y each have an outside basis in 
PRS of $5. In Year 1, PRS has $0 of ATI, $20 of business interest 
income, and $40 of business interest expense. PRS allocates its $20 of 
business interest income $10 to X and $10 to Y. PRS allocates $40 of 
business interest expense $20 to X and $20 to Y. X has $100 of ATI and 
$20 of business interest expense from its sole proprietorship. Y has $0 
of ATI and $20 of business interest expense from its sole 
proprietorship.
    (ii) Partnership-level. In Year 1, PRS's section 163(j) limit is 30 
percent of its ATI plus its business interest income, or $20 (($0 x 30 
percent) + $20). Thus, PRS has $0 of excess business interest income, $0 
of excess taxable income, $20 of deductible business interest expense,

[[Page 462]]

and $20 of excess business interest expense. Such $20 of deductible 
business interest expense is includable in nonseparately stated income 
or loss of PRS, and not subject to further limitation under section 
163(j) by the partners.
    (iii) Partner-level allocations. Pursuant to Sec.  1.163(j)-6(f)(2), 
X and Y are each allocated $10 of deductible business interest expense 
and $10 of excess business interest expense. After adjusting each 
partner's respective basis for business interest income under section 
705(a)(1)(A), pursuant to Sec.  1.163(j)-6(h)(1), X and Y each take 
their $10 of deductible business interest expense into account when 
reducing their outside basis in PRS before taking the $10 of excess 
business interest expense into account. Following each partner's 
reduction in outside basis due to the $10 of deductible business 
interest expense, each partner has $5 of outside basis remaining in PRS. 
Pursuant to Sec.  1.163(j)-6(h)(2), each partner has $5 of excess 
business interest expense and $5 of negative section 163(j) expense. In 
sum, at the end of Year 1, X and Y each have $5 of excess business 
interest expense from PRS which reduces each partner's outside basis to 
$0 (and is not treated as paid or accrued by the partners until such 
partner is allocated excess taxable income or excess business interest 
income from PRS in a succeeding taxable year), and $5 of negative 
section 163(j) expense (which is suspended under section 704(d) and not 
treated as excess business interest expense of the partners until such 
time as the negative section 163(j) expense is no longer subject to a 
limitation under section 704(d)).
    (iv) Partner-level computations. X, in computing its limit under 
section 163(j), has $100 of ATI (from its sole proprietorship) and $20 
of business interest expense (from its sole proprietorship). X's section 
163(j) limit is $30 ($100 x 30 percent). Thus, $20 of X's business 
interest expense is deductible business interest expense. Y, in 
computing its limit under section 163(j), has $20 of business interest 
expense (from its sole proprietorship). Y's section 163(j) limit is $0 
($0 x 30 percent). Thus, $20 of Y's business interest expense is not 
allowed as a deduction in Year 1, and is treated as business interest 
expense paid or accrued by Y in Year 2.
    (8) Example 8--(i) Facts. The facts are the same as in Example 7 in 
paragraph (o)(7)(i) of this section. In Year 2, PRS has $20 of gross 
income that is taken into account in determining PRS's ATI (in other 
words, properly allocable to a trade or business), $30 of gross 
deductions from an investment activity, and $0 of business interest 
expense. PRS allocates the items comprising its $20 of ATI $10 to X and 
$10 to Y. PRS allocates the items comprising its $30 of gross deductions 
$15 to X and $15 to Y. X has $100 of ATI and $20 of business interest 
expense from its sole proprietorship. Y has $0 of ATI and $20 of 
business interest expense from its sole proprietorship.
    (ii) Partnership-level. In Year 2, PRS's section 163(j) limit is 30 
percent of its ATI plus its business interest income, or $6 ($20 x 30 
percent). Because PRS has no business interest expense, all $20 of its 
ATI is excess taxable income.
    (iii) Partner-level allocations. Pursuant to Sec.  1.163(j)-6(f)(2), 
X and Y are each allocated $10 of excess taxable income. Because X and Y 
are each allocated $10 of excess taxable income from PRS, X and Y each 
increase their ATI by $10. Pursuant to Sec.  1.704-(1)(d)(2), each 
partner's limitation on losses under section 704(d) must be allocated to 
its distributive share of each such loss. Thus, each partner reduces its 
adjusted basis of $10 (attributable to the allocation of items 
comprising PRS's ATI in Year 2) by $7.50 of gross deductions from Year 2 
($10 x ($15 of total gross deductions from Year 2/$20 of total losses 
disallowed)), and $2.50 of excess business interest expense that was 
carried over as negative section 163(j) expense from Year 1 ($10 x ($5 
of negative section 163(j) expense treated as excess business interest 
expense solely for the purposes of section 704(d)/$20 of total losses 
disallowed)). Following the application of section 704(d), each partner 
has $7.50 of excess business interest expense from PRS ($5 excess 
business interest expense from Year 1, plus $2.50 of excess business 
interest expense that was formerly negative section 163(j) expense 
carried over from Year 1). Excess

[[Page 463]]

business interest expense from a partnership is treated as paid or 
accrued by a partner to the extent excess taxable income and excess 
business interest income are allocated from such partnership to the 
partner. As a result, X and Y each treat $7.50 of excess business 
interest expense as paid or accrued in Year 2.
    (iv) Partner-level computations. X, in computing its limit under 
section 163(j), has $110 of ATI ($100 from its sole proprietorship, plus 
$10 excess taxable income) and $27.50 of business interest expense ($20 
from its sole proprietorship, plus $7.50 excess business interest 
expense treated as paid or accrued in Year 2). X's section 163(j) limit 
is $33 ($110 x 30 percent). Thus, $27.50 of X's business interest 
expense is deductible business interest expense. At the end of Year 2, X 
has $0 of excess business interest expense from PRS ($5 from Year 1, 
plus $2.50 treated as excess business interest expense in Year 2, less 
$7.50 treated as paid or accrued in Year 2), and $2.50 of negative 
section 163(j) expense from PRS. Y, in computing its limit under section 
163(j), has $10 of ATI ($0 from its sole proprietorship, plus $10 excess 
taxable income) and $47.50 of business interest expense ($20 from its 
sole proprietorship, plus $20 disallowed business interest expense from 
Year 1, plus $7.50 excess business interest expense treated as paid or 
accrued in Year 2). Y's section 163(j) limit is $3 ($10 x 30 percent). 
Thus, $3 of Y's business interest expense is deductible business 
interest expense. The $44.50 of Y's business interest expense not 
allowed as a deduction ($47.50 business interest expense, less $3 
section 163(j) limit) is treated as business interest expense paid or 
accrued by Y in Year 3. At the end of Year 2, Y has $0 of excess 
business interest expense from PRS ($5 from Year 1, plus $2.50 treated 
as excess business interest expense in Year 2, less $7.50 treated as 
paid or accrued in Year 2), and $2.50 of negative section 163(j) expense 
from PRS.
    (9) Example 9--(i) Facts. X and Y are equal partners in partnership 
PRS, and are not members of a consolidated group. At the beginning of 
Year 1, X and Y each have $120 of outside basis in PRS. Neither X nor 
Y's share of partnership liabilities exceeds the adjusted basis of its 
entire interest. In Year 1, X is allocated $20 of excess business 
interest expense, which reduces its outside basis from $120 to $100. In 
Year 2, X sells 80 percent of its interest in PRS to Z for $160. 
Immediately prior to the sale, X's entire PRS interest had a fair market 
value of $200 and the transferred portion of the interest had a fair 
market value of $160.
    (ii) Basis adjustment. Immediately before the sale to Z, X increases 
its basis in the portion of the interest sold by 80 percent of the 
amount of the excess of the amount of the basis reduction under 
paragraph (h)(2) of this section ($20) over the portion of any excess 
business interest expense allocated the partner under paragraph (f)(2) 
of this section that has previously been treated under paragraph (g) of 
this section as business interest expense paid or accrued by X ($0). 
Therefore, X's basis in the portion of its interest sold is $96 (($100 x 
80%) + ($20 x 80%)), and X's gain is $64 ($160-$96). Following the sale, 
X has $20 of outside basis in its remaining partnership interest and $4 
of excess business interest expense.
    (10) Example 10--(i) Facts. X and Y are equal partners in 
partnership PRS, and are not members of a consolidated group. At the 
beginning of Year 1, X and Y each have an outside basis in PRS of $10. 
Neither X nor Y's share of partnership liabilities exceeds the adjusted 
basis of its entire interest. In Year 1, X is allocated $8 of excess 
business interest expense and $12 of loss from PRS. As a result, X has 
$4 of excess business interest expense, $4 of negative section 163(j) 
expense, $6 of allowable loss, $6 of loss suspended under section 
704(d), and $0 of outside basis in PRS at the end of Year 1. In Year 2, 
X sells 50 percent of its interest in PRS to Z for $20. Immediately 
prior to the sale, X's entire partnership interest had a fair market 
value of $40 and the transferred portion of the interest had a fair 
market value of $20.
    (ii) Basis adjustment. Immediately before the sale to Z, X increases 
its basis in the portion of the interest sold by 50 percent of the 
amount of the excess of the amount of the basis reduction under 
paragraph (h)(2) of this section ($4) over the portion of any excess 
business interest expense allocated the

[[Page 464]]

partner under paragraph (f)(2) of this section that has previously been 
treated under paragraph (g) of this section as business interest expense 
paid or accrued by X ($0). Therefore, X's basis in the portion of its 
interest sold is $2 (($0 x 50%) + $2), and X's gain is $18 ($20-$2). 
Following the sale, X has $0 of outside basis in its remaining 
partnership interest, $2 of excess business interest expense, $4 of 
negative section 163(j) expense, and $6 of loss suspended under section 
704(d).
    (11) Example 11--(i) Facts. X (a corporation), Y (an individual), 
and Z (an individual) are equal partners in partnership PRS. X, Y, and Z 
are subject to section 163(j). PRS is not subject to section 163(j) 
under section 163(j)(3). In 2021, PRS has $150 of trade or business 
income (not taking into account business interest income or business 
interest expense), $30 of business interest income, and $45 of business 
interest expense. PRS also has $75 of investment income and $60 of 
investment interest expense. PRS allocates its items of income, gain, 
loss, and deduction equally among its partners. X, Y, and Z each have 
$10 of business interest expense from their respective businesses.
    (ii) Partnership-level. PRS is not subject to section 163(j) by 
reason of section 163(j)(3). As a result, none of PRS's $45 of business 
interest expense is subject to the section 163(j) limitation.
    (iii) Partner-level allocations. Because PRS is not subject to 
section 163(j) by reason of section 163(j)(3), PRS's $45 of business 
interest expense does not retain its character as business interest 
expense for purposes of section 163(j). As a result, such business 
interest expense is not subject to the section 163(j) limitation at the 
level of either the partnership or partner. Additionally, pursuant to 
Sec.  1.163(j)-6(m)(1), each partner includes its share of non-excepted 
trade or business items of income, gain, loss, and deduction (including 
business interest expense and business interest income) of PRS when 
calculating its ATI. As a result, each partner increases its ATI by $45 
(one third of $150 + $30-$45). Also, X increases its ATI by an 
additional $25 because its items of investment income and loss from PRS 
are recharacterized as non-excepted trade or business income and loss at 
its level pursuant to Sec. Sec.  1.163(j)-4(b)(3)(i) and 1.163(j)-
10(b)(6). Further, X increases its business interest expense by its $20 
allocation of investment interest expense from PRS pursuant to 
Sec. Sec.  1.163(j)-4(b)(3)(i) and 1.163(j)-10(b)(6).
    (iv) Partner-level computations. X, in computing its limit under 
section 163(j), has $70 of ATI and $30 of business interest expense. X's 
section 163(j) limit is $21 ($70 x 30 percent). Thus, X has $21 of 
deductible business interest expense. X's $9 of business interest 
expense not allowed as a deduction is treated as business interest 
expense paid or accrued by X in 2020. Y and Z, in computing their 
respective limits under section 163(j), each have $45 of ATI and $10 of 
business interest expense. Y and Z each have a section 163(j) limit of 
$13.50 ($45-30 percent). Thus, Y and Z each have $10 of deductible 
business interest expense.
    (12) Example 12--(i) Facts. The facts are the same as in Example 11 
in paragraph (o)(11)(i) of this section, except PRS has $200 of 
depreciation deductions in addition to its other items of income, gain, 
loss, and deduction.
    (ii) Partnership-level. Same analysis as Example 11 in paragraph 
(o)(11)(ii) of this section.
    (iii) Partner-level allocations. Because PRS is not subject to 
section 163(j) by reason of section 163(j)(3), PRS's $45 of business 
interest expense does not retain its character as business interest 
expense for purposes of section 163(j). As a result, such business 
interest expense is not subject to the section 163(j) limitation at the 
level of either the partnership or partner. Additionally, pursuant to 
Sec.  1.163(j)-6(m)(1), each partner includes its share of non-excepted 
trade or business items of income, gain, loss, and deduction (including 
business interest expense and business interest income) of PRS when 
calculating its ATI; however, a net loss allocation of trade or business 
items from an exempt entity does not reduce a partner's ATI. Because 
each of the partners has a net loss allocation of trade or business 
items from PRS, none of the partners adjust their ATI for the trade or 
business items of PRS. X, the corporate partner, increases its ATI by

[[Page 465]]

$25 because its items of investment income and loss from PRS are 
recharacterized as trade or business income and loss at its level 
pursuant to Sec. Sec.  1.163(j)-4(b)(3)(i) and 1.163(j)-10(b)(6). 
Further, X increases its business interest expense by its $20 allocation 
of investment interest expense from PRS pursuant to Sec. Sec.  1.163(j)-
4(b)(3)(i) and 1.163(j)-10(b)(6).
    (iv) Partner-level computations. In computing its limit under 
section 163(j), each partner has $0 of ATI and $10 of business interest 
expense. Each partner's section 163(j) limit is $0 ($0 x 30 percent). 
Thus, each partner's $10 of business interest expense is not allowed as 
a deduction and is treated as business interest expense paid or accrued 
by the partner in 2020. X, in computing its limit under section 163(j), 
has $25 of ATI and $30 of business interest expense. X's section 163(j) 
limit is $7.50 ($25 x 30 percent). Thus, X has $7.50 of deductible 
business interest expense. X's $22.50 of business interest expense not 
allowed as a deduction is treated as business interest expense paid or 
accrued by X in 2020. Y and Z, in computing their respective limits 
under section 163(j), each have $0 of ATI and $10 of business interest 
expense. Thus, Y and Z each have $10 of business interest expense not 
allowed as a deduction that is treated as business interest expense paid 
or accrued in 2020.
    (13) Example 13--(i) Facts. X, Y, and Z are equal partners in 
partnership PRS. X, Y, and Z are each individuals subject to section 
163(j). PRS is not subject to section 163(j) under section 163(j)(3). 
PRS has one excepted and one non-excepted trade or business. In Year 1, 
PRS has $200 of income and $10 of business interest expense from its 
excepted trade or business, and $60 of business interest income and $30 
of business interest expense from its non-excepted trade or business. 
PRS allocates its items of income, gain, loss, and deduction equally 
among its partners. X, Y, and Z each have $10 of business interest 
expense from their respective businesses.
    (ii) Partnership-level. PRS is not subject to section 163(j) by 
reason of section 163(j)(3). As a result, none of PRS's business 
interest expense is subject to the section 163(j) limitation.
    (iii) Partner-level allocations. Because PRS's business interest 
expense is not subject to the section 163(j) limitation, such business 
interest expense is not subject to the section 163(j) limitation at the 
level of either the partnership or partner. Additionally, pursuant to 
Sec.  1.163(j)-6(m)(1), each partner includes its share of non-excepted 
trade or business items of income, gain, loss, and deduction (including 
business interest expense and business interest income) of PRS when 
calculating its ATI. Therefore, each partner increases its ATI by $10 
(each partner's share of $20 of non-excepted income less each partner's 
share of $10 of non-excepted loss).
    (iv) Partner-level computations. In computing its limit under 
section 163(j), each partner has $10 of ATI and $10 of business interest 
expense. Each partner's section 163(j) limit is $3 ($10 x 30 percent). 
Thus, each partner has $3 of deductible business interest expense. Each 
partner has $7 of business interest expense not allowed as a deduction 
that is treated as business interest expense paid or accrued by the 
partner in Year 2.
    (14) Example 14--(i) Facts. The facts are the same as in Example 5 
in paragraph (o)(5)(i) of this section, except in Year 2 Y is not 
subject to section 163(j) under section 163(j)(3).
    (ii) Partnership-level. Same analysis as Example 5 in paragraph 
(o)(5)(ii) of this section.
    (iii) Partner-level allocations. Same analysis as Example 5 in 
paragraph (o)(5)(iii) of this section.
    (iv) Partner-level computations. For X, same analysis as Example 5 
in paragraph (o)(5)(iv) of this section. Y is not subject to section 
163(j) under section 163(j)(3). Thus, all $42 of business interest 
expense ($20 from its sole proprietorship, plus $20 disallowed business 
interest expense from Year 1, plus $2 excess business interest expense 
treated as paid or accrued in Year 2) is not subject to limitation under 
Sec.  1.163(j)-2(d). At the end of Year 2, Y has $3 of excess business 
interest expense from PRS ($5 from Year 1, less $2 treated as paid or 
accrued in Year 2).

[[Page 466]]

    (15) Example 15--(i) Facts. The facts are the same as in Example 5 
in paragraph (o)(5)(i) of this section, except in Year 2 PRS and Y 
become not subject to section 163(j) by reason of section 163(j)(3).
    (ii) Partnership-level. In Year 2, PRS is not subject to section 
163(j) by reason of section 163(j)(3). As a result, none of PRS's $40 of 
business interest expense is subject to the section 163(j) limitation at 
the level of either the partnership or partner.
    (iii) Partner-level allocations. Because PRS is not subject to 
section 163(j) by reason of section 163(j)(3), PRS's $40 of business 
interest expense does not retain its character as business interest 
expense for purposes of section 163(j). As a result, such business 
interest expense is not subject to the section 163(j) limitation at the 
level of either the partnership or partner. Additionally, pursuant to 
Sec.  1.163(j)-6(m)(1), each partner includes its share of non-excepted 
trade or business items of income, gain, loss, and deduction (including 
business interest expense and business interest income) of PRS when 
calculating its ATI. As a result, X and Y each increase their ATI by 
$35.60. Further, because PRS is not subject to section 163(j) by reason 
of section 163(j)(3), the excess business interest expense from Year 1 
is treated as paid or accrued by the partners pursuant to Sec.  
1.163(j)-6(m)(3). As a result, X and Y each treat their $5 of excess 
business interest expense from Year 1 as paid or accrued in Year 2, and 
increase their business interest expense by $5.
    (iv) Partner-level computations. X, in computing its limit under 
section 163(j), has $135.60 of ATI ($100 from its sole proprietorship, 
plus $35.60 ATI from PRS) and $25 of business interest expense ($20 from 
its sole proprietorship, plus $5 of excess business interest expense 
treated as paid or accrued in Year 2). X's section 163(j) limit is 
$40.68 ($135.60 x 30 percent). Thus, $25 of X's business interest 
expense is deductible business interest expense. Y is not subject to 
section 163(j) under section 163(j)(3). As a result, Y's business 
interest expense is not subject to the section 163(j) limitation. Thus, 
all $45 of Y's business interest expense ($20 from its sole 
proprietorship, plus $20 disallowed from year 1, plus $5 of excess 
business interest expense treated as paid or accrued in Year 2) is not 
subject to the section 163(j) limitation.
    (16) Example 16--(i) Facts. The facts are the same as in Example 1 
in paragraph (o)(1)(i) of this section, except that PRS's only trade or 
business is a real property trade or business for which PRS does not 
make the election provided for in section 163(j)(7)(B). In Year 2, when 
PRS's only trade or business is still its real property trade or 
business, PRS makes the election provided for in section 163(j)(7)(B). 
Further, in Year 2, PRS has $100 of income and $40 of business interest 
expense. PRS allocates its items of income, gain, deduction, and loss 
equally between X and Y. X has $100 of ATI and $20 of business interest 
expense from its sole proprietorship. Y has $0 of ATI and $20 of 
business interest expense from its sole proprietorship.
    (ii) Partnership-level. In Year 2, PRS is not subject to section 
163(j) because its only trade or business is an excepted trade or 
business. As a result, none of PRS's $40 of business interest expense is 
subject to the section 163(j) limitation at the level of either the 
partnership or partner.
    (iii) Partner-level allocations. Because PRS is not subject to 
section 163(j), PRS's $40 of business interest expense does not retain 
its character as business interest expense for purposes of section 
163(j). As a result, such business interest expense is not subject to 
the section 163(j) limitation at the partners' level. Pursuant to Sec.  
1.163(j)-6(m)(1), the partners do not include their respective $50 
shares of income from PRS when calculating their own ATI because such 
$50 is excepted trade or business income.
    (iv) Partner-level computations. X, in computing its limit under 
section 163(j), has $100 of ATI ($100 from its sole proprietorship) and 
$20 of business interest expense ($20 from its sole proprietorship). X's 
section 163(j) limit is $30 ($100 x 30 percent). Thus, $20 of X's 
business interest expense is deductible business interest expense. At 
the end of Year 2, X has $5 of excess business interest expense from PRS 
($5 from Year

[[Page 467]]

1). Y, in computing its limit under section 163(j), has $0 of ATI and 
$40 of business interest expense ($20 from its sole proprietorship, plus 
$20 disallowed business interest expense from Year 1). Y's section 
163(j) limit is $0. Thus, Y's $40 of business interest expense not 
allowed as a deduction is treated as business interest expense paid or 
accrued by Y in Year 3. At the end of Year 2, Y has $5 of excess 
business interest expense from PRS ($5 from Year 1).
    (17) Example 17: Facts. A (an individual) and B (a corporation) own 
all of the interests in partnership PRS. At the beginning of Year 1, A 
and B each have $100 section 704(b) capital account and $100 of basis in 
PRS. In Year 1, PRS has $100 of ATI, $10 of investment interest income, 
$20 of business interest income (BII), $60 of business interest expense 
(BIE), and $10 of floor plan financing interest expense. PRS's ATI 
consists of $100 of gross income and $0 of gross deductions. PRS 
allocates its items comprising ATI $100 to A and $0 to B. PRS allocates 
its business interest income $10 to A and $10 to B. PRS allocates its 
business interest expense $30 to A and $30 to B. PRS allocates all $10 
of its investment interest income and all $10 of its floor plan 
financing interest expense to B. A has ATI from a sole proprietorship, 
unrelated to PRS, in the amount of $300.
    (i) First, PRS determines its limitation pursuant to Sec.  1.163(j)-
2. PRS's section 163(j) limit is 30 percent of its ATI plus its business 
interest income, or $50 (($100 x 30 percent) + $20). Thus, PRS has $0 of 
excess business interest income (EBII), $0 of excess taxable income, $50 
of deductible business interest expense, and $10 of excess business 
interest expense. PRS takes its $10 of floor plan financing into account 
in determining its nonseparately stated taxable income or loss.
    (ii) Second, PRS determines each partner's allocable share of 
section 163(j) items used in its own section 163(j) calculation. B's $10 
of investment interest income is not included in B's allocable business 
interest income amount because the $10 of investment interest income was 
not taken into account in PRS's section 163(j) calculation. B's $10 of 
floor plan financing interest expense is not included in B's allocable 
business interest expense. The $300 of ATI from A's sole proprietorship 
is not included in A's allocable ATI amount because the $300 was not 
taken into account in PRS's section 163(j) calculation.

                                        Table 1 to Paragraph (o)(17)(ii)
----------------------------------------------------------------------------------------------------------------
                                                                         A               B             Total
----------------------------------------------------------------------------------------------------------------
Allocable ATI...................................................            $100              $0            $100
Allocable BII...................................................              10              10              20
Allocable BIE...................................................              30              30              60
----------------------------------------------------------------------------------------------------------------

    (iii) Third, PRS compares each partner's allocable business interest 
income to such partner's allocable business interest expense. Because 
each partner's allocable business interest expense exceeds its allocable 
business interest income by $20 ($30-$10), each partner has an allocable 
business interest income deficit of $20. Thus, the total allocable 
business interest income deficit is $40 ($20 + $20). No partner has 
allocable business interest income excess because no partner has 
allocable business interest income in excess of its allocable business 
interest expense. Thus, the total allocable business interest income 
excess is $0.

                                        Table 2 to Paragraph (o)(17)(iii)
----------------------------------------------------------------------------------------------------------------
                                                                         A               B             Total
----------------------------------------------------------------------------------------------------------------
Allocable BII...................................................             $10             $10             N/A
Allocable BIE...................................................              30              30             N/A
If allocable BII exceeds allocable BIE, then such amount =                     0               0              $0
 Allocable BII excess...........................................

[[Page 468]]

 
If allocable BIE exceeds allocable BII, then such amount =                    20              20              40
 Allocable BII deficit..........................................
----------------------------------------------------------------------------------------------------------------

    (iv) Fourth, PRS determines each partner's final allocable business 
interest income excess. Because no partner had any allocable business 
interest income excess, each partner has final allocable business 
interest income excess of $0.
    (v) Fifth, PRS determines each partner's remaining business interest 
expense. PRS determines A's remaining business interest expense by 
reducing, but not below $0, A's allocable business interest income 
deficit ($20) by the product of the total allocable business interest 
income excess ($0) and the ratio of A's allocable business interest 
income deficit to the total business interest income deficit ($20/$40). 
Therefore, A's allocable business interest income deficit of $20 is 
reduced by $0 ($0 x 50 percent). As a result, A's remaining business 
interest expense is $20. PRS determines B's remaining business interest 
expense by reducing, but not below $0, B's allocable business interest 
income deficit ($20) by the product of the total allocable business 
interest income excess ($0) and the ratio of B's allocable business 
interest income deficit to the total business interest income deficit 
($20/$40). Therefore, B's allocable business interest income deficit of 
$20 is reduced by $0 ($0 x 50 percent). As a result, B's remaining 
business interest expense is $20.

                                         Table 3 to Paragraph (o)(17)(v)
----------------------------------------------------------------------------------------------------------------
                                                                         A               B             Total
----------------------------------------------------------------------------------------------------------------
Allocable BII deficit...........................................             $20             $20             $40
Less: (Total allocable BII excess) x (Allocable BII deficit/                   0               0             N/A
 Total allocable BII deficit)...................................
= Remaining BIE.................................................              20              20              40
----------------------------------------------------------------------------------------------------------------

    (vi) Sixth, PRS determines each partner's final allocable ATI. Any 
partner with a negative allocable ATI, or an allocable ATI of $0, has a 
positive allocable ATI of $0. Therefore, B has a positive allocable ATI 
of $0. Because A's allocable ATI is comprised of $100 of income and gain 
and $0 of deduction and loss, A has positive allocable ATI of $100. 
Thus, the total positive allocable ATI is $100 ($100 + $0). PRS 
determines A's final allocable ATI by reducing, but not below $0, A's 
positive allocable ATI ($100) by the product of total negative allocable 
ATI ($0) and the ratio of A's positive allocable ATI to the total 
positive allocable ATI ($100/$100). Therefore, A's positive allocable 
ATI is reduced by $0 ($0 x 100 percent). As a result, A's final 
allocable ATI is $100. Because B has a positive allocable ATI of $0, B's 
final allocable ATI is $0.

                                        Table 4 to Paragraph (o)(17)(vi)
----------------------------------------------------------------------------------------------------------------
                                                                         A               B             Total
----------------------------------------------------------------------------------------------------------------
Allocable ATI...................................................            $100              $0            $100

[[Page 469]]

 
If deduction and loss items comprising allocable ATI exceed                    0               0               0
 income and gain items comprising allocable ATI, then such
 excess amount = Negative allocable ATI.........................
If income and gain items comprising allocable ATI equal or                   100               0             100
 exceed deduction and loss items comprising allocable ATI, then
 such amount = Positive allocable ATI...........................
----------------------------------------------------------------------------------------------------------------


                                        Table 5 to Paragraph (o)(17)(vi)
----------------------------------------------------------------------------------------------------------------
                                                                         A               B             Total
----------------------------------------------------------------------------------------------------------------
Positive allocable ATI..........................................            $100              $0            $100
Less: (Total negative allocable ATI) x (Positive allocable ATI/                0               0             N/A
 Total positive allocable ATI)..................................
= Final allocable ATI...........................................             100               0             100
----------------------------------------------------------------------------------------------------------------

    (vii) Seventh, PRS compares each partner's ATI capacity (ATIC) 
amount to such partner's remaining business interest expense. A's ATIC 
amount is $30 ($100 x 30 percent) and B's ATIC amount is $0 ($0 x 30 
percent). Because A's ATIC amount exceeds its remaining business 
interest expense by $10 ($30-$20), A has an ATIC excess of $10. B does 
not have any ATIC excess. Thus, the total ATIC excess is $10 ($10 + $0). 
A does not have any ATIC deficit. Because B's remaining business 
interest expense exceeds its ATIC amount by $20 ($20-$0), B has an ATIC 
deficit of $20. Thus, the total ATIC deficit is $20 ($0 + $20).

                                        Table 6 to Paragraph (o)(17)(vii)
----------------------------------------------------------------------------------------------------------------
                                                                         A               B             Total
----------------------------------------------------------------------------------------------------------------
ATIC (Final allocable ATI x 30 percent).........................             $30              $0             N/A
Remaining BIE...................................................              20              20             N/A
If ATIC exceeds remaining BIE, then such excess = ATIC excess...              10               0             $10

[[Page 470]]

 
If remaining BIE exceeds ATIC, then such excess = ATIC deficit..               0              20              20
----------------------------------------------------------------------------------------------------------------

    (viii)(A) Eighth, PRS must perform the calculations and make the 
necessary adjustments described under paragraph (f)(2)(viii) of this 
section if, and only if, PRS has--
    (1) An excess business interest expense greater than $0 under 
paragraph (f)(2)(i) of this section;
    (2) A total negative allocable ATI greater than $0 under paragraph 
(f)(2)(vi) of this section; and
    (3) A total ATIC excess amount greater than $0 under paragraph 
(f)(2)(vii) of this section.
    (B) Because PRS does not meet all three requirements in paragraph 
(o)(17)(viii)(A) of this section, PRS does not perform the calculations 
or adjustments described in paragraph (f)(2)(viii) of this section. In 
sum, the correct amounts to be used in paragraphs (o)(17)(ix) and (x) of 
this section are as follows.

                                      Table 7 to Paragraph (o)(17)(viii)(B)
----------------------------------------------------------------------------------------------------------------
                                                                         A               B             Total
----------------------------------------------------------------------------------------------------------------
ATIC excess.....................................................             $10              $0             $10
ATIC deficit....................................................               0              20              20
----------------------------------------------------------------------------------------------------------------

    (ix) Ninth, PRS determines each partner's final ATIC excess amount. 
Because A has an ATIC excess, PRS must determine A's final ATIC excess 
amount. A's final ATIC excess amount is A's ATIC excess ($10), reduced, 
but not below $0, by the product of the total ATIC deficit ($20) and the 
ratio of A's ATIC excess to the total ATIC excess ($10/$10). Therefore, 
A has $0 of final ATIC excess ($10-($20 x 100 percent)).

                                        Table 8 to Paragraph (o)(17)(ix)
----------------------------------------------------------------------------------------------------------------
                                                                         A               B             Total
----------------------------------------------------------------------------------------------------------------
ATIC excess.....................................................             $10              $0             N/A
Less: (Total ATIC deficit) x (ATIC excess/Total ATIC excess)....              20               0             N/A
= Final ATIC excess.............................................               0               0              $0
----------------------------------------------------------------------------------------------------------------

    (x) Tenth, PRS determines each partner's final ATIC deficit amount. 
Because B has an ATIC deficit, PRS must determine B's final ATIC deficit 
amount. B's final ATIC deficit amount is B's ATIC deficit ($20), 
reduced, but not below $0, by the product of the total ATIC excess ($10) 
and the ratio of B's ATIC deficit to the total ATIC deficit ($20/$20). 
Therefore, B has $10 of final ATIC deficit ($20-($10 x 100 percent)).

                                         Table 9 to Paragraph (o)(17)(x)
----------------------------------------------------------------------------------------------------------------
                                                                         A               B             Total
----------------------------------------------------------------------------------------------------------------
ATIC deficit....................................................              $0             $20             N/A
Less: (Total ATIC excess) x (ATIC deficit/Total ATIC deficit)...               0              10             N/A
= Final ATIC deficit............................................               0              10             $10
----------------------------------------------------------------------------------------------------------------

    (xi) Eleventh, PRS allocates deductible business interest expense 
and section 163(j) excess items to the partners. Pursuant to paragraph 
(f)(2)(i) of this section, PRS has $10 of excess business interest 
expense. PRS allocates the excess business interest expense dollar for 
dollar to the partners with final ATIC deficits amounts. Thus, PRS 
allocates all $10 of its excess business interest expense to B. A 
partner's allocable business interest expense is deductible business 
interest expense to the extent it exceeds such partner's share of excess 
business interest expense. Therefore, A has deductible

[[Page 471]]

business interest expense of $30 ($30-$0) and B has deductible business 
interest expense of $20 ($30-$10). As a result of its allocations from 
PRS, A increases its section 704(b) capital account and basis in PRS by 
$80 to $180. As a result of its allocations from PRS, B decreases its 
capital account and basis in PRS by $20 to $80.

                                        Table 10 to Paragraph (o)(17)(xi)
----------------------------------------------------------------------------------------------------------------
                                                                         A               B             Total
----------------------------------------------------------------------------------------------------------------
Deductible BIE..................................................             $30             $20             $50
EBIE allocated..................................................               0              10              10
ETI allocated...................................................               0               0               0
EBII allocated..................................................               0               0               0
----------------------------------------------------------------------------------------------------------------

    (18) Example 18: Facts. A, B, and C own all of the interests in 
partnership PRS. In Year 1, PRS has $150 of ATI, $10 of business 
interest income, and $40 of business interest expense. PRS's ATI 
consists of $200 of gross income and $50 of gross deductions. PRS 
allocates its items comprising ATI ($50) to A, $200 to B, and $0 to C. 
PRS allocates its business interest income $0 to A, $0 to B, and $10 to 
C. PRS allocates its business interest expense $30 to A, $10 to B, and 
$0 to C.
    (i) First, PRS determines its limitation pursuant to Sec.  1.163(j)-
2. PRS's section 163(j) limit is 30 percent of its ATI plus its business 
interest income, or $55 (($150 x 30 percent) + $10). Thus, PRS has $0 of 
excess business interest income, $50 of excess taxable income, $40 of 
deductible business interest expense, and $0 of excess business interest 
expense.
    (ii) Second, PRS determines each partner's allocable share of 
section 163(j) items used in its own section 163(j) calculation.

                                        Table 11 to Paragraph (o)(18)(ii)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Allocable ATI...................................           ($50)            $200              $0            $150
Allocable BII...................................               0               0              10              10
Allocable BIE...................................              30              10               0              40
----------------------------------------------------------------------------------------------------------------

    (iii) Third, PRS compares each partner's allocable business interest 
income to such partner's allocable business interest expense. Because 
A's allocable business interest expense exceeds its allocable business 
interest income by $30 ($30-$0), A has an allocable business interest 
income deficit of $30. Because B's allocable business interest expense 
exceeds its allocable business interest income by $10 ($10-$0), B has an 
allocable business interest income deficit of $10. C does not have any 
allocable business interest income deficit. Thus, the total allocable 
business interest income deficit is $40 ($30 + $10 + $0). A and B do not 
have any allocable business interest income excess. Because C's 
allocable business interest income exceeds its allocable business 
interest expense by $10 ($10-$0), C has an allocable business interest 
income excess of $10. Thus, the total allocable business interest income 
excess is $10 ($0 + $0 + $10).

                                       Table 12 to Paragraph (o)(18)(iii)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Allocable BII...................................              $0              $0             $10             N/A
Allocable BIE...................................              30              10               0             N/A
If allocable BII exceeds allocable BIE, then                   0               0              10             $10
 such amount = Allocable BII excess.............
If allocable BIE exceeds allocable BII, then                  30              10               0              40
 such amount = Allocable BII deficit............
----------------------------------------------------------------------------------------------------------------

    (iv) Fourth, PRS determines each partner's final allocable business 
interest income excess. Because A and B do

[[Page 472]]

not have any allocable business interest income excess, each partner has 
final allocable business interest income excess of $0. PRS determines 
C's final allocable business interest income excess by reducing, but not 
below $0, C's allocable business interest income excess ($10) by the 
product of the total allocable business interest income deficit ($40) 
and the ratio of C's allocable business interest income excess to the 
total allocable business interest income excess ($10/$10). Therefore, 
C's allocable business interest income excess of $10 is reduced by $10 
($40 x 100 percent). As a result, C's allocable business interest income 
excess is $0.

                                        Table 13 to Paragraph (o)(18)(iv)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Allocable BII excess............................              $0              $0             $10             N/A
Less: (Total allocable BII deficit) x (Allocable               0               0              40             N/A
 BII excess/Total allocable BII excess).........
= Final Allocable BII Excess....................               0               0               0             $10
----------------------------------------------------------------------------------------------------------------

    (v) Fifth, PRS determines each partner's remaining business interest 
expense. PRS determines A's remaining business interest expense by 
reducing, but not below $0, A's allocable business interest income 
deficit ($30) by the product of the total allocable business interest 
income excess ($10) and the ratio of A's allocable business interest 
income deficit to the total business interest income deficit ($30/$40). 
Therefore, A's allocable business interest income deficit of $30 is 
reduced by $7.50 ($10 x 75 percent). As a result, A's remaining business 
interest expense is $22.50. PRS determines B's remaining business 
interest expense by reducing, but not below $0, B's allocable business 
interest income deficit ($10) by the product of the total allocable 
business interest income excess ($10) and the ratio of B's allocable 
business interest income deficit to the total business interest income 
deficit ($10/$40). Therefore, B's allocable business interest income 
deficit of $10 is reduced by $2.50 ($10 x 25 percent). As a result, B's 
remaining business interest expense is $7.50. Because C does not have 
any allocable business interest income deficit, C's remaining business 
interest expense is $0.

                                        Table 14 to Paragraph (o)(18)(v)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Allocable BII deficit...........................             $30             $10              $0             $40
Less: (Total allocable BII excess) x (Allocable             7.50            2.50               0             N/A
 BII deficit/Total allocable BII deficit).......
= Remaining BIE.................................           22.50            7.50               0             N/A
----------------------------------------------------------------------------------------------------------------

    (vi) Sixth, PRS determines each partner's final allocable ATI. 
Because A's allocable ATI is comprised of $50 of items of deduction and 
loss and $0 of income and gain, A has negative allocable ATI of $50. A 
is the only partner with negative allocable ATI. Thus, the total 
negative allocable ATI amount is $50. Any partner with a negative 
allocable ATI, or an allocable ATI of $0, has a positive allocable ATI 
of $0. Therefore, A and C have a positive allocable ATI of $0. Because 
B's allocable ATI is comprised of $200 of items of income and gain and 
$0 of deduction and loss, B has positive allocable ATI of $200. Thus, 
the total positive allocable ATI is $200 ($0 + $200 + $0). PRS 
determines B's final allocable ATI by reducing, but not below $0, B's 
positive allocable ATI ($200) by the product of total negative allocable 
ATI ($50) and the ratio of B's positive allocable ATI to the total 
positive allocable ATI ($200/$200). Therefore, B's positive allocable 
ATI is reduced by $50 ($50 x 100 percent). As a result, B's final 
allocable ATI is $150.

[[Page 473]]



                                        Table 15 to Paragraph (o)(18)(vi)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Allocable ATI...................................           ($50)            $200              $0            $150
If deduction and loss items comprising allocable              50               0               0              50
 ATI exceed income and gain items comprising
 allocable ATI, then such excess amount =
 Negative allocable ATI.........................
If income and gain items comprising allocable                  0             200               0             200
 ATI equal or exceed deduction and loss items
 comprising allocable ATI, then such amount =
 Positive allocable ATI.........................
----------------------------------------------------------------------------------------------------------------


                                        Table 16 to Paragraph (o)(18)(vi)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Positive allocable ATI..........................              $0            $200              $0            $200
Less: (Total negative allocable ATI) x (Positive               0              50               0             N/A
 allocable ATI/Total positive allocable ATI)....
= Final allocable ATI...........................               0             150               0             150
----------------------------------------------------------------------------------------------------------------

    (vii) Seventh, PRS compares each partner's ATI capacity (ATIC) 
amount to such partner's remaining business interest expense. A's ATIC 
amount is $0 ($0 x 30 percent), B's ATIC amount is $45 ($150 x 30 
percent), and C's ATIC amount is $0 ($0 x 30 percent). A does not have 
any ATIC excess. Because B's ATIC amount exceeds its remaining business 
interest expense by $37.50 ($45-$7.50), B has an ATIC excess amount of 
$37.50. C does not have any ATIC excess. Thus, the total ATIC excess 
amount is $37.50 ($0 + $37.50 + $0). Because A's remaining business 
interest expense exceeds its ATIC amount by $22.50 ($22.50-$0), A has an 
ATIC deficit of $22.50. B and C do not have any ATIC deficit. Thus, the 
total ATIC deficit is $22.50 ($22.50 + $0 + $0).

                                       Table 17 to Paragraph (o)(18)(vii)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
ATIC (Final allocable ATI x 30 percent).........              $0             $45              $0             N/A
Remaining BIE...................................           22.50            7.50               0             N/A
If ATIC exceeds remaining BIE, then such excess                0           37.50               0          $37.50
 = ATIC excess..................................
If remaining BIE exceeds ATIC, then such excess            22.50               0               0           22.50
 = ATIC deficit.................................
----------------------------------------------------------------------------------------------------------------

    (viii)(A) Eighth, PRS must perform the calculations and make the 
necessary adjustments described under paragraph (f)(2)(viii) of this 
section if, and only if, PRS has--
    (1) An excess business interest expense greater than $0 under 
paragraph (f)(2)(i) of this section;
    (2) A total negative allocable ATI greater than $0 under paragraph 
(f)(2)(vi) of this section; and
    (3) A total ATIC excess amount greater than $0 under paragraph 
(f)(2)(vii) of this section.
    (B) Because PRS does not meet all three requirements in paragraph 
(o)(18)(viii)(A) of this section, PRS does not perform the calculations 
or adjustments described in paragraph (f)(2)(viii) of this section. In 
sum, the correct amounts to be used in paragraphs (o)(18)(ix) and (x) of 
this section are as follows.

                                     Table 18 to Paragraph (o)(18)(viii)(B)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
ATIC excess.....................................              $0          $37.50              $0          $37.50
ATIC deficit....................................           22.50               0               0           22.50
----------------------------------------------------------------------------------------------------------------


[[Page 474]]

    (ix) Ninth, PRS determines each partner's final ATIC excess amount. 
Because B has ATIC excess, PRS must determine B's final ATIC excess 
amount. B's final ATIC excess amount is B's ATIC excess ($37.50), 
reduced, but not below $0, by the product of the total ATIC deficit 
($22.50) and the ratio of B's ATIC excess to the total ATIC excess 
($37.50/$37.50). Therefore, B has $15 of final ATIC excess ($37.50-
($22.50 x 100 percent)).

                                        Table 19 to Paragraph (o)(18)(ix)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
ATIC excess.....................................              $0          $37.50              $0             N/A
Less: (Total ATIC deficit) x (ATIC excess/Total                0           22.50               0             N/A
 ATIC excess)...................................
= Final ATIC excess.............................               0              15               0             $15
----------------------------------------------------------------------------------------------------------------

    (x) Tenth, PRS determines each partner's final ATIC deficit amount. 
Because A has an ATIC deficit, PRS must determine A's final ATIC deficit 
amount. A's final ATIC deficit amount is A's ATIC deficit ($22.50), 
reduced, but not below $0, by the product of the total ATIC excess 
($37.50) and the ratio of A's ATIC deficit to the total ATIC deficit 
($22.50/$22.50). Therefore, A has $0 of final ATIC deficit ($22.50-
($37.50 x 100 percent)).

                                        Table 20 to Paragraph (o)(18)(x)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
ATIC deficit....................................          $22.50              $0              $0             N/A
Less: (Total ATIC excess) x (ATIC deficit/Total            37.50               0               0             N/A
 ATIC deficit)..................................
= Final ATIC deficit............................               0               0               0               0
----------------------------------------------------------------------------------------------------------------

    (xi) Eleventh, PRS allocates deductible business interest expense 
and section 163(j) excess items to the partners. Pursuant to paragraph 
(f)(2)(i) of this section, PRS has $50 of excess taxable income and $40 
of deductible business interest expense. After grossing up each 
partner's final ATIC excess amounts by ten-thirds, excess taxable income 
is allocated dollar for dollar to partners with final ATIC excess 
amounts. Thus, PRS allocates its excess taxable income $50 to B. A 
partner's allocable business interest expense is deductible business 
interest expense to the extent it exceeds such partner's share of excess 
business interest expense. Therefore, A has deductible business interest 
expense of $30 ($30-$0), B has deductible business interest expense of 
$10 ($10-$0), and C has deductible business interest expense of $0 ($0-
$0).

                                        Table 21 to Paragraph (o)(18)(xi)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Deductible BIE..................................             $30             $10              $0             $40
EBIE allocated..................................               0               0               0               0
ETI allocated...................................               0              50               0              50
EBII allocated..................................               0               0               0               0
----------------------------------------------------------------------------------------------------------------

    (19) Example 19: Facts. A, B, and C own all of the interests in 
partnership PRS. In Year 1, PRS has $100 of ATI, $0 of business interest 
income, and $50 of business interest expense. PRS's ATI consists of $200 
of gross income and $100 of gross deductions. PRS allocates its items 
comprising ATI $100 to A, $100 to B, and ($100) to C. PRS allocates its 
business interest expense $0 to A, $25 to B, and $25 to C.
    (i) First, PRS determines its limitation pursuant to Sec.  1.163(j)-
2. PRS's section 163(j) limit is 30 percent of its ATI

[[Page 475]]

plus its business interest income, or $30 ($100 x 30 percent). Thus, PRS 
has $30 of deductible business interest expense and $20 of excess 
business interest expense.
    (ii) Second, PRS determines each partner's allocable share of 
section 163(j) items used in its own section 163(j) calculation.

                                        Table 22 to Paragraph (o)(19)(ii)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Allocable ATI...................................            $100            $100          ($100)            $100
Allocable BII...................................               0               0               0               0
Allocable BIE...................................               0              25              25              50
----------------------------------------------------------------------------------------------------------------

    (iii) Third, PRS compares each partner's allocable business interest 
income to such partner's allocable business interest expense. No partner 
has allocable business interest income. Consequently, each partner's 
allocable business interest income deficit is equal to such partner's 
allocable business interest expense. Thus, A's allocable business 
interest income deficit is $0, B's allocable business interest income 
deficit is $25, and C's allocable business interest income deficit is 
$25. The total allocable business interest income deficit is $50 ($0 + 
$25 + $25). No partner has allocable business interest income excess 
because no partner has allocable business interest income in excess of 
its allocable business interest expense. Thus, the total allocable 
business interest income excess is $0.

                                       Table 23 to Paragraph (o)(19)(iii)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Allocable BII...................................              $0              $0              $0             N/A
Allocable BIE...................................               0              25              25             N/A
If allocable BII exceeds allocable BIE, then                   0               0               0              $0
 such amount = Allocable BII excess.............
If allocable BIE exceeds allocable BII, then                   0              25              25              50
 such amount = Allocable BII deficit............
----------------------------------------------------------------------------------------------------------------

    (iv) Fourth, PRS determines each partner's final allocable business 
interest income excess. Because no partner had any allocable business 
interest income excess, each partner has final allocable business 
interest income excess of $0.
    (v) Fifth, PRS determines each partner's remaining business interest 
expense. Because no partner has any allocable business interest income 
excess, each partner's remaining business interest expense equals its 
allocable business interest income deficit. Thus, A's remaining business 
interest expense is $0, B's remaining business interest expense is $25, 
and C's remaining business interest expense is $25.

                                        Table 24 to Paragraph (o)(19)(v)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Allocable BII deficit...........................              $0             $25             $25             $50
Less: (Total allocable BII excess) x (Allocable                0               0               0             N/A
 BII deficit/Total allocable BII deficit).......
= Remaining BIE.................................               0              25              25             N/A
----------------------------------------------------------------------------------------------------------------

    (vi) Sixth, PRS determines each partner's final allocable ATI. 
Because C's allocable ATI is comprised of $100 of items of deduction and 
loss and $0 of income and gain, C has negative allocable ATI of $100. C 
is the only partner with negative allocable ATI. Thus, the total 
negative allocable ATI amount is $100. Any partner with a negative 
allocable ATI, or an allocable ATI of $0,

[[Page 476]]

has a positive allocable ATI of $0. Therefore, C has a positive 
allocable ATI of $0. Because A's allocable ATI is comprised of $100 of 
items of income and gain and $0 of deduction and loss, A has positive 
allocable ATI of $100. Because B's allocable ATI is comprised of $100 of 
items of income and gain and $0 of deduction and loss, B has positive 
allocable ATI of $100. Thus, the total positive allocable ATI is $200 
($100 + $100 + $0). PRS determines A's final allocable ATI by reducing, 
but not below $0, A's positive allocable ATI ($100) by the product of 
total negative allocable ATI ($100) and the ratio of A's positive 
allocable ATI to the total positive allocable ATI ($100/$200). 
Therefore, A's positive allocable ATI is reduced by $50 ($100 x 50 
percent). As a result, A's final allocable ATI is $50. PRS determines 
B's final allocable ATI by reducing, but not below $0, B's positive 
allocable ATI ($100) by the product of total negative allocable ATI 
($100) and the ratio of B's positive allocable ATI to the total positive 
allocable ATI ($100/$200). Therefore, B's positive allocable ATI is 
reduced by $50 ($100 x 50 percent). As a result, B's final allocable ATI 
is $50. Because C has a positive allocable ATI of $0, C's final 
allocable ATI is $0.

                                        Table 25 to Paragraph (o)(19)(vi)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Allocable ATI...................................            $100            $100          ($100)            $100
If deduction and loss items comprising allocable               0               0             100             100
 ATI exceed income and gain items comprising
 allocable ATI, then such excess amount =
 Negative allocable ATI.........................
If income and gain items comprising allocable                100             100               0             200
 ATI equal or exceed deduction and loss items
 comprising allocable ATI, then such amount =
 Positive allocable ATI.........................
----------------------------------------------------------------------------------------------------------------


                                        Table 26 to Paragraph (o)(19)(vi)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Positive allocable ATI..........................            $100            $100              $0            $200
Less: (Total negative allocable ATI) x (Positive              50              50               0             N/A
 allocable ATI/Total positive allocable ATI)....
= Final allocable ATI...........................              50              50               0             100
----------------------------------------------------------------------------------------------------------------

    (vii) Seventh, PRS compares each partner's ATI capacity (ATIC) 
amount to such partner's remaining business interest expense. A's ATIC 
amount is $15 ($50 x 30 percent), B's ATIC amount is $15 ($50 x 30 
percent), and C's ATIC amount is $0 ($0 x 30 percent). Because A's ATIC 
amount exceeds its remaining business interest expense by $15 ($15-$0), 
A has an ATIC excess of $15. B and C do not have any ATIC excess. Thus, 
the total ATIC excess is $15 ($15 + $0 + $0). A does not have any ATIC 
deficit. Because B's remaining business interest expense exceeds its 
ATIC amount by $10 ($25-$15), B has an ATIC deficit of $10. Because C's 
remaining business interest expense exceeds its ATIC amount by $25 ($25-
$0), C has an ATIC deficit of $25. Thus, the total ATIC deficit is $35 
($0 + $10 + $25).

                                       Table 27 to Paragraph (o)(19)(vii)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
ATIC (Final allocable ATI x 30 percent).........             $15             $15              $0             N/A
Remaining BIE...................................               0              25              25             N/A
If ATIC exceeds remaining BIE, then such excess               15               0               0             $15
 = ATIC excess..................................
If remaining BIE exceeds ATIC, then such excess                0              10              25              35
 = ATIC deficit.................................
----------------------------------------------------------------------------------------------------------------


[[Page 477]]

    (viii)(A) Eighth, PRS must perform the calculations and make the 
necessary adjustments described under paragraph (f)(2)(viii) of this 
section if, and only if, PRS has--
    (1) An excess business interest expense greater than $0 under 
paragraph (f)(2)(i) of this section;
    (2) A total negative allocable ATI greater than $0 under paragraph 
(f)(2)(vi) of this section; and
    (3) A total ATIC excess greater than $0 under paragraph (f)(2)(vii) 
of this section. Because PRS satisfies each of these three requirements, 
PRS must perform the calculations and make the necessary adjustments 
described under paragraphs (f)(2)(viii)(B) and (C) or (D) of this 
section.
    (B) PRS must determine each partner's priority amount and usable 
priority amount. Only partners with an ATIC deficit under paragraph 
(f)(2)(vii) of this section can have a priority amount greater than $0. 
Thus, only partners B and C can have a priority amount greater than $0. 
PRS determines a partner's priority amount as 30 percent of the amount 
by which such partner's allocable positive ATI exceeds its final 
allocable ATI. Therefore, A's priority amount is $0, B's priority amount 
is $15 (($100-$50) x 30 percent), and C's priority amount is $0 (($0-$0) 
x 30 percent). Thus, the total priority amount is $15 ($0 + $15 + $0). 
Next, PRS must determine each partner's usable priority amount. Each 
partner's usable priority amount is the lesser of such partner's 
priority amount or ATIC deficit. Thus, A has a usable priority amount of 
$0, B has a usable priority amount of $10, and C has a usable priority 
amount of $0. As a result, the total usable priority amount is $10 ($0 + 
$10 + $0). Because the total ATIC excess under paragraph (f)(2)(vii) of 
this section ($15) is greater than the total usable priority amount 
($10), PRS must perform the adjustments described in paragraph 
(f)(2)(viii)(C) of this section.

                                     Table 28 to Paragraph (o)(19)(viii)(B)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
(Positive allocable ATI--Final allocable ATI)...              $0             $50              $0             N/A
Multiplied by 30 percent........................             30%             30%             30%             N/A
= Priority amount...............................              $0             $15              $0             $15
----------------------------------------------------------------------------------------------------------------


                                     Table 29 to Paragraph (o)(19)(viii)(B)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Priority amount.................................              $0             $15              $0             N/A
ATIC deficit....................................               0              10              25             N/A
Lesser of priority amount or ATIC deficit =                    0              10               0             $10
 Usable priority amount.........................
----------------------------------------------------------------------------------------------------------------

    (C) For purposes of paragraph (f)(2)(ix) of this section, each 
partner's final ATIC excess is $0. For purposes of paragraph (f)(2)(x) 
of this section, the following terms have the following meanings. Each 
partner's ATIC deficit is such partner's ATIC deficit as determined 
pursuant to paragraph (f)(2)(vii) of this section reduced by such 
partner's usable priority amount. Thus, A's ATIC deficit is $0 ($0-$0), 
B's ATIC deficit is $0 ($10-$10), and C's ATIC deficit is $25 ($25-$0). 
The total ATIC deficit is the total ATIC deficit determined pursuant to 
paragraph (f)(2)(vii) ($35) reduced by the total usable priority amount 
($10). Thus, the total ATIC deficit is $25 ($35-$10). The total ATIC 
excess is the total ATIC excess determined pursuant to paragraph 
(f)(2)(vii) of this section ($15) reduced by the total usable priority 
amount ($10). Thus, the total ATIC excess is $5 ($15-$5).

                                     Table 30 to Paragraph (o)(19)(viii)(C)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
ATIC deficit....................................              $0             $10             $25             N/A

[[Page 478]]

 
Less: Usable priority amount....................               0              10               0             N/A
= ATIC deficit for purposes of paragraph                       0               0              25             $25
 (f)(2)(x) of this section......................
----------------------------------------------------------------------------------------------------------------

    (D)(1) In light of the fact that the total ATIC excess was greater 
than the total usable priority amount under paragraph (f)(2)(viii)(B) of 
this section, paragraph (f)(2)(viii)(D) of this section does not apply.
    (2) In sum, the correct amounts to be used in paragraphs (o)(19)(ix) 
and (x) of this section are as follows.

                                    Table 31 to Paragraph (o)(19)(viii)(D)(2)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
ATIC excess.....................................              $5              $0              $0              $5
ATIC deficit....................................               0               0              25              25
----------------------------------------------------------------------------------------------------------------

    (ix) Ninth, PRS determines each partner's final ATIC excess amount. 
Pursuant to paragraph (f)(2)(viii)(C) of this section, each partner's 
final ATIC excess amount is $0.
    (x) Tenth, PRS determines each partner's final ATIC deficit amount. 
Because C has an ATIC deficit, PRS must determine C's final ATIC deficit 
amount. C's final ATIC deficit amount is C's ATIC deficit ($25), 
reduced, but not below $0, by the product of the total ATIC excess ($5) 
and the ratio of C's ATIC deficit to the total ATIC deficit ($25/$25). 
Therefore, C has $20 of final ATIC deficit ($25-($5 x 100 percent)).

                                        Table 32 to Paragraph (o)(19)(x)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
ATIC deficit....................................              $0              $0             $25             N/A
Less: (Total ATIC excess) x (ATIC deficit/Total                0               0               5             N/A
 ATIC deficit)..................................
= Final ATIC deficit............................               0               0              20             $20
----------------------------------------------------------------------------------------------------------------

    (xi) Eleventh, PRS allocates deductible business interest expense 
and section 163(j) excess items to the partners. Pursuant to paragraph 
(f)(2)(i) of this section, PRS has $20 of excess business interest 
expense. PRS allocates the excess business interest expense dollar for 
dollar to the partners with final ATIC deficits. Thus, PRS allocates its 
excess business interest expense $20 to C. A partner's allocable 
business interest expense is deductible business interest expense to the 
extent it exceeds such partner's share of excess business interest 
expense. Therefore, A has deductible business interest expense of $0 
($0-$0), B has deductible business interest expense of $25 ($25-$0), and 
C has deductible business interest expense of $5 ($25-$20).

                                        Table 33 to Paragraph (o)(19)(xi)
----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Deductible BIE..................................              $0             $25              $5             $30
EBIE allocated..................................               0               0              20              20
ETI allocated...................................               0               0               0               0
EBII allocated..................................               0               0               0               0
----------------------------------------------------------------------------------------------------------------


[[Page 479]]

    (20) Example 20: Facts. A, B, C, and D own all of the interests in 
partnership PRS. In Year 1, PRS has $200 of ATI, $0 of business interest 
income, and $140 of business interest expense. PRS's ATI consists of 
$600 of gross income and $400 of gross deductions. PRS allocates its 
items comprising ATI $100 to A, $100 to B, $400 to C, and ($400) to D. 
PRS allocates its business interest expense $0 to A, $40 to B, $60 to C, 
and $40 to D.
    (i) First, PRS determines its limitation pursuant to Sec.  1.163(j)-
2. PRS's section 163(j) limit is 30 percent of its ATI plus its business 
interest income, or $60 ($200 x 30 percent). Thus, PRS has $60 of 
deductible business interest expense and $80 of excess business interest 
expense.
    (ii) Second, PRS determines each partner's allocable share of 
section 163(j) items used in its own section 163(j) calculation.

                                        Table 34 to Paragraph (o)(20)(ii)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Allocable ATI...................            $100            $100            $400          ($400)            $200
Allocable BII...................               0               0               0               0               0
Allocable BIE...................               0              40              60              40             140
----------------------------------------------------------------------------------------------------------------

    (iii) Third, PRS compares each partner's allocable business interest 
income to such partner's allocable business interest expense. No partner 
has allocable business interest income. Consequently, each partner's 
allocable business interest income deficit is equal to such partner's 
allocable business interest expense. Thus, A's allocable business 
interest income deficit is $0, B's allocable business interest income 
deficit is $40, C's allocable business interest income deficit is $60, 
and D's allocable business interest income deficit is $40. The total 
allocable business interest income deficit is $140 ($0 + $40 + $60 + 
$40). No partner has allocable business interest income excess because 
no partner has allocable business interest income in excess of its 
allocable business interest expense. Thus, the total allocable business 
interest income excess is $0.

                                       Table 35 to Paragraph (o)(20)(iii)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Allocable BII...................              $0              $0              $0              $0             N/A
Allocable BIE...................               0              40              60              40             N/A
If allocable BII exceeds                       0               0               0               0              $0
 allocable BIE, then such amount
 = Allocable BII excess.........
If allocable BIE exceeds                       0              40              60              40             140
 allocable BII, then such amount
 = Allocable BII deficit........
----------------------------------------------------------------------------------------------------------------

    (iv) Fourth, PRS determines each partner's final allocable business 
interest income excess. Because no partner has any allocable business 
interest income excess, each partner has final allocable business 
interest income excess of $0.
    (v) Fifth, PRS determines each partner's remaining business interest 
expense. Because no partner has any allocable business interest income 
excess, each partner's remaining business interest expense equals its 
allocable business interest income deficit. Thus, A's remaining business 
interest expense is $0, B's remaining business interest expense is $40, 
C's remaining business interest expense is $60, and D's remaining 
business interest expense is $40.

                                        Table 36 to Paragraph (o)(20)(v)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Allocable BII deficit...........              $0             $40             $60             $40            $140

[[Page 480]]

 
Less: (Total allocable BII                     0               0               0               0             N/A
 excess) x (Allocable BII
 deficit/Total allocable BII
 deficit).......................
= Remaining BIE.................               0              40              60              40             N/A
----------------------------------------------------------------------------------------------------------------

    (vi) Sixth, PRS determines each partner's final allocable ATI. 
Because D's allocable ATI is comprised of $400 of items of deduction and 
loss and $0 of income and gain, D has negative allocable ATI of $400. D 
is the only partner with negative allocable ATI. Thus, the total 
negative allocable ATI amount is $400. Any partner with a negative 
allocable ATI, or an allocable ATI of $0, has a positive allocable ATI 
of $0. Therefore, D has a positive allocable ATI of $0. PRS determines 
A's final allocable ATI by reducing, but not below $0, A's positive 
allocable ATI ($100) by the product of total negative allocable ATI 
($400) and the ratio of A's positive allocable ATI to the total positive 
allocable ATI ($100/$600). Therefore, A's positive allocable ATI is 
reduced by $66.67 ($400 x 16.67 percent). As a result, A's final 
allocable ATI is $33.33. PRS determines B's final allocable ATI by 
reducing, but not below $0, B's positive allocable ATI ($100) by the 
product of total negative allocable ATI ($400) and the ratio of B's 
positive allocable ATI to the total positive allocable ATI ($100/$600). 
Therefore, B's positive allocable ATI is reduced by $66.67 ($400 x 16.67 
percent). As a result, B's final allocable ATI is $33.33. PRS determines 
C's final allocable ATI by reducing, but not below $0, C's positive 
allocable ATI ($400) by the product of total negative allocable ATI 
($400) and the ratio of C's positive allocable ATI to the total positive 
allocable ATI ($400/$600). Therefore, C's positive allocable ATI is 
reduced by $266.67 ($400 x 66.67 percent). As a result, C's final 
allocable ATI is $133.33. Because D has a positive allocable ATI of $0, 
D's final allocable ATI is $0.

                                        Table 37 to Paragraph (o)(20)(vi)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Allocable ATI...................            $100            $100            $400          ($400)            $200
If deduction and loss items                    0               0               0             400             400
 comprising allocable ATI exceed
 income and gain items
 comprising allocable ATI, then
 such excess amount = Negative
 allocable ATI..................
If income and gain items                     100             100             400               0             600
 comprising allocable ATI equal
 or exceed deduction and loss
 items comprising allocable ATI,
 then such amount = Positive
 allocable ATI..................
----------------------------------------------------------------------------------------------------------------


                                        Table 38 to Paragraph (o)(20)(vi)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Positive allocable ATI..........            $100            $100            $400              $0            $600
Less: (Total negative allocable            66.67           66.67          266.67               0             N/A
 ATI) x (Positive allocable ATI/
 Total positive allocable ATI)..
= Final allocable ATI...........           33.33           33.33          133.33               0             200
----------------------------------------------------------------------------------------------------------------

    (vii) Seventh, PRS compares each partner's ATI capacity (ATIC) 
amount to such partner's remaining business interest expense. A's ATIC 
amount is $10 ($33.33 x 30 percent), B's ATIC amount is $10 ($33.33 x 30 
percent), C's ATIC amount is $40 ($133.33 x 30 percent), and D's ATIC 
amount is $0 ($0 x 30 percent). Because A's ATIC amount exceeds its 
remaining business interest

[[Page 481]]

expense by $10 ($10-$0), A has an ATIC excess of $10. B, C, and D do not 
have any ATIC excess. Thus, the total ATIC excess is $10 ($10 + $0 + $0 
+ $0). A does not have any ATIC deficit. Because B's remaining business 
interest expense exceeds its ATIC amount by $30 ($40-$10), B has an ATIC 
deficit of $30. Because C's remaining business interest expense exceeds 
its ATIC amount by $20 ($60-$40), C has an ATIC deficit of $20. Because 
D's remaining business interest expense exceeds its ATIC amount by $40 
($40-$0), D has an ATIC deficit of $40. Thus, the total ATIC deficit is 
$90 ($0 + $30 + $20 + $40).

                                       Table 39 to Paragraph (o)(20)(vii)
----------------------------------------------------------------------------------------------------------------
                _                        A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
ATIC (Final allocable ATI x 30               $10             $10             $40              $0             N/A
 percent).......................
Remaining BIE...................               0              40              60              40             N/A
If ATIC exceeds remaining BIE,                10               0               0               0             $10
 then such excess = ATIC excess.
If remaining BIE exceeds ATIC,                 0              30              20              40              90
 then such excess = ATIC deficit
----------------------------------------------------------------------------------------------------------------

    (viii)(A) Eighth, PRS must perform the calculations and make the 
necessary adjustments described under paragraph (f)(2)(viii) of this 
section if, and only if, PRS has (1) an excess business interest expense 
greater than $0 under paragraph (f)(2)(i) of this section, (2) a total 
negative allocable ATI greater than $0 under paragraph (f)(2)(vi) of 
this section, and (3) a total ATIC excess amount greater than $0 under 
paragraph (f)(2)(vii) of this section. Because PRS satisfies each of 
these three requirements, PRS must perform the calculations and make the 
necessary adjustments described under paragraphs (f)(2)(viii)(B) and (C) 
or paragraph (f)(2)(viii)(D) of this section.
    (B) PRS must determine each partner's priority amount and usable 
priority amount. Only partners with an ATIC deficit under paragraph 
(f)(2)(vii) of this section can have a priority amount greater than $0. 
Thus, only partners B, C, and D can have a priority amount greater than 
$0. PRS determines a partner's priority amount as 30 percent of the 
amount by which such partner's allocable positive ATI exceeds its final 
allocable ATI. Therefore, B's priority amount is $20 (($100-$33.33) x 30 
percent), C's priority amount is $80 (($400-$133.33) x 30 percent), and 
D's priority amount is $0 (($0-$0) x 30 percent). Thus, the total 
priority amount is $100 ($0 + $20 + $80 + $0). Next, PRS must determine 
each partner's usable priority amount. Each partner's usable priority 
amount is the lesser of such partner's priority amount or ATIC deficit. 
Thus, A has a usable priority amount of $0, B has a usable priority 
amount of $20, C has a usable priority amount of $20, and D has a usable 
priority amount of $0. As a result, the total usable priority amount is 
$40 ($0 + $20 + $20 + $0). Because the total usable priority amount 
($40) is greater than the total ATIC excess under paragraph (f)(2)(vii) 
of this section ($10), PRS must perform the adjustments described in 
paragraph (f)(2)(viii)(D) of this section.

                                     Table 40 to Paragraph (o)(20)(viii)(B)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
(Positive allocable ATI--Final                $0          $66.67         $266.67              $0             N/A
 allocable ATI).................
Multiplied by 30 percent........             30%             30%             30%             30%             N/A
= Priority amount...............               0              20              80               0            $100
----------------------------------------------------------------------------------------------------------------


                                     Table 41 to Paragraph (o)(20)(viii)(B)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Priority amount.................              $0             $20             $80              $0             N/A
ATIC deficit....................               0              30              20              40             N/A

[[Page 482]]

 
Lesser of priority amount or                   0              20              20               0             $40
 ATIC deficit = Usable priority
 amount.........................
----------------------------------------------------------------------------------------------------------------

    (C) In light of the fact that the total usable priority amount is 
greater than the total ATIC excess under paragraph (f)(2)(viii)(B) of 
this section, paragraph (f)(2)(viii)(C) of this section does not apply.
    (D)(1) Because B and C are the only partners with priority amounts 
greater than $0, B and C are priority partners, while A and D are non-
priority partners. For purposes of paragraph (f)(2)(ix) of this section, 
each partner's final ATIC excess amount is $0. For purposes of paragraph 
(f)(2)(x) of this section, each non-priority partner's final ATIC 
deficit amount is such partner's ATIC deficit determined pursuant to 
paragraph (f)(2)(vii) of this section. Therefore, A has a final ATIC 
deficit of $0 and D has a final ATIC deficit of $40. Additionally, for 
purposes of paragraph (f)(2)(x) of this section, PRS must determine each 
priority partner's step eight excess share. A priority partner's step 
eight excess share is the product of the total ATIC excess and the ratio 
of the partner's priority amount to the total priority amount. Thus, B's 
step eight excess share is $2 ($10 x ($20/$100)) and C's step eight 
excess share is $8 ($10 x ($80/$100)). To the extent a priority 
partner's step eight excess share exceeds its ATIC deficit, the excess 
will be the partner's ATIC excess for purposes of paragraph (f)(2)(x) of 
this section. Thus, B and C each have an ATIC excess of $0, resulting in 
a total ATIC excess is $0. To the extent a priority partner's ATIC 
deficit exceeds its step eight excess share, the excess will be the 
partner's ATIC deficit for purposes of paragraph (f)(2)(x) of this 
section. Because B's ATIC deficit ($30) exceeds its step eight excess 
share ($2), B's ATIC deficit for purposes of paragraph (f)(2)(x) of this 
section is $28 ($30-$2). Because C's ATIC deficit ($20) exceeds its step 
eight excess share ($8), C's ATIC deficit for purposes of paragraph 
(f)(2)(x) of this section is $12 ($20-$8). Thus, the total ATIC deficit 
is $40 ($28 + $12).

                                    Table 42 to Paragraph (o)(20)(viii)(D)(1)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Non-priority partners ATIC                    $0             N/A             N/A             $40             N/A
 deficit in paragraph
 (f)(2)(vii) = Final ATIC
 deficit for purposes of
 paragraph (f)(2)(x) of this
 section........................
----------------------------------------------------------------------------------------------------------------


                                    Table 43 to Paragraph (o)(20)(viii)(D)(1)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Priority partners step eight                 N/A              $2              $8             N/A             N/A
 excess share = (Total ATIC
 excess) x (Priority/Total
 priority)......................
ATIC deficit....................             N/A              30              20             N/A             N/A
If step eight excess share                   N/A               0               0             N/A               0
 exceeds ATIC deficit, then such
 excess = ATIC excess for
 purposes of paragraph (f)(2)(x)
 of this section................
If ATIC deficit exceeds step                 N/A              28              12             N/A              40
 eight excess share, then such
 excess = ATIC deficit for
 purposes of paragraph (f)(2)(x)
 of this section................
----------------------------------------------------------------------------------------------------------------


[[Page 483]]

    (2) In sum, the correct amounts to be used in paragraphs (o)(20)(ix) 
and (x) of this section are as follows.

                                    Table 44 to Paragraph (o)(20)(viii)(D)(2)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
ATIC excess.....................              $0              $0              $0              $0              $0
ATIC deficit....................               0              28              12               0              40
Non-priority partner final ATIC                0               0               0               0             N/A
 deficit........................
----------------------------------------------------------------------------------------------------------------

    (ix) Ninth, PRS determines each partner's final ATIC excess amount. 
Pursuant to paragraph (f)(2)(viii)(D) of this section, each priority and 
non-priority partner's final ATIC excess amount is $0.
    (x) Tenth, PRS determines each partner's final ATIC deficit amount. 
Because B has an ATIC deficit, PRS must determine B's final ATIC deficit 
amount. B's final ATIC deficit amount is B's ATIC deficit ($28), 
reduced, but not below $0, by the product of the total ATIC excess ($0) 
and the ratio of B's ATIC deficit to the total ATIC deficit ($28/$40). 
Therefore, B has $28 of final ATIC deficit ($28-($0 x 70 percent)). 
Because C has an ATIC deficit, PRS must determine C's final ATIC deficit 
amount. C's final ATIC deficit amount is C's ATIC deficit ($12), 
reduced, but not below $0, by the product of the total ATIC excess ($0) 
and the ratio of C's ATIC deficit to the total ATIC deficit ($12/$40). 
Therefore, C has $12 of final ATIC deficit ($12-($0 x 30 percent)). 
Pursuant to paragraph (f)(2)(viii)(D) of this section, D's final ATIC 
deficit amount is $40.

                                        Table 45 to Paragraph (o)(20)(x)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
ATIC deficit....................             N/A             $28             $12             N/A             N/A
Less: (Total ATIC excess) x                  N/A               0               0             N/A             N/A
 (ATIC deficit/Total ATIC
 deficit).......................
= Final ATIC deficit............              $0              28              12             $40             $80
----------------------------------------------------------------------------------------------------------------

    (xi) Eleventh, PRS allocates deductible business interest expense 
and section 163(j) excess items to the partners. Pursuant to paragraph 
(f)(2)(i) of this section, PRS has $80 of excess business interest 
expense. PRS allocates the excess business interest expense dollar for 
dollar to the partners with final ATIC deficits. Thus, PRS allocates its 
excess business interest expense $28 to B, $12 to C, and $40 to D. A 
partner's allocable business interest expense is deductible business 
interest expense to the extent it exceeds such partner's share of excess 
business interest expense. Therefore, A has deductible business interest 
expense of $0 ($0-$0), B has deductible business interest expense of $12 
($40-$28), C has deductible business interest expense of $48 ($60-$12), 
and D has deductible business interest expense of $0 ($40-$40).

                                        Table 46 to Paragraph (o)(20)(xi)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Deductible BIE..................              $0             $12             $48              $0             $60
EBIE allocated..................               0              28              12              40              80
ETI allocated...................               0               0               0               0               0
EBII allocated..................               0               0               0               0               0
----------------------------------------------------------------------------------------------------------------

    (21) Example 21: Facts. A, B, C, and D own all of the interests in 
partnership PRS. In Year 1, PRS has $200 of ATI, $0 of business interest 
income, and $150 of

[[Page 484]]

business interest expense. PRS's ATI consists of $500 of gross income 
and $300 of gross deductions. PRS allocates its items comprising ATI $50 
to A, $50 to B, $400 to C, and ($300) to D. PRS allocates its business 
interest expense $0 to A, $50 to B, $50 to C, and $50 to D.
    (i) First, PRS determines its limitation pursuant to Sec.  1.163(j)-
2. PRS's section 163(j) limit is 30 percent of its ATI plus its business 
interest income, or $60 ($200 x 30 percent). Thus, PRS has $60 of 
deductible business interest expense, and $90 of excess business 
interest expense.
    (ii) Second, PRS determines each partner's allocable share of 
section 163(j) items used in its own section 163(j) calculation.

                                        Table 47 to Paragraph (o)(21)(ii)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Allocable ATI...................             $50             $50            $400          ($300)            $200
Allocable BII...................               0               0               0               0               0
Allocable BIE...................               0              50              50              50             150
----------------------------------------------------------------------------------------------------------------

    (iii) Third, PRS compares each partner's allocable business interest 
income to such partner's allocable business interest expense. No partner 
has allocable business interest income. Consequently, each partner's 
allocable business interest income deficit is equal to such partner's 
allocable business interest expense. Thus, A's allocable business 
interest income deficit is $0, B's allocable business interest income 
deficit is $50, C's allocable business interest income deficit is $50, 
and D's allocable business interest income deficit is $50. The total 
allocable business interest income deficit is $150 ($0 + $50 + $50 + 
$50). No partner has allocable business interest income excess because 
no partner has allocable business interest income in excess of its 
allocable business interest expense. Thus, the total allocable business 
interest income excess is $0.

                                       Table 48 to Paragraph (o)(21)(iii)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Allocable BII...................              $0              $0              $0              $0             N/A
Allocable BIE...................               0              50              50              50             N/A
If allocable BII exceeds                       0               0               0               0               0
 allocable BIE, then such amount
 = Allocable BII excess.........
If allocable BIE exceeds                       0              50              50              50             150
 allocable BII, then such amount
 = Allocable BII deficit........
----------------------------------------------------------------------------------------------------------------

    (iv) Fourth, PRS determines each partner's final allocable business 
interest income excess. Because no partner has any allocable business 
interest income excess, each partner has final allocable business 
interest income excess of $0.
    (v) Fifth, PRS determines each partner's remaining business interest 
expense. Because no partner has any allocable business interest income 
excess, each partner's remaining business interest expense equals its 
allocable business interest income deficit. Thus, A's remaining business 
interest expense is $0, B's remaining business interest expense is $50, 
C's remaining business interest expense is $50, and D's remaining 
business interest expense is $50.

                                        Table 49 to Paragraph (o)(21)(v)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Allocable BII deficit...........              $0             $50             $50             $50            $150
Less: (Total allocable BII                     0               0               0               0             N/A
 excess) x (Allocable BII
 deficit/Total allocable BII
 deficit).......................

[[Page 485]]

 
= Remaining BIE.................               0              50              50              50             N/A
----------------------------------------------------------------------------------------------------------------

    (vi) Sixth, PRS determines each partner's final allocable ATI. 
Because D's allocable ATI is comprised of $300 of items of deduction and 
loss and $0 of income and gain, D has negative allocable ATI of $300. D 
is the only partner with negative allocable ATI. Thus, the total 
negative allocable ATI amount is $300. Any partner with a negative 
allocable ATI, or an allocable ATI of $0, has a positive allocable ATI 
of $0. Therefore, D has a positive allocable ATI of $0. PRS determines 
A's final allocable ATI by reducing, but not below $0, A's positive 
allocable ATI ($50) by the product of total negative allocable ATI 
($300) and the ratio of A's positive allocable ATI to the total positive 
allocable ATI ($50/$500). Therefore, A's positive allocable ATI is 
reduced by $30 ($300 x 10 percent). As a result, A's final allocable ATI 
is $20. PRS determines B's final allocable ATI by reducing, but not 
below $0, B's positive allocable ATI ($50) by the product of total 
negative allocable ATI ($300) and the ratio of B's positive allocable 
ATI to the total positive allocable ATI ($50/$500). Therefore, B's 
positive allocable ATI is reduced by $30 ($300 x 10 percent). As a 
result, B's final allocable ATI is $20. PRS determines C's final 
allocable ATI by reducing, but not below $0, C's positive allocable ATI 
($400) by the product of total negative allocable ATI ($300) and the 
ratio of C's positive allocable ATI to the total positive allocable ATI 
($400/$500). Therefore, C's positive allocable ATI is reduced by $240 
($300 x 80 percent). As a result, C's final allocable ATI is $160. 
Because D has a positive allocable ATI of $0, D's final allocable ATI is 
$0.

                                        Table 50 to Paragraph (o)(21)(vi)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Allocable ATI...................             $50             $50            $400          ($300)            $200
If deduction and loss items                    0               0               0             300             300
 comprising allocable ATI exceed
 income and gain items
 comprising allocable ATI, then
 such excess amount = Negative
 allocable ATI..................
If income and gain items                      50              50             400               0             500
 comprising allocable ATI equal
 or exceed deduction and loss
 items comprising allocable ATI,
 then such amount = Positive
 allocable ATI..................
----------------------------------------------------------------------------------------------------------------


                                        Table 51 to Paragraph (o)(21)(vi)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Positive allocable ATI..........             $50             $50            $400              $0            $500
Less: (Total negative allocable               30              30             240               0             N/A
 ATI) x (Positive allocable ATI/
 Total positive allocable ATI)..
= Final allocable ATI...........              20              20             160               0             200
----------------------------------------------------------------------------------------------------------------

    (vii) Seventh, PRS compares each partner's ATI capacity (ATIC) 
amount to such partner's remaining business interest expense. A's ATIC 
amount is $6 ($20 x 30 percent), B's ATIC amount is $6 ($20 x 30 
percent), C's ATIC amount is $48 ($160 x 30 percent), and D's ATIC 
amount is $0 ($0 x 30 percent). Because A's ATIC amount exceeds its 
remaining business interest expense by $6 ($6-$0), A has an ATIC excess 
of $6. B, C, and D do not have any ATIC excess. Thus, the total ATIC 
excess amount is $6 ($6 + $0 + $0 + $0). A does

[[Page 486]]

not have any ATIC deficit. Because B's remaining business interest 
expense exceeds its ATIC amount by $44 ($50-$6), B has an ATIC deficit 
of $44. Because C's remaining business interest expense exceeds its ATIC 
amount by $2 ($50-$48), C has an ATIC deficit of $2. Because D's 
remaining business interest expense exceeds its ATIC amount by $50 ($50-
$0), D has an ATIC deficit of $50. Thus, the total ATIC deficit is $96 
($0 + $44 + $2 + $50).

                                       Table 52 to Paragraph (o)(21)(vii)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
ATIC (Final allocable ATI x 30                $6              $6             $48              $0             N/A
 percent).......................
Remaining BIE...................               0              50              50              50             N/A
If ATIC exceeds remaining BIE,                 6               0               0               0              $6
 then such excess = ATIC excess.
If remaining BIE exceeds ATIC,                 0              44               2              50              96
 then such excess = ATIC deficit
----------------------------------------------------------------------------------------------------------------

    (viii)(A) Eighth, PRS must perform the calculations and make the 
necessary adjustments described under paragraph (f)(2)(viii) of this 
section if, and only if, PRS has--
    (1) An excess business interest expense greater than $0 under 
paragraph (f)(2)(i) of this section;
    (2) A total negative allocable ATI greater than $0 under paragraph 
(f)(2)(vi) of this section; and
    (3) A total ATIC excess amount greater than $0 under paragraph 
(f)(2)(vii) of this section. Because PRS satisfies each of these three 
requirements, PRS must perform the calculations and make the necessary 
adjustments described under paragraph (f)(2)(viii) of this section.
    (B) PRS must determine each partner's priority amount and usable 
priority amount. Only partners with an ATIC deficit under paragraph 
(f)(2)(vii) of this section of this section can have a priority amount 
greater than $0. Thus, only partners B, C, and D can have a priority 
amount greater than $0. PRS determines a partner's priority amount as 30 
percent of the amount by which such partner's allocable positive ATI 
exceeds its final allocable ATI. Therefore, B's priority amount is $9 
(($50-$20) x 30 percent), C's priority amount is $72 (($400-$160) x 30 
percent), and D's priority amount is $0 (($0-$0) x 30 percent). Thus, 
the total priority amount is $81 ($0 + $9 + $72 + $0). Next, PRS must 
determine each partner's usable priority amount. Each partner's usable 
priority amount is the lesser of such partner's priority amount or ATIC 
deficit. Thus, B has a usable priority amount of $9, C has a usable 
priority amount of $2, and D has a usable priority amount of $0. As a 
result, the total usable priority amount is $11 ($0 + $9 + $2 + $0). 
Because the total usable priority amount ($11) is greater than the total 
ATIC excess ($6) under paragraph (f)(2)(vii) of this section, PRS must 
perform the adjustments described in paragraph (f)(2)(viii)(D) of this 
section.

                                     Table 53 to Paragraph (o)(21)(viii)(B)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
(Positive allocable ATI-Final                 $0             $30            $240              $0             N/A
 allocable ATI).................
Multiplied by 30 percent........             30%             30%             30%             30%             N/A
= Priority amount...............              $0              $9             $72              $0             $81
----------------------------------------------------------------------------------------------------------------


                                     Table 54 to Paragraph (o)(21)(viii)(B)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Priority amount.................              $0              $9             $72              $0             N/A
ATIC deficit....................               0              44               2              50             N/A
Lesser of priority amount or                   0               9               2               0             $11
 ATIC deficit = Usable priority
 amount.........................
----------------------------------------------------------------------------------------------------------------


[[Page 487]]

    (C) In light of the fact that the total usable priority amount is 
greater than the total ATIC excess under paragraph (f)(2)(viii)(B) of 
this section, paragraph (f)(2)(viii)(C) of this section does not apply.
    (D)(1) Because B and C are the only partners with priority amounts 
greater than $0, B and C are priority partners, while A and D are non-
priority partners. For purposes of paragraph (f)(2)(ix) of this section, 
each partner's final ATIC excess amount is $0. For purposes of paragraph 
(f)(2)(x) of this section, each non-priority partner's final ATIC 
deficit amount is such partner's ATIC deficit determined pursuant to 
paragraph (f)(2)(vii) of this section. Therefore, A has a final ATIC 
deficit of $0 and D has a final ATIC deficit of $50. Additionally, for 
purposes of paragraph (f)(2)(x) of this section, PRS must determine each 
priority partner's step eight excess share. A priority partner's step 
eight excess share is the product of the total ATIC excess and the ratio 
of the partner's priority amount to the total priority amount. Thus, B's 
step eight excess share is $0.67 ($6 x ($9/$81)) and C's step eight 
excess share is $5.33 ($6 x ($72/$81)). To the extent a priority 
partner's step eight excess share exceeds its ATIC deficit, the excess 
will be the partner's ATIC excess for purposes of paragraph (f)(2)(x) of 
this section. B's step eight excess share does not exceed its ATIC 
deficit. Because C's step eight excess share ($5.33) exceeds its ATIC 
deficit ($2), C's ATIC excess for purposes of paragraph (f)(2)(x) of 
this section is $3.33 ($5.33-$2). Thus, the total ATIC excess for 
purposes of paragraph (f)(2)(x) of this section is $3.33 ($0 + $3.33). 
To the extent a priority partner's ATIC deficit exceeds its step eight 
excess share, the excess will be the partner's ATIC deficit for purposes 
of paragraph (f)(2)(x) of this section. Because B's ATIC deficit ($44) 
exceeds its step eight excess share ($0.67), B's ATIC deficit for 
purposes of paragraph (f)(2)(x) of this section is $43.33 ($44-$0.67). 
C's ATIC deficit does not exceed its step eight excess share. Thus, the 
total ATIC deficit for purposes of paragraph (f)(2)(x) of this section 
is $43.33 ($43.33 + $0).

                                    Table 55 to Paragraph (o)(21)(viii)(D)(1)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Non-priority partners ATIC                    $0             N/A             N/A             $50             N/A
 deficit in paragraph
 (f)(2)(vii) = Final ATIC
 deficit for purposes of
 paragraph (f)(2)(x) of this
 section........................
----------------------------------------------------------------------------------------------------------------


                                    Table 56 to Paragraph (o)(21)(viii)(D)(1)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Priority partners step eight                 N/A           $0.67           $5.33             N/A             N/A
 excess share = (Total ATIC
 excess) x (Priority/Total
 priority)......................
ATIC deficit....................             N/A              44               2             N/A             N/A
If step eight excess share                   N/A               0            3.33             N/A           $3.33
 exceeds ATIC deficit, then such
 excess = ATIC excess for
 purposes of paragraph (f)(2)(x)
 of this section................
If ATIC deficit exceeds step                 N/A           43.33               0             N/A           43.33
 eight excess share, then such
 excess = ATIC deficit for
 purposes of paragraph (f)(2)(x)
 of this section................
----------------------------------------------------------------------------------------------------------------

    (2) In sum, the correct amounts to be used in paragraphs (o)(21)(ix) 
and (x) of this section are as follows.

[[Page 488]]



                                    Table 57 to Paragraph (o)(21)(viii)(D)(2)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
ATIC excess.....................              $0              $0           $3.33              $0           $3.33
ATIC deficit....................               0           43.33               0               0           43.33
Non-priority partner final ATIC                0               0               0              50             N/A
 deficit........................
----------------------------------------------------------------------------------------------------------------

    (ix) Ninth, PRS determines each partner's final ATIC excess amount. 
Pursuant to paragraph (f)(2)(viii)(D) of this section, each priority and 
non-priority partner's final ATIC excess amount is $0.
    (x) Tenth, PRS determines each partner's final ATIC deficit amount. 
Because B has an ATIC deficit, PRS must determine B's final ATIC deficit 
amount. B's final ATIC deficit amount is B's ATIC deficit ($43.33), 
reduced, but not below $0, by the product of the total ATIC excess 
($3.33) and the ratio of B's ATIC deficit to the total ATIC deficit 
($43.33/$43.33). Therefore, B has $40 of final ATIC deficit ($43.33-
($3.33 x 100 percent)). Pursuant to paragraph (f)(2)(viii)(D) of this 
section, D's final ATIC deficit amount is $40.

                                        Table 58 to Paragraph (o)(21)(x)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
ATIC deficit....................              $0          $43.33              $0             N/A             N/A
Less: (Total ATIC excess) x                    0            3.33               0             N/A             N/A
 (ATIC deficit/Total ATIC
 deficit).......................
= Final ATIC deficit............               0              40               0             $50             $90
----------------------------------------------------------------------------------------------------------------

    (xi) Eleventh, PRS allocates deductible business interest expense 
and section 163(j) excess items to the partners. Pursuant to paragraph 
(f)(2)(i) of this section, PRS has $90 of excess business interest 
expense. PRS allocates the excess business interest expense dollar for 
dollar to the partners with final ATIC deficits. Thus, PRS allocates its 
excess business interest expense $40 to B and $50 to D. A partner's 
allocable business interest expense is deductible business interest 
expense to the extent it exceeds such partner's share of excess business 
interest expense. Therefore, A has deductible business interest expense 
of $0 ($0-$0), B has deductible business interest expense of $10 ($50-
$40), C has deductible business interest expense of $50 ($50-$0), and D 
has deductible business interest expense of $0 ($50-$50).

                                        Table 59 to Paragraph (o)(21)(xi)
----------------------------------------------------------------------------------------------------------------
                                         A               B               C               D             Total
----------------------------------------------------------------------------------------------------------------
Deductible BIE..................              $0             $10             $50              $0             $60
EBIE allocated..................               0              40               0              50              90
ETI allocated...................               0               0               0               0               0
EBII allocated..................               0               0               0               0               0
----------------------------------------------------------------------------------------------------------------

    (22) Example 22--(i) Facts. A and B are equal shareholders in X, a 
subchapter S corporation. In Year 1, X has $100 of ATI and $40 of 
business interest expense. A has $100 of ATI and $20 of business 
interest expense from its sole proprietorship. B has $0 of ATI and $20 
of business interest expense from its sole proprietorship.
    (ii) S corporation-level. In Year 1, X's section 163(j) limit is 30 
percent of its ATI, or $30 ($100 x 30 percent). Thus, X has $30 of 
deductible business interest expense and $10 of disallowed business 
interest expense. Such $30 of deductible business interest expense is 
includable in X's nonseparately stated income or loss, and is not 
subject to further limitation under section 163(j). X carries forward 
the $10 of disallowed business interest expense to Year 2 as a 
disallowed business interest expense

[[Page 489]]

carryforward under Sec.  1.163(j)-2(c). X may not currently deduct all 
$40 of its business interest expense in Year 1. X only reduces its 
accumulated adjustments account in Year 1 by the $30 of deductible 
business interest expense in Year 1 under Sec.  1.163(j)-6(l)(7).
    (iii) Shareholder allocations. A and B are each allocated $35 of 
nonseparately stated taxable income ($50 items of income or gain, less 
$15 of deductible business interest expense) from X. A and B do not 
reduce their basis in X by the $10 of disallowed business interest 
expense.
    (iv) Shareholder-level computations. A, in computing its limit under 
section 163(j), has $100 of ATI and $20 of business interest expense 
from its sole proprietorship. A's section 163(j) limit is $30 ($100 x 30 
percent). Thus, A's $20 of business interest expense is deductible 
business interest expense. B, in computing its limit under section 
163(j), has $20 of business interest expense from its sole 
proprietorship. B's section 163(j) limit is $0 ($0 x 30 percent). Thus, 
B's $20 of business interest expense is not allowed as a deduction and 
is treated as business interest expense paid or accrued by B in Year 2.
    (23) Example 23--(i) Facts. The facts are the same as in Example 22 
in paragraph (o)(22)(i) of this section. In Year 2, X has $233.33 of 
ATI, $0 of business interest income, and $30 of business interest 
expense. A has $100 of ATI and $20 of business interest expense from its 
sole proprietorship. B has $0 of ATI and $20 of business interest 
expense from its sole proprietorship.
    (ii) S corporation-level. In Year 2, X's section 163(j) limit is 30 
percent of its ATI plus its business interest income, or $70 ($233.33 x 
30 percent). Because X's section 163(j) limit exceeds X's $40 of 
business interest expense ($30 from Year 2, plus the $10 disallowed 
business interest expense carryforwards from Year 1), X may deduct all 
$40 of business interest expense in Year 2. Such $40 of deductible 
business interest expense is includable in X's nonseparately stated 
income or loss, and is not subject to further limitation under section 
163(j). Pursuant to Sec.  1.163(j)-6(l)(7), X must reduce its 
accumulated adjustments account by $40. Additionally, X has $100 of 
excess taxable income under Sec.  1.163(j)-1(b)(17).
    (iii) Shareholder allocations. A and B are each allocated $96.67 of 
nonseparately stated taxable income ($116.67 items of income or gain, 
less $20 of deductible business interest expense) from X. Additionally, 
A and B are each allocated $50 of excess taxable income under Sec.  
1.163(j)-6(l)(4). As a result, A and B each increase their ATI by $50.
    (iv) Shareholder-level computations. A, in computing its limit under 
section 163(j), has $150 of ATI ($100 from its sole proprietorship, plus 
$50 excess taxable income) and $20 of business interest expense (from 
its sole proprietorship). A's section 163(j) limit is $45 ($150 x 30 
percent). Thus, A's $20 of business interest expense is deductible 
business interest expense. B, in computing its limit under section 
163(j), has $50 of ATI ($0 from its sole proprietorship, plus $50 excess 
taxable income) and $40 of business interest expense ($20 from its sole 
proprietorship, plus $20 disallowed business interest expense from its 
sole proprietorship in Year 1). B's section 163(j) limit is $15 ($50 x 
30 percent). Thus, $15 of B's business interest expense is deductible 
business interest expense. The $25 of B's business interest expense not 
allowed as a deduction ($40 business interest expense, less $15 section 
163(j) limit) is treated as business interest expense paid or accrued by 
B in Year 3.
    (24) Example 24--(i) Facts. On January 1, 2020, L and M form LM, a 
publicly traded partnership (as defined in Sec.  1.7704-1), and agree 
that each will be allocated a 50 percent share of all LM items. The 
partnership agreement provides that LM will make allocations under 
section 704(c) using the remedial allocation method under Sec.  1.704-
3(d). L contributes depreciable property with an adjusted tax basis of 
$4,000 and a fair market value of $10,000. The property is depreciated 
using the straight-line method with a 10-year recovery period and has 4 
years remaining on its recovery period. M contributes $10,000 in cash, 
which LM uses to purchase land. Except for the depreciation deductions, 
LM's expenses equal its income in each year of the 10 years commencing 
with the year LM is formed.

[[Page 490]]

LM has a valid section 754 election in effect.
    (ii) Section 163(j) remedial items and partner basis items. LM sells 
the asset contributed by L in a fully taxable transaction at a time when 
the adjusted basis of the property is $4,000. Under Sec.  1.163(j)-
6(e)(2)(ii), solely for purposes of Sec.  1.163(j)-6, the tax gain of 
$6,000 is allocated equally between L and M ($3,000 each). To avoid 
shifting built-in gain to the non-contributing partner (M) in a manner 
consistent with the rule in section 704(c), a remedial deduction of 
$3,000 is allocated to M (leaving M with no net tax gain), and remedial 
income of $3,000 is allocated to L (leaving L with total tax gain of 
$6,000).
    (25) Example 25--(i) Facts. The facts are the same as Example 24 in 
paragraph (o)(24) of this section except the property contributed by L 
had an adjusted tax basis of zero. For each of the 10 years following 
the contribution, there would be $500 of section 704(c) remedial income 
allocated to L and $500 of remedial deductions allocated to M with 
respect to the contributed asset. A buyer of M's units would step into 
M's shoes with respect to the $500 of annual remedial deductions. A 
buyer of L's units would step into L's shoes with respect to the $500 of 
annual remedial income and would have an annual section 743(b) deduction 
of $1,000 (net $500 of deductions).
    (ii) Analysis. Pursuant to Sec.  1.163(j)-6(d)(2)(ii), solely for 
purposes of Sec.  1.163(j)-6, a buyer of L's units immediately after 
formation of LM would offset its $500 annual section 704(c) remedial 
income allocation with $500 of annual section 743(b) adjustment (leaving 
the buyer with net $500 of section 743(b) deduction). As a result, such 
buyer would be in the same position as a buyer of M's units. Each buyer 
would have net deductions of $500 per year, which would not affect ATI 
before 2022.
    (26) Example 26--(i) Facts. X and Y are partners in partnership PRS. 
In Year 1, PRS had $200 of excess business interest expense. Pursuant to 
Sec.  1.163(j)-6(f)(2), PRS allocated $100 of such excess business 
interest expense to each of its partners. In Year 2, X lends $10,000 to 
PRS and receives $1,000 of interest income for the taxable year (self-
charged lending transaction). X is not in the trade or business of 
lending money. The $1,000 of interest expense resulting from this loan 
is allocable to PRS's trade or business assets. As a result, such $1,000 
of interest expense is business interest expense of PRS. X and Y are 
each allocated $500 of such business interest expense as their 
distributive share of PRS's business interest expense for the taxable 
year. Additionally, in Year 2, PRS has $3,000 of ATI. PRS allocates the 
items comprising its $3,000 of ATI $0 to X and $3,000 to Y.
    (ii) Partnership-level. In Year 2, PRS's section 163(j) limit is 30 
percent of its ATI plus its business interest income, or $900 ($3,000 x 
30 percent). Thus, PRS has $900 of deductible business interest expense, 
$100 of excess business interest expense, $0 of excess taxable income, 
and $0 of excess business interest income. Pursuant to Sec.  1.163(j)-
6(f)(2), $400 of X's allocation of business interest expense is treated 
as deductible business interest expense, $100 of X's allocation of 
business interest expense is treated as excess business interest 
expense, and $500 of Y's allocation of business interest expense is 
treated as deductible business interest expense.
    (iii) Lending partner. Pursuant to Sec.  1.163(j)-6(n), X treats 
$100 of its $1,000 of interest income as excess business interest income 
allocated from PRS in Year 2. Because X is deemed to have been allocated 
$100 of excess business interest income from PRS, and excess business 
interest expense from a partnership is treated as paid or accrued by a 
partner to the extent excess business interest income is allocated from 
such partnership to a partner, X treats its $100 allocation of excess 
business interest expense from PRS in Year 2 as business interest 
expense paid or accrued in Year 2. X, in computing its limit under 
section 163(j), has $100 of business interest income ($100 deemed 
allocation of excess business interest income from PRS in Year 2) and 
$100 of business interest expense ($100 allocation of excess business 
interest expense treated as paid or accrued in Year 2). Thus, X's $100 
of business interest expense is deductible business interest expense. At 
the end of Year 2, X has $100 of excess business interest expense from 
PRS

[[Page 491]]

($100 from Year 1). X treats $900 of its $1,000 of interest income as 
investment income for purposes of section 163(d).
    (27)-(33) [Reserved]
    (34) Example 34--(i) Facts. X and Y are equal partners in 
partnership PRS. Further, X and Y share the profits of PRS equally. In 
2019, PRS had ATI of $100. Additionally, in 2019, PRS had $100 of 
section 704(b) income which was allocated $50 to X and $50 to Y (PRS did 
not have any section 704(c) income in 2019). In 2020, PRS's only items 
of income, gain, loss or deduction was $1 of trade or business income, 
which it allocated to X pursuant to section 704(c).
    (ii) Partnership-level. In 2020, PRS makes the election described in 
Sec.  1.163(j)-6(d)(5) to use its 2019 ATI in 2020. As a result, PRS has 
$100 of ATI in 2020. PRS does not have any business interest expense. 
Therefore, PRS has $100 of excess taxable income in 2020.
    (iii) Partner-level allocations. PRS allocates its $100 of excess 
taxable income to X and Y pursuant to Sec.  1.163(j)-6(f)(2). To 
determine each partner's share of the $100 of excess taxable income, PRS 
must determine each partner's allocable ATI (as defined in Sec.  
1.163(j)-6(f)(2)(ii)). Because PRS made the election described in Sec.  
1.163(j)-6(d)(5), PRS must determine the allocable ATI of each of its 
partners pursuant to paragraph (d)(5). Specifically, PRS determines each 
partner's share of allocable ATI based on PRS's 2019 section 704 income, 
gain, loss, and deduction. PRS had $100 of section 704(b) income in 2019 
which was allocated $50 to X and $50 to Y. Therefore, in 2020, X and Y 
are both allocated $50 of excess taxable income (50% x $100).
    (35) Example 35--(i) Facts. X, a partner in partnership PRS, was 
allocated $20 of excess business interest expense from PRS in 2018 and 
$10 of excess business interest expense from PRS in 2019. In 2020, PRS 
allocated $16 of excess taxable income to X.
    (ii) Analysis. X treats 50 percent of its $10 of excess business 
interest expense allocated from PRS in 2019 as Sec.  1.163(j)-6(g)(4) 
business interest expense. Thus, $5 of Sec.  1.163(j)-6(g)(4) business 
interest expense is treated as paid or accrued by X in 2020 and is not 
subject to the section 163(j) limitation at X's level. Because X was 
allocated $16 of excess taxable income from PRS in 2020, X treats $16 of 
its $25 of excess business interest expense as business interest expense 
paid or accrued pursuant to Sec.  1.163(j)-6(g)(2). X, in computing its 
limit under section 163(j) in 2020, has $16 of ATI (as a result of its 
allocation of $16 of excess taxable income from PRS), $0 of business 
interest income, and $16 of business interest expense ($16 of excess 
business interest expense treated as paid or accrued in 2020). Pursuant 
to Sec.  1.163(j)-2(b)(2)(i), X's section 163(j) limit in 2020 is $8 
($16 x 50 percent). Thus, X has $8 of business interest expense that is 
deductible under section 163(j). The $8 of X's business interest expense 
not allowed as a deduction ($16 business interest expense subject to 
section 163(j), less $8 section 163(j) limit) is treated as business 
interest expense paid or accrued by X in 2021. At the end of 2020, X has 
$9 of excess business interest expense from PRS ($20 from 2018, plus $10 
from 2019, less $5 treated as paid or accrued pursuant to Sec.  
1.163(j)-6(g)(4), less $16 treated as paid or accrued pursuant to Sec.  
1.163(j)-6(g)(2)).
    (36) Example 36--(i) Facts. X is a partner in partnership PRS. At 
the beginning of 2018, X's outside basis in PRS was $100. X was 
allocated $20 of excess business interest expense from PRS in 2018 and 
$10 of excess business interest expense from PRS in 2019. X sold its PRS 
interest in 2019 for $70.
    (ii) Analysis. X treats 50 percent of its $10 of excess business 
interest expense allocated from PRS in 2019 as Sec.  1.163(j)-6(g)(4) 
business interest expense. Thus, $5 of Sec.  1.163(j)-6(g)(4) business 
interest expense is treated as paid or accrued by X in 2020 and is not 
subject to the section 163(j) limitation at X's level. Pursuant to 
paragraph (h)(3) of this section, immediately before the disposition, X 
increases the basis of its PRS interest from $70 to $95 (add back of $20 
of EBIE from 2018 and $5 of remaining EBIE from 2019). Thus, X has a $25 
section 741 loss recognized on the sale ($70-$95).
    (p) Applicability dates. (1)In general. This section applies to 
taxable years beginning on or after November 13, 2020. However, 
taxpayers and their related parties, within the meaning of sections 
267(b) and 707(b)(1), may

[[Page 492]]

choose to apply the rules of this section to a taxable year beginning 
after December 31, 2017, so long as the taxpayers and their related 
parties consistently apply the rules of the section 163(j) regulations, 
and, if applicable, Sec. Sec.  1.263A-9, 1.263A-15, 1.381(c)(20)-1, 
1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 1.383-1, 1.469-9, 
1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 1.1377-1, 1.1502-13, 
1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 1.1502-99 (to the 
extent they effectuate the rules of Sec. Sec.  1.382-2, 1.382-5, 1.382-
6, and 1.383-1), and 1.1504-4, to that taxable year.
    (2) Paragraphs (c)(1) and (2), (d)(3) through (5), (e)(5), 
(f)(1)(iii), (g)(4), (n), and (o)(24) through (29), and (34) through 
(36). Paragraphs (c)(1) and (2), (d)(3) through (5), (e)(5), 
(f)(1)(iii), (g)(4), (n), and (o)(24) through (29), and (34) through 
(36) of this section apply to taxable years beginning on or after March 
22, 2021. However, taxpayers and their related parties, within the 
meaning of sections 267(b) (determined without regard to section 
267(c)(3)) and 707(b)(1), may choose to apply the rules in paragraphs 
(c)(1) and (2), (d)(3) through (5), (e)(5), (f)(1)(iii), (g)(4), (n), 
and (o)(24) through (29), and (34) through (36) to a taxable year 
beginning after December 31, 2017, and before March 22, 2021, provided 
that those taxpayers and their related parties consistently apply all of 
the rules in T.D. 9905 (Sec. Sec.  1.163(j)-0 through 1.163(j)-11, 
effective November 13, 2020) as modified by T.D. 9943 (effective January 
13, 2021), and, if applicable, Sec. Sec.  1.263A-9, 1.263A-15, 
1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 
1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 
1.1377-1, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 
1.1502-99 (to the extent they effectuate the rules of Sec. Sec.  1.382-
2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4 contained in T.D. 9905 
as modified by T.D. 9943, for that taxable year and for each subsequent 
taxable year.

[T.D. 9905, 85 FR 56760, Sept. 14, 2020, as amended by T.D. 9943, 86 FR 
5529, Jan. 19, 2021]



Sec.  1.163(j)-7  Application of the section 163(j) limitation to 
foreign corporations and United States shareholders.

    (a) Overview. This section provides rules for the application of 
section 163(j) to relevant foreign corporations and United States 
shareholders of relevant foreign corporations. Paragraph (b) of this 
section provides the general rule regarding the application of section 
163(j) to a relevant foreign corporation. Paragraph (c) of this section 
provides rules for applying section 163(j) to CFC group members of a CFC 
group. Paragraph (d) of this section provides rules for determining a 
specified group and specified group members. Paragraph (e) of this 
section provides rules and procedures for treating a specified group 
member as a CFC group member and for determining a CFC group. Paragraph 
(f) of this section provides rules regarding the treatment of a CFC 
group member that has ECI. Paragraph (g) of this section provides rules 
concerning the computation of ATI of an applicable CFC. Paragraph (h) of 
this section provides a safe harbor that exempts certain stand-alone 
applicable CFCs and CFC groups from the application of section 163(j) 
for a taxable year. Paragraphs (i) and (j) of this section are reserved. 
Paragraph (k) of this section provides definitions that apply for 
purposes of this section (see also Sec.  1.163(j)-1 for additional 
definitions). Paragraph (l) of this section provides examples 
illustrating the application of this section.
    (b) General rule regarding the application of section 163(j) to 
relevant foreign corporations. Except as otherwise provided in this 
section, section 163(j) and the section 163(j) regulations apply to 
determine the deductibility of a relevant foreign corporation's business 
interest expense for purposes of computing its taxable income for U.S. 
income tax purposes (if any) in the same manner as those provisions 
apply to determine the deductibility of a domestic C corporation's 
business interest expense for purposes of computing its taxable income. 
See also Sec.  1.952-2. If a relevant foreign corporation is a direct or 
indirect partner in a partnership, see Sec.  1.163(j)-6 (concerning the 
application of section 163(j) to partnerships).

[[Page 493]]

    (c) Application of section 163(j) to CFC group members of a CFC 
group--(1) Scope. This paragraph (c) provides rules for applying section 
163(j) to a CFC group and a CFC group member. Paragraph (c)(2) of this 
section provides rules for computing a single section 163(j) limitation 
for a specified period of a CFC group. Paragraph (c)(3) of this section 
provides rules for allocating a CFC group's section 163(j) limitation to 
CFC group members for specified taxable years. Paragraph (c)(4) of this 
section provides currency translation rules. Paragraph (c)(5) of this 
section provides special rules for specified periods beginning in 2019 
or 2020.
    (2) Calculation of section 163(j) limitation for a CFC group for a 
specified period--(i) In general. A single section 163(j) limitation is 
computed for a specified period of a CFC group. For purposes of applying 
section 163(j) and the section 163(j) regulations, the current-year 
business interest expense, disallowed business interest expense 
carryforwards, business interest income, floor plan financing interest 
expense, and ATI of a CFC group for a specified period equal the sums of 
each CFC group member's respective amounts for its specified taxable 
year with respect to the specified period. A CFC group member's current-
year business interest expense, business interest income, floor plan 
financing interest expense, and ATI for a specified taxable year are 
generally determined on a separate-company basis. For purposes of 
determining the ATI of a CFC group, Sec.  1.163(j)-1(b)(1)(vii) 
(providing that ATI cannot be less than zero) applies with respect to 
the ATI of the CFC group but not the ATI of any CFC group member.
    (ii) Certain transactions between CFC group members disregarded. Any 
transaction between CFC group members of a CFC group that is entered 
into with a principal purpose of affecting a CFC group or a CFC group 
member's section 163(j) limitation by increasing or decreasing a CFC 
group or a CFC group member's ATI or business interest income for a 
specified taxable year is disregarded for purposes of applying section 
163(j) and the section 163(j) regulations.
    (3) Deduction of business interest expense--(i) CFC group business 
interest expense--(A) In general. The extent to which a CFC group 
member's current-year business interest expense and disallowed business 
interest expense carryforwards for a specified taxable year that ends 
with or within a specified period may be deducted under section 163(j) 
is determined under the rules and principles of Sec.  1.163(j)-5(a)(2) 
and (b)(3)(ii), subject to the modifications described in paragraph 
(c)(3)(i)(B) of this section.
    (B) Modifications to relevant terms. For purposes of paragraph 
(c)(3)(i)(A) of this section, the rules and principles of Sec.  
1.163(j)-5(b)(3)(ii) are applied by--
    (1) Replacing ``Sec.  1.163(j)-4(d)(2)'' in Sec.  1.163(j)-
5(a)(2)(ii) with ``Sec.  1.163(j)-7(c)(2)(i)'';
    (2) Replacing the term ``allocable share of the consolidated group's 
remaining section 163(j) limitation'' with ``allocable share of the CFC 
group's remaining section 163(j) limitation'';
    (3) Replacing the terms ``consolidated group'' and ``group'' with 
``CFC group'';
    (4) Replacing the term ``consolidated group's remaining section 
163(j) limitation'' with ``CFC group's remaining section 163(j) 
limitation'';
    (5) Replacing the term ``consolidated return year'' with ``specified 
period'';
    (6) Replacing the term ``current year'' or ``current-year'' with 
``current specified period'' or ``specified taxable year with respect to 
the current specified period,'' as the context requires;
    (7) Replacing the term ``member'' with ``CFC group member''; and
    (8) Replacing the term ``taxable year'' with ``specified taxable 
year with respect to a specified period.''
    (ii) Carryforwards treated as attributable to the same taxable year. 
For purposes of applying the principles of Sec.  1.163(j)-5(b)(3)(ii), 
as required under paragraph (c)(3)(i) of this section, CFC group 
members' disallowed business interest expense carryforwards that arose 
in specified taxable years with respect to the same specified period are 
treated as disallowed business interest expense carryforwards from 
taxable years ending on the same date and are deducted on a pro rata 
basis, under the principles of Sec.  1.163(j)-5(b)(3)(ii)(C)(3),

[[Page 494]]

pursuant to paragraph (c)(3)(i) of this section.
    (iii) Multiple specified taxable years of a CFC group member with 
respect to a specified period. If a CFC group member has more than one 
specified taxable year (each year, an applicable specified taxable year) 
with respect to a single specified period of a CFC group, then all the 
applicable specified taxable years are taken into account for purposes 
of applying the principles of Sec.  1.163(j)-5(b)(3)(ii), as required 
under paragraph (c)(3)(i) of this section, with respect to the specified 
period. The portion of the section 163(j) limitation allocable to 
disallowed business interest expense carryforwards of the CFC group 
member that arose in taxable years before the first applicable specified 
taxable year is prorated among the applicable specified taxable years in 
proportion to the number of days in each applicable specified taxable 
year.
    (iv) Limitation on pre-group disallowed business interest expense 
carryforward--(A) General rule--(1) CFC group member pre-group 
disallowed business interest expense carryforward. This paragraph 
(c)(3)(iv) applies to pre-group disallowed business interest expense 
carryforwards of a CFC group member. The amount of the pre-group 
disallowed business interest expense carryforwards described in the 
preceding sentence that may be included in any CFC group member's 
business interest expense deduction for any specified taxable year under 
this paragraph (c)(3) may not exceed the aggregate section 163(j) 
limitation for all specified periods of the CFC group, determined by 
reference only to the CFC group member's items of income, gain, 
deduction, and loss, and reduced (including below zero) by the CFC group 
member's business interest expense (including disallowed business 
interest expense carryforwards) taken into account as a deduction by the 
CFC group member in all specified taxable years in which the CFC group 
member has continuously been a CFC group member of the CFC group 
(cumulative section 163(j) pre-group carryforward limitation).
    (2) Subgrouping. In the case of a pre-group disallowed business 
interest expense carryforward, a pre-group subgroup is composed of the 
CFC group member with the pre-group disallowed business interest expense 
carryforward (the loss member) and each other CFC group member of the 
loss member's CFC group (the current group) that was a member of the CFC 
group in which the pre-group disallowed business interest expense 
carryforward arose and joined the specified group of the current group 
at the same time as the loss member. A CFC group member that is a member 
of a pre-group subgroup remains a member of the pre-group subgroup until 
its first taxable year during which it ceases to be a member of the same 
specified group as the loss member. For purposes of this paragraph (c), 
the rules and principles of Sec.  1.163(j)-5(d)(1)(B) apply to a pre-
group subgroup as if the pre-group subgroup were a SRLY subgroup.
    (3) Transition rule. Solely for purposes of paragraph 
(c)(3)(iv)(A)(2) of this section, a CFC group includes a group of 
applicable CFCs for which a CFC group election was made under guidance 
under section 163(j) published on December 28, 2018. Therefore, if the 
requirements of paragraph (c)(3)(iv)(A)(2) of this section are 
satisfied, a group of applicable CFCs described in the preceding 
sentence may be treated as a pre-group subgroup.
    (B) Deduction of pre-group disallowed business interest expense 
carryforwards. Notwithstanding paragraph (c)(3)(iv)(A)(1) of this 
section, pre-group disallowed business interest expense carryforwards 
are available for deduction by a CFC group member in its specified 
taxable year only to the extent the CFC group has remaining section 
163(j) limitation for the specified period after the deduction of 
current-year business interest expense and disallowed business interest 
expense carryforwards from earlier taxable years that are permitted to 
be deducted in specified taxable years of CFC group members with respect 
to the specified period. See paragraph (c)(3)(i) of this section and 
Sec.  1.163(j)-5(b)(3)(ii)(A). Pre-group disallowed business interest 
expense carryforwards are deducted on a pro rata basis (under the 
principles of paragraph (c)(3)(i) of this section and Sec.  1.163(j)-
5(b)(3)(ii)(C)(4)) with other disallowed business interest expense

[[Page 495]]

carryforwards from taxable years ending on the same date.
    (4) Currency translation. For purposes of applying this paragraph 
(c), items of a CFC group member are translated into a single currency 
for the CFC group and back to the functional currency of the CFC group 
member using the average exchange rate for the CFC group member's 
specified taxable year. The single currency for the CFC group may be the 
U.S. dollar or the functional currency of a plurality of the CFC group 
members.
    (5) Special rule for specified periods beginning in 2019 or 2020--
(i) 50 percent ATI limitation applies to a specified period of a CFC 
group. In the case of a CFC group, Sec.  1.163(j)-2(b)(2) (including the 
election under Sec.  1.163(j)-2(b)(2)(ii)) applies to a specified period 
of the CFC group beginning in 2019 or 2020, rather than to a specified 
taxable year of a CFC group member. An election under Sec.  1.163(j)-
2(b)(2)(ii) for a specified period of a CFC group is not effective 
unless made by each designated U.S. person. Except as otherwise provided 
in this paragraph (c)(5)(i), the election is made in accordance with 
Revenue Procedure 2020-22, 2020-18 I.R.B. 745. For purposes of applying 
Sec.  1.964-1(c), the election is treated as if made for each CFC group 
member.
    (ii) Election to use 2019 ATI applies to a specified period of a CFC 
group--(A) In general. In the case of a CFC group, for purposes of 
applying paragraph (c)(2) of this section, an election under Sec.  
1.163(j)-2(b)(3)(i) is made for a specified period of a CFC group 
beginning in 2020 and applies to the specified taxable years of each CFC 
group member with respect to such specified period, taking into account 
the application of paragraph (c)(5)(ii)(B) of this section. The election 
under Sec.  1.163(j)-2(b)(3)(i) does not apply to any specified taxable 
year of a CFC group member other than those described in the preceding 
sentence. An election under Sec.  1.163(j)-2(b)(3)(i) for a specified 
period of a CFC group is not effective unless made by each designated 
U.S. person. Except as otherwise provided in this paragraph 
(c)(5)(ii)(A), the election is made in accordance with Revenue Procedure 
2020-22, 2020-18 I.R.B. 745. For purposes of applying Sec.  1.964-1(c), 
the election is treated as if made for each CFC group member.
    (B) Specified taxable years that do not begin in 2020. If a 
specified taxable year of a CFC group member with respect to the 
specified period described in paragraph (c)(5)(ii)(A) of this section 
begins in 2019, then, for purposes of applying paragraph (c)(2) of this 
section, Sec.  1.163(j)-2(b)(3) is applied to such specified taxable 
year by substituting ``2018'' for ``2019'' and ``2019'' for ``2020.'' If 
a specified taxable year of a CFC group member with respect to the 
specified period described in paragraph (c)(5)(ii)(A) of this section 
begins in 2021, then, for purposes of applying paragraph (c)(2) of this 
section, Sec.  1.163(j)-2(b)(3) is applied to such specified taxable 
year by substituting ``2020'' for ``2019'' and ``2021'' for ``2020.''
    (d) Determination of a specified group and specified group members--
(1) Scope. This paragraph (d) provides rules for determining a specified 
group and specified group members. Paragraph (d)(2) of this section 
provides rules for determining a specified group. Paragraph (d)(3) of 
this section provides rules for determining specified group members.
    (2) Rules for determining a specified group--(i) Definition of a 
specified group. Subject to paragraph (d)(2)(ii) of this section, the 
term specified group means one or more applicable CFCs or chains of 
applicable CFCs connected through stock ownership with a specified group 
parent (which is included in the specified group only if it is an 
applicable CFC), but only if--
    (A) The specified group parent owns directly or indirectly stock 
meeting the requirements of section 1504(a)(2)(B) in at least one 
applicable CFC; and
    (B) Stock meeting the requirements of section 1504(a)(2)(B) in each 
of the applicable CFCs (except the specified group parent) is owned 
directly or indirectly by one or more of the other applicable CFCs or 
the specified group parent.
    (ii) Indirect ownership. For purposes of applying paragraph 
(d)(2)(i) of this section, stock is owned indirectly only if it is owned 
under section 318(a)(2)(A) through a partnership or under section 
318(a)(2)(A) or (B) through an estate or

[[Page 496]]

trust not described in section 7701(a)(30).
    (iii) Specified group parent. The term specified group parent means 
a qualified U.S. person or an applicable CFC.
    (iv) Qualified U.S. person. The term qualified U.S. person means a 
United States person described in section 7701(a)(30)(A) or (C). For 
purposes of this paragraph (d), members of a consolidated group that 
file (or that are required to file) a consolidated U.S. Federal income 
tax return are treated as a single qualified U.S person and individuals 
described in section 7701(a)(30)(A) whose filing status is married 
filing jointly are treated as a single qualified U.S. person.
    (v) Stock. For purposes of this paragraph (d)(2), the term stock has 
the same meaning as ``stock'' in section 1504 (without regard to Sec.  
1.1504-4, except as provided in paragraph (d)(2)(vi) of this section) 
and all shares of stock within a single class are considered to have the 
same value. Thus, control premiums and minority and blockage discounts 
within a single class are not taken into account.
    (vi) Options treated as exercised. For purposes of this paragraph 
(d)(2), options that are reasonably certain to be exercised, as 
determined under Sec.  1.1504-4(g), are treated as exercised. For 
purposes of this paragraph (d)(2)(vi), options include call options, 
warrants, convertible obligations, put options, and any other instrument 
treated as an option under Sec.  1.1504-4(d), determined by replacing 
the term ``a principal purpose of avoiding the application of section 
1504 and this section'' with ``a principal purpose of avoiding the 
application of section 163(j).''
    (vii) When a specified group ceases to exist. The principles of 
Sec.  1.1502-75(d)(1), (d)(2)(i) and (ii), and (d)(3)(i) through (iv) 
apply for purposes of determining when a specified group ceases to 
exist. Solely for purposes of applying these principles, references to 
the common parent are treated as references to the specified group 
parent and each applicable CFC that is treated as a specified group 
member for a taxable year with respect to a specified period is treated 
as affiliated with the specified group parent from the beginning to the 
end of the specified period, without regard to the beginning or end of 
its taxable year.
    (3) Rules for determining a specified group member. If two or more 
applicable CFCs are included in a specified group on the last day of a 
taxable year of each applicable CFC that ends with or within a specified 
period, then each applicable CFC is a specified group member with 
respect to the specified period for its entire taxable year ending with 
or within the specified period. If only one applicable CFC is included 
in a specified group on the last day of its taxable year that ends with 
or within the specified period, it is not a specified group member. If 
an applicable CFC has multiple taxable years that end with or within a 
specified period, this paragraph (d)(3) is applied separately to each 
taxable year to determine if the applicable CFC is a specified group 
member for such taxable year.
    (e) Rules and procedures for treating a specified group as a CFC 
group--(1) Scope. This paragraph (e) provides rules and procedures for 
treating a specified group member as a CFC group member and for 
determining a CFC group for purposes of applying section 163(j) and the 
section 163(j) regulations.
    (2) CFC group and CFC group member--(i) CFC group. The term CFC 
group means, with respect to a specified period, all CFC group members 
for their specified taxable years.
    (ii) CFC group member. The term CFC group member means, with respect 
to a specified taxable year and a specified period, a specified group 
member of a specified group for which a CFC group election is in effect. 
However, notwithstanding the prior sentence, a specified group member is 
not treated as a CFC group member for a taxable year of the specified 
group member beginning before January 1, 2018.
    (3) Duration of a CFC group. A CFC group continues until the CFC 
group election is revoked, or there is no longer a specified period with 
respect to the specified group. A failure to provide the information 
described in paragraph (e)(6) of this section does not terminate a CFC 
group election.
    (4) Joining or leaving a CFC group. If an applicable CFC becomes a 
specified group member for a specified taxable year with respect to a 
specified period

[[Page 497]]

of a specified group for which a CFC group election is in effect, the 
CFC group election applies to the applicable CFC and the applicable CFC 
becomes a CFC group member. If an applicable CFC ceases to be a 
specified group member for a specified taxable year with respect to a 
specified period of a specified group for which a CFC group election is 
in effect, the CFC group election terminates solely with respect to the 
applicable CFC.
    (5) Manner of making or revoking a CFC group election--(i) In 
general. An election is made or revoked under this paragraph (e)(5) (CFC 
group election) with respect to a specified period of a specified group. 
A CFC group election remains in effect for each specified period of the 
specified group until revoked. A CFC group election that is in effect 
with respect to a specified period of a specified group applies to each 
specified group member for its specified taxable year that ends with or 
within the specified period. The making or revoking of a CFC group 
election is not effective unless made or revoked by each designated U.S. 
person.
    (ii) Revocation by election. A CFC group election cannot be revoked 
with respect to any specified period beginning before 60 months 
following the last day of the specified period for which the election 
was made. Once a CFC group election has been revoked, a new CFC group 
election cannot be made with respect to any specified period beginning 
before 60 months following the last day of the specified period for 
which the election was revoked.
    (iii) Timing. A CFC group election must be made or revoked with 
respect to a specified period of a specified group no later than the due 
date (taking into account extensions, if any) of the original Federal 
income tax return for the taxable year of each designated U.S. person in 
which or with which the specified period ends.
    (iv) Election statement. To make or revoke a CFC group election for 
a specified period of a specified group, each designated U.S. person 
must attach a statement to its relevant Federal income tax or 
information return in accordance with publications, forms, instructions, 
or other guidance. The statement must include the name and taxpayer 
identification number of all designated U.S. persons, a statement that 
the CFC group election is being made or revoked, as applicable, the 
specified period for which the CFC group election is being made or 
revoked, and the name of each CFC group member and its specified taxable 
year with respect to the specified period. The statement must be filed 
in the manner prescribed in publications, forms, instructions, or other 
guidance.
    (v) Effect of prior CFC group election. A CFC group election is made 
solely pursuant to the provisions of this paragraph (e)(5), without 
regard to whether a CFC group election described in guidance under 
section 163(j) published on December 28, 2018, was in effect.
    (6) Annual information reporting. Each designated U.S. person must 
attach a statement to its relevant Federal income tax or information 
return for each taxable year in which a CFC group election is in effect 
that contains information concerning the computation of the CFC group's 
section 163(j) limitation and the application of paragraph (c)(3) of 
this section to the CFC group in accordance with publications, forms, 
instructions, or other guidance.
    (f) Treatment of a CFC group member that has ECI--(1) In general. If 
a CFC group member has ECI in its specified taxable year, then for 
purposes of section 163(j) and the section 163(j) regulations--
    (i) The items, disallowed business interest expense carryforwards, 
and other attributes of the CFC group member that are ECI are treated as 
items, disallowed business interest expense carryforwards, and 
attributes of a separate applicable CFC (such deemed corporation, an ECI 
deemed corporation) that has the same taxable year and shareholders as 
the applicable CFC; and
    (ii) The ECI deemed corporation is not treated as a specified group 
member for the specified taxable year.
    (2) [Reserved]
    (g) Rules concerning the computation of adjusted taxable income of a 
relevant foreign corporation--(1) Tentative taxable income. For purposes 
of computing the tentative taxable income of a relevant foreign 
corporation for a taxable year,

[[Page 498]]

the relevant foreign corporation's gross income and allowable deductions 
are determined under the principles of Sec.  1.952-2 or under the rules 
of section 882 for determining income that is, or deductions that are 
allocable to, effectively connected income, as applicable.
    (2) Treatment of certain dividends. For purposes of computing the 
ATI of a relevant foreign corporation for a taxable year, any dividend 
included in gross income that is received from a related person, within 
the meaning of section 954(d)(3), with respect to the distributee is 
subtracted from tentative taxable income.
    (3) Treatment of certain foreign income taxes. For purposes of 
computing the ATI of a relevant foreign corporation for a taxable year, 
no deduction is taken into account for any foreign income tax (as 
defined in Sec.  1.960-1(b), but substituting the phrase ``relevant 
foreign corporation'' for the phrase ``controlled foreign 
corporation'').
    (4) Anti-abuse rule--(i) In general. If a specified group member of 
a specified group or an applicable partnership (specified lender) 
includes an amount (payment amount) in income and such amount is 
attributable to business interest expense incurred by another specified 
group member or an applicable partnership of the specified group 
(specified borrower) during its taxable year, then the ATI of the 
specified borrower for the taxable year is increased by the ATI 
adjustment amount if--
    (A) The business interest expense is incurred with a principal 
purpose of reducing the Federal income tax liability of any United 
States shareholder of a specified group member (including over other 
taxable years);
    (B) Absent the application of this paragraph (g)(4), the effect of 
the specified borrower treating all or part of the payment amount as 
disallowed business interest expense would be to reduce the Federal 
income tax liability of any United States shareholder of a specified 
group member; and
    (C) Either no CFC group election is in effect with respect to the 
specified group or the specified borrower is an applicable partnership.
    (ii) ATI adjustment amount--(A) In general. For purposes of this 
paragraph (g)(4), the term ATI adjustment amount means, with respect to 
a specified borrower and a taxable year, the product of 3\1/3\ and the 
lesser of the payment amount or the disallowed business interest 
expense, computed without regard to this paragraph (g)(4).
    (B) Special rule for taxable years or specified periods beginning in 
2019 or 2020. For any taxable year of an applicable CFC or specified 
taxable year of a CFC group member with respect to a specified period 
for which the section 163(j) limitation is determined based, in part, on 
50 percent of ATI, in accordance with Sec.  1.163(j)-2(b)(2), paragraph 
(g)(4)(ii)(A) of this section is applied by substituting ``2'' for 
``3\1/3\.''
    (iii) Applicable partnership. For purposes of this paragraph (g)(4), 
the term applicable partnership means, with respect to a specified 
group, a partnership in which at least 80 percent of the interests in 
profits or capital is owned, directly or indirectly through one or more 
other partnerships, by specified group members of the specified group. 
For purposes of this paragraph (g)(4)(iii), a partner's interest in the 
profits of a partnership is determined in accordance with the rules and 
principles of Sec.  1.706-1(b)(4)(ii) and a partner's interest in the 
capital of a partnership is determined in accordance with the rules and 
principles of Sec.  1.706-1(b)(4)(iii).
    (h) Election to apply safe-harbor--(1) In general. If an election to 
apply this paragraph (h)(1) (safe-harbor election) is in effect with 
respect to a taxable year of a stand-alone applicable CFC or a specified 
taxable year of a CFC group member, as applicable, then, for such year, 
no portion of the applicable CFC's business interest expense is 
disallowed under the section 163(j) limitation. This paragraph (h) does 
not apply to excess business interest expense, as described in Sec.  
1.163(j)-6(f)(2), until the taxable year in which it is treated as paid 
or accrued by an applicable CFC under Sec.  1.163(j)-6(g)(2)(i). 
Furthermore, excess business interest expense is not taken into account 
for purposes of determining whether the safe-harbor election is 
available for a stand-alone applicable CFC or a CFC group until the 
taxable year in which it is treated as paid or accrued by an applicable 
CFC under Sec.  1.163(j)-6(g)(2)(i).

[[Page 499]]

    (2) Eligibility for safe-harbor election--(i) Stand-alone applicable 
CFC. The safe-harbor election may be made for the taxable year of a 
stand-alone applicable CFC only if, for the taxable year, the business 
interest expense of the applicable CFC is less than or equal to either--
    (A) The business interest income of the applicable CFC; or
    (B) 30 percent of the lesser of the eligible amount or the qualified 
tentative taxable income of the applicable CFC.
    (ii) CFC group. The safe-harbor election may be made for the 
specified period of a CFC group only if, for the specified period, no 
CFC group member has any pre-group disallowed business interest expense 
carryforward and the business interest expense of the CFC group for the 
specified period is less than or equal to either--
    (A) The business interest income of the CFC group; or
    (B) 30 percent of the lesser of the eligible amount or the qualified 
tentative taxable income of the CFC group.
    (iii) Currency translation. For purposes of applying this paragraph 
(h), BII, BIE, and qualified tentative taxable income of a stand-alone 
applicable CFC or a CFC group must be determined using the U.S. dollar. 
If BII, BIE, or any items of income, gain, deduction, or loss that are 
taken into account in computing qualified tentative taxable income are 
maintained in a currency other than the U.S. dollar, then those items 
must be translated into the U.S. dollar using the average exchange rate 
for the taxable year or the specified taxable year, as applicable.
    (3) Eligible amount--(i) Stand-alone applicable CFC. The eligible 
amount of a stand-alone applicable CFC for a taxable year is the sum of 
the amounts a domestic corporation would include in gross income under 
sections 951(a)(1)(A) and 951A(a), reduced by any deductions that would 
be allowed under section 245A (by reason of section 964(e)(4)) or 
section 250(a)(1)(B)(i), determined as if the domestic corporation has a 
taxable year that ends on the last date of the taxable year of the 
stand-alone applicable CFC, it wholly owns the stand-alone applicable 
CFC throughout the CFC's taxable year, it does not own any assets other 
than stock in the stand-alone applicable CFC, and it has no other items 
of income, gain, deduction, or loss.
    (ii) CFC group. The eligible amount of a CFC group for a specified 
period is the sum of the amounts a domestic corporation would include in 
gross income under sections 951(a)(1)(A) and 951A(a), reduced by any 
deductions that would be allowed under section 245A (by reason of 
section 964(e)(4)) or section 250(a)(1)(B)(i), determined as if the 
domestic corporation has a taxable year that is the specified period, it 
wholly owns each CFC group member throughout the CFC group member's 
specified taxable year, it does not own any assets other than stock in 
the CFC group members, and it has no other items of income, gain, 
deduction, or loss.
    (iii) Additional rules for determining an eligible amount. For 
purposes of paragraphs (h)(3)(i) and (ii) of this section, the amounts 
that would be included in gross income of a United States shareholder 
under sections 951(a)(1)(A) and 951A(a), and any corresponding 
deductions that would be allowed under section 245A (by reason of 
section 964(e)(4)) or section 250(a)(1)(B)(i), are determined by taking 
into account any elections that are made with respect to the applicable 
CFC(s), including under Sec.  1.954-1(d)(5) (relating to the subpart F 
high-tax exception) and Sec.  1.951A-2(c)(7)(viii) (relating to the 
GILTI high-tax exclusion). These amounts are also determined without 
regard to any section 163(j) limitation on business interest expense and 
without regard to any disallowed business interest expense carryovers. 
In addition, those amounts are determined by only taking in account 
items of the applicable CFC(s) that are properly allocable to a non-
excepted trade or business under Sec.  1.163(j)-10.
    (4) Qualified tentative taxable income. The term qualified tentative 
taxable income means, with respect to a taxable year of a stand-alone 
applicable CFC, the applicable CFC's tentative taxable income, and with 
respect to a specified period of a CFC group, the sum of each CFC group 
member's tentative taxable income for the specified taxable year; 
provided that for purposes of this paragraph (h)(4), tentative taxable 
income

[[Page 500]]

is determined by taking into account only items properly allocable to a 
non-excepted trade or business under Sec.  1.163(j)-10.
    (5) Manner of making a safe-harbor election--(i) In general. A safe-
harbor election is an annual election made under this paragraph (h)(5) 
with respect to a taxable year of a stand-alone applicable CFC or with 
respect to a specified period of a CFC group. A safe-harbor election 
that is made with respect to a specified period of a CFC group is 
effective with respect to each CFC group member for its specified 
taxable year. A safe-harbor election is only effective if made by each 
designated U.S. person with respect to a stand-alone applicable CFC or a 
CFC group. A safe-harbor election is made with respect to a taxable year 
of a stand-alone applicable CFC, or a specified period of a CFC group, 
no later than the due date (taking into account extensions, if any) of 
the original Federal income tax return for the taxable year of each 
designated U.S. person, respectively, in which or with which the taxable 
year of the stand-alone applicable CFC ends or the specified period of 
the CFC group ends.
    (ii) Election statement. To make a safe-harbor election, each 
designated U.S. person must attach to its relevant Federal income tax 
return or information return a statement that includes the name and 
taxpayer identification number of all designated U.S. persons, a 
statement that a safe-harbor election is being made pursuant to Sec.  
1.163(j)-7(h) and a calculation that substantiates that the requirements 
for making the election are satisfied, and the taxable year of the 
stand-alone applicable CFC or the specified period of the CFC group, as 
applicable, for which the safe-harbor election is being made in 
accordance with publications, forms, instructions, or other guidance. In 
the case of a CFC group, the statement must also include the name of 
each CFC group member and its specified taxable year that ends with or 
within the specified period for which the safe-harbor election is being 
made. The statement must be filed in the manner prescribed in 
publications, forms, instructions, or other guidance.
    (6) Special rule for taxable years or specified periods beginning in 
2019 or 2020. In the case of a stand-alone applicable CFC, for any 
taxable year beginning in 2019 or 2020, paragraph (h)(2)(i) of this 
section is applied by substituting ``50 percent'' for ``30 percent.'' In 
the case of a CFC group, for any specified period beginning in 2019 or 
2020, paragraph (h)(2)(ii)(A) of this section is applied by substituting 
``50 percent'' for ``30 percent.''
    (k) Definitions. The following definitions apply for purposes of 
this section.
    (1) Applicable partnership. The term applicable partnership has the 
meaning provided in paragraph (g)(4)(iii) of this section.
    (2) Applicable specified taxable year. The term applicable specified 
taxable year has the meaning provided in paragraph (c)(3)(iii) of this 
section.
    (3) ATI adjustment amount. The term ATI adjustment amount has the 
meaning provided in paragraph (g)(4)(ii) of this section.
    (4)-(5) [Reserved].
    (6) CFC group. The term CFC group has the meaning provided in 
paragraph (e)(2)(i) of this section.
    (7) CFC group election. The term CFC group election means the 
election described in paragraph (e)(5) of this section.
    (8) CFC group member. The term CFC group member has the meaning 
provided in paragraph (e)(2)(ii) of this section.
    (9) [Reserved].
    (10) Cumulative section 163(j) pre-group carryforward limitation. 
The term cumulative section 163(j) pre-group carryforward limitation has 
the meaning provided in paragraph (c)(3)(iv)(A)(1) of this section.
    (11) Current group. The term current group has the meaning provided 
in paragraph (c)(3)(iv)(A)(2) of this section.
    (12) Designated U.S. person. The term designated U.S. person means--
    (i) With respect to a stand-alone applicable CFC, each controlling 
domestic shareholder, as defined in Sec.  1.964-1(c)(5)(i) of the 
applicable CFC; or
    (ii) With respect to a specified group, the specified group parent, 
if the specified group parent is a qualified U.S. person, or each 
controlling domestic shareholder, as defined in Sec.  1.964-

[[Page 501]]

1(c)(5)(i), of the specified group parent, if the specified group parent 
is an applicable CFC.
    (13) ECI deemed corporation. The term ECI deemed corporation has the 
meaning provided in paragraph (f)(1)(i) of this section.
    (14) Effectively connected income. The term effectively connected 
income (or ECI) means income or gain that is ECI, as defined in Sec.  
1.884-1(d)(1)(iii), and deduction or loss that is allocable to, ECI, as 
defined in Sec.  1.884-1(d)(1)(iii).
    (15) Eligible amount. The term eligible amount has the meaning 
provided in paragraph (h)(3)(i) of this section.
    (16) Former group. The term former group has the meaning provided in 
paragraph (c)(3)(iv)(A)(2) of this section.
    (17) Loss member. The term loss member has the meaning provided in 
paragraph (c)(3)(iv)(A)(2) of this section.
    (18) Payment amount. The term payment amount has the meaning 
provided in paragraph (g)(4)(i) of this section.
    (19) Pre-group disallowed business interest expense carryforward. 
The term pre-group disallowed business interest expense carryforward 
means, with respect to a CFC group member and a specified taxable year, 
any disallowed business interest expense carryforward of the CFC group 
member that arose in a taxable year during which the CFC group member 
(or its predecessor) was not a CFC group member of the CFC group.
    (20) Qualified tentative taxable income. The term qualified 
tentative taxable income has the meaning provided in paragraph (h)(4) of 
this section.
    (21) Qualified U.S. person. The term qualified U.S. person has the 
meaning provided in paragraph (d)(2)(iv) of this section.
    (22) Relevant period. The term relevant period has the meaning 
provided in paragraph (c)(3)(iv)(A)(2) of this section.
    (23) Safe-harbor election. The term safe-harbor election has the 
meaning provided in paragraph (h)(1) of this section.
    (24) Specified borrower. The term specified borrower has the meaning 
provided in paragraph (g)(4)(i) of this section.
    (25) Specified group. The term specified group has the meaning 
provided in paragraph (d)(2)(i) of this section.
    (26) Specified group member. The term specified group member has the 
meaning provided in paragraph (d)(3) of this section.
    (27) Specified group parent. The term specified group parent has the 
meaning provided in paragraph (d)(2)(iii) of this section.
    (28) Specified lender. The term specified lender has the meaning 
provided in paragraph (g)(4)(i) of this section.
    (29) Specified period--(i) In general. Except as otherwise provided 
in paragraph (k)(29)(ii) of this section, the term specified period 
means, with respect to a specified group--
    (A) If the specified group parent is a qualified U.S. person, the 
period ending on the last day of the taxable year of the specified group 
parent and beginning on the first day after the last day of the 
specified group's immediately preceding specified period; or
    (B) If the specified group parent is an applicable CFC, the period 
ending on the last day of the specified group parent's required year 
described in section 898(c)(1), without regard to section 898(c)(2), and 
beginning on the first day after the last day of the specified group's 
immediately preceding specified period.
    (ii) Short specified period. A specified period begins no earlier 
than the first date on which a specified group exists. A specified 
period ends on the date a specified group ceases to exist under 
paragraph (d)(2)(vii) of this section. If the last day of a specified 
period, as determined under paragraph (k)(29)(i) of this section, 
changes, and, but for this paragraph (k)(29)(ii), the change in the last 
day of the specified period would result in the specified period being 
longer than 12 months, the specified period ends on the date on which 
the specified period would have ended had the change not occurred.
    (30) Specified taxable year. The term specified taxable year means, 
with respect to an applicable CFC that is a specified group member of a 
specified group and a specified period, a taxable year of the applicable 
CFC that ends with or within the specified period.
    (31) Stand-alone applicable CFC. The term stand-alone applicable CFC 
means any applicable CFC that is not a specified group member.

[[Page 502]]

    (32) Stock. The term stock has the meaning provided in paragraph 
(d)(2)(v) of this section.
    (l) Examples. The following examples illustrate the application of 
this section. For each example, unless otherwise stated, no exemptions 
from the application of section 163(j) are available, no foreign 
corporation has ECI, and all relevant taxable years and specified 
periods begin after December 31, 2020.
    (1) Example 1. Specified taxable years included in specified period 
of a specified group--(i) Facts. As of June 30, Year 1, USP, a domestic 
corporation, owns 60 percent of the common stock of FP, which owns all 
of the stock of FC1, FC2, and FC3. The remaining 40 percent of the 
common stock of FP is owned by an unrelated foreign corporation. FP has 
a single class of stock. FP acquired the stock of FC3 from an unrelated 
person on March 22, Year 1. The acquisition did not result in a change 
in FC3's taxable year or a close of its taxable year. USP's interest in 
FP and FP's interest in FC1 and FC2 has been the same for several years. 
USP has a taxable year ending June 30, Year 1, which is not a short 
taxable year. Each of FP, FC1, FC2, and FC3 are applicable CFCs. 
Pursuant to section 898(c)(2), FP and FC1 have taxable years ending May 
31, Year 1. Pursuant to section 898(c)(1), FC2 and FC3 have taxable 
years ending June 30, Year 1.
    (ii) Analysis--(A) Determining a specified group and specified 
period of the specified group. Pursuant to paragraph (d) of this 
section, FP, FC1, FC2, and FC3 are members of a specified group, and FP 
is the specified group parent. Because the specified group parent, FP, 
is an applicable CFC, the specified period of the specified group is the 
period ending on June 30, Year 1, which is the last day of FP's required 
year described in section 898(c)(1), without regard to section 
898(c)(2), and beginning on July 1, Year 0, which is the first day 
following the last day of the specified group's immediately preceding 
specified period (June 30, Year 0). See paragraph (k)(29)(i)(B) of this 
section.
    (B) Determining the specified taxable years with respect to the 
specified period. Pursuant to paragraph (d)(3) of this section, because 
each of FP and FC1 are included in the specified group on the last day 
of their taxable years ending May 31, Year 1, and such taxable years end 
with or within the specified period ending June 30, Year 1, FP and FC1 
are specified group members with respect to the specified period ending 
June 30, Year 1, for their entire taxable years ending May 31, Year 1, 
and those taxable years are specified taxable years. Similarly, because 
each of FC2 and FC3 are included in the specified group on the last day 
of their taxable years ending June 30, Year 1, and such taxable years 
end with or within the specified period ending June 30, Year 1, FC2 and 
FC3 are specified group members with respect to the specified period 
ending June 30, Year 1, for their entire taxable years ending June 30, 
Year 1, and those taxable years are specified taxable years. The fact 
that FC3 was acquired on March 22, Year 1, does not prevent FC3 from 
being a specified group member with respect to the specified period for 
the portion of its specified taxable year before March 22, Year 1.
    (2) Example 2. CFC groups--(i) Facts. The facts are the same as in 
Example 1 in paragraph (l)(1)(i) of this section except that, in 
addition, a CFC group election is in place with respect to the specified 
period ending June 30, Year 1.
    (ii) Analysis. Because a CFC group election is in place for the 
specified period ending June 30, Year 1, pursuant to paragraph 
(e)(2)(ii) of this section, each specified group member is a CFC group 
member with respect to its specified taxable year ending with or within 
the specified period. Accordingly, FP, FC1, FC2, and FC3 are CFC group 
members with respect to the specified period ending June 30, Year 1, for 
their specified taxable years ending May 31, Year 1, and June 30, Year 
1, respectively. Pursuant to paragraph (e)(2)(i) of this section, the 
CFC group for the specified period ending June 30, Year 1, consists of 
FP, FC1, FC2, and FC3 for their specified taxable years ending May 31, 
Year 1, and June 30, Year 1, respectively. Pursuant to paragraph (c)(2) 
of this section, a single section 163(j) limitation is computed for the 
specified period ending June 30, Year 1. That section 163(j) calculation 
will include FP and FC1's specified taxable

[[Page 503]]

years ending May 31, Year 1, and FC2 and FC3's specified taxable years 
ending June 30, Year 1.
    (3) Example 3. Application of anti-abuse rule--(i) Facts. USP, a 
domestic corporation, owns all of the stock of CFC1 and CFC2. Thus, USP 
is the specified group parent of a specified group, the specified group 
members of which are CFC1 and CFC2. USP has a calendar year taxable 
year. All specified group members also have a calendar year taxable year 
and a functional currency of the U.S. dollar. CFC1 is organized in, and 
a tax resident of, a jurisdiction that imposes no tax on certain types 
of income, including interest income. With respect to Year 1, USP 
expects to pay no residual U.S. tax on its income inclusion under 
section 951A(a) (GILTI inclusion amount) and expects to have unused 
foreign tax credits in the category described in section 904(d)(1)(A). A 
CFC group election is not in effect for Year 1. With a principal purpose 
of reducing USP's Federal income tax liability in subsequent taxable 
years, on January 1, Year 1, CFC1 loans $100x to CFC2. On December 31, 
Year 1, CFC2 pays interest of $10x to CFC1 and repays the principal of 
$100x. Absent the application of paragraph (g)(4)(i) of this section, 
all $10x of CFC2's interest expense would be disallowed business 
interest expense and, therefore, CFC2 would have $10x of disallowed 
business interest expense carryforward to Year 2. In Year 2, CFC2 
disposes of one of its businesses at a substantial gain that gives rise 
to tested income (within the meaning of section 951A(c)(2)(A) and Sec.  
1.951A-2(b)(1)). As a result of the gain being included in the ATI of 
CFC2, absent the application of paragraph (g)(4)(i) of this section, 
CFC2 would be allowed to deduct the entire $10x of disallowed business 
interest expense carryforward and therefore reduce the amount of its 
tested income. Also, USP would pay residual U.S. tax on its GILTI 
inclusion amount in Year 2, without regard to the application of 
paragraph (g)(4)(i) of this section.
    (ii) Analysis. The $10x of business interest expense paid in Year 1 
is a payment amount described in paragraph (g)(4)(i) of this section 
because it is between specified group members, CFC1 and CFC2. 
Furthermore, the requirements of paragraphs (g)(4)(i)(A), (B), and (C) 
of this section are satisfied because the $10x of business interest 
expense is incurred with a principal purpose of reducing USP's Federal 
income tax liability; absent the application of paragraph (g)(4)(i) of 
this section, the effect of CFC2 treating the $10x of business interest 
expense as disallowed business interest expense in Year 1 would be to 
reduce USP's Federal income tax liability in Year 2; and no CFC group 
election is in effect with respect to the specified group in Year 1. 
Because the requirements of paragraphs (g)(4)(i)(A), (B), and (C) of 
this section are satisfied, CFC2's ATI for Year 1 is increased by the 
ATI adjustment amount, or $33.33x, which is the amount equal to 3 \1/3\ 
multiplied by $10x (the lesser of the payment amount of $10x and the 
disallowed business interest expense of $10x). As a result, the $10x of 
business interest expense is not disallowed business interest expense of 
CFC2 in Year 1, and therefore does not give rise to a disallowed 
business interest expense carryforward to Year 2.
    (m) Applicability dates--(1) General applicability date. Except as 
provided in paragraph (m)(2) of this section, this section applies for a 
taxable year of a foreign corporation beginning on or after November 13, 
2020.
    (2) Exception. Paragraphs (a), (c)(1), (c)(2)(i) and (ii), and 
(c)(3) through (5), (d), (e), (f)(1), (g)(3) and (4), (h), and (k)(1) 
through (3), (6) through (8), and (10) through (32) of this section 
apply for a taxable year of a foreign corporation beginning on or after 
March 22, 2021.
    (3) Early application--(i) Rules for paragraphs (b) and (g)(1) and 
(2) of this section. Taxpayers and their related parties, within the 
meaning of sections 267(b) (determined without regard to section 
267(c)(3)) and 707(b)(1), may choose to apply the rules in paragraphs 
(b) and (g)(1) and (2) of this section for a taxable year beginning 
after December 31, 2017, and before November 13, 2020, provided that 
those taxpayers and their related parties consistently apply all of 
those rules and the rules described in paragraph (m)(4) of this section 
for that taxable year. If a taxpayer and its related parties apply the 
rules described in paragraph (m)(4) of

[[Page 504]]

this section, as contained in T.D. 9905 (Sec. Sec.  1.163(j)-0 through 
1.163(j)-11, effective November 13, 2020), they will be considered as 
applying the rules described in paragraph (m)(4) of this section for 
purposes of this paragraph (m)(3)(i).
    (ii) Rules for certain other paragraphs in this section. Taxpayers 
and their related parties, within the meaning of sections 267(b) 
(determined without regard to section 267(c)(3)) and 707(b)(1), may 
choose to apply the rules in paragraphs (a), (c)(1), (c)(2)(i) and (ii), 
and (c)(3) through (5), (d), (e), (f)(1), (g)(3) and (4), (h), and 
(k)(1) through (3), (6) through (8), and (10) through (32) of this 
section for a taxable year beginning after December 31, 2017, and before 
March 22, 2021, provided that those taxpayers and their related parties 
consistently apply all of those rules and the rules described in 
paragraph (m)(4) of this section for that taxable year and for each 
subsequent taxable year. If a taxpayer and its related parties apply the 
rules described in paragraph (m)(4) of this section, as contained in 
T.D. 9905 (Sec. Sec.  1.163(j)-0 through 1.163(j)-11, effective November 
13, 2020) as modified by T.D. 9943 (effective January 13, 2021),they 
will be considered as applying the rules described in paragraph (m)(4) 
of this section for purposes of this paragraph (m)(3)(ii).
    (4) Additional rules that must be applied consistently. The rules 
described in this paragraph (m)(4) are the section 163(j) regulations 
and, if applicable, Sec. Sec.  1.263A-9, 1.263A-15, 1.381(c)(20)-1, 
1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 1.383-1, 1.469-9, 
1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 1.1377-1, 1.1502-13, 
1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 1.1502-99 (to the 
extent they effectuate the rules of Sec. Sec.  1.382-2, 1.382-5, 1.382-
6, and 1.383-1) and 1.1504-4.
    (5) Election for prior taxable years and specified periods. 
Notwithstanding paragraph (e)(5)(iii) or (h)(5)(i) of this section, in 
the case of a specified period of a specified group or a taxable year of 
a stand-alone applicable CFC that ends with or within a taxable year of 
a designated U.S. person ending before November 13, 2020, a CFC group 
election or a safe-harbor election may be made on an amended Federal 
income tax return filed on or before the due date (taking into account 
extensions, if any) of the original Federal income tax return for the 
first taxable year of each designated U.S. person ending on or after 
November 13, 2020.

[T.D. 9905, 85 FR 56760, Sept. 14, 2020, as amended by T.D. 9943, 86 FR 
5532, Jan. 19, 2021]



Sec.  1.163(j)-8  [Reserved]



Sec.  1.163(j)-9  Elections for excepted trades or businesses; 
safe harbor for certain REITs.

    (a) Overview. The limitation in section 163(j) applies to business 
interest, which is defined under section 163(j)(5) as interest properly 
allocable to a trade or business. The term trade or business does not 
include any electing real property trade or business or any electing 
farming business. See section 163(j)(7). This section provides the rules 
and procedures for taxpayers to follow in making an election under 
section 163(j)(7)(B) for a trade or business to be an electing real 
property trade or business and an election under section 163(j)(7)(C) 
for a trade or business to be an electing farming business.
    (b) Availability of election--(1) In general. An election under 
section 163(j)(7)(B) for a real property trade or business to be an 
electing real property trade or business is available to any trade or 
business that is described in Sec.  1.163(j)-1(b)(14)(i), (ii), or 
(iii), and an election under section 163(j)(7)(C) for a farming business 
to be an electing farming business is available to any trade or business 
that is described in Sec.  1.163(j)-1(b)(13)(i), (ii), or (iii).
    (2) Special rules--(i) Exempt small businesses. An election 
described in paragraph (b)(1) of this section is available regardless of 
whether the real property trade or business or farming business making 
the election also meets the requirements of the small business exemption 
in section 163(j)(3) and Sec.  1.163(j)-2(d). See paragraph (c)(2) of 
this section for the effect of the election relating to depreciation.
    (ii) Section 162 trade or business not required for electing real 
property trade or business. An election described in paragraph (b)(1) of 
this section to be an electing real property trade or business is 
available regardless of whether the

[[Page 505]]

trade or business with respect to which the election is made is a trade 
or business under section 162. For example, a taxpayer engaged in 
activities described in section 469(c)(7)(C) and Sec.  1.469-9(b)(2), as 
required in Sec.  1.163(j)-1(b)(14)(i), may make an election for a trade 
or business to be an electing real property trade or business, 
regardless of whether its activities rise to the level of a section 162 
trade or business.
    (c) Scope and effect of election--(1) In general. An election under 
this section is made with respect to each eligible trade or business of 
the taxpayer and applies only to such trade or business for which the 
election is made. An election under this section applies to the taxable 
year in which the election is made and to all subsequent taxable years. 
See paragraph (e) of this section for terminations of elections.
    (2) Irrevocability. An election under this section is irrevocable.
    (3) Depreciation. Taxpayers making an election under this section 
are required to use the alternative depreciation system for certain 
types of property under section 163(j)(11) and cannot claim the 
additional first-year depreciation deduction under section 168(k) for 
those types of property.
    (d) Time and manner of making election--(1) In general. Subject to 
paragraph (f) of this section, a taxpayer makes an election under this 
section by attaching an election statement to the taxpayer's timely 
filed original Federal income tax return, including extensions. A 
taxpayer may make elections for multiple trades or businesses on a 
single election statement.
    (2) Election statement contents. The election statement should be 
titled ``Section 1.163(j)-9 Election'' and must contain the following 
information for each trade or business:
    (i) The taxpayer's name;
    (ii) The taxpayer's address;
    (iii) The taxpayer's social security number (SSN) or employer 
identification number (EIN);
    (iv) A description of the taxpayer's electing trade or business 
sufficient to demonstrate qualification for an election under this 
section, including the principal business activity code; and
    (v) A statement that the taxpayer is making an election under 
section 163(j)(7)(B) or (C), as applicable.
    (3) Consolidated group's trade or business. For a consolidated 
group's trade or business, the election under this section is made by 
the agent for the group, as defined in Sec.  1.1502-77, on behalf of 
itself and members of the consolidated group. Only the name and taxpayer 
identification number (TIN) of the agent for the group, as defined in 
Sec.  1.1502-77, must be provided on the election statement.
    (4) Partnership's trade or business. An election for a partnership 
must be made on the partnership's return for a trade or business that 
the partnership conducts. An election by a partnership does not apply to 
a trade or business conducted by a partner outside the partnership.
    (e) Termination of election--(1) In general. An election under this 
section automatically terminates if a taxpayer ceases to engage in the 
electing trade or business. A taxpayer is considered to cease to engage 
in an electing trade or business if the taxpayer sells or transfers 
substantially all of the assets of the electing trade or business to an 
acquirer that is not a related party in a taxable asset transfer. A 
taxpayer is also considered to cease to engage in an electing trade or 
business if the taxpayer terminates its existence for Federal income tax 
purposes or ceases operation of the electing trade or business, except 
to the extent that such termination or cessation results in the sale or 
transfer of substantially all of the assets of the electing trade or 
business to an acquirer that is a related party, or in a transaction 
that is not a taxable asset transfer.
    (2) Taxable asset transfer defined. For purposes of this paragraph 
(e), the term taxable asset transfer means a transfer in which the 
acquirer's basis or adjusted basis in the assets is not determined, 
directly or indirectly, in whole or in part, by reference to the 
transferor's basis in the assets.
    (3) Related party defined. For purposes of this paragraph (e), the 
term related party means any person who bears a relationship to the 
taxpayer which is described in section 267(b) or 707(b)(1).

[[Page 506]]

    (4) Anti-abuse rule. If, within 60 months of a sale or transfer of 
assets described in paragraph (e)(1) of this section, the taxpayer or a 
related party reacquires substantially all of the assets that were used 
in the taxpayer's prior electing trade or business, or substantially 
similar assets, and resumes conducting such prior electing trade or 
business, the taxpayer's previously terminated election under this 
section is reinstated and is effective on the date the prior electing 
trade or business is reacquired.
    (f) Additional guidance. The rules and procedures regarding the time 
and manner of making an election under this section and the election 
statement contents in paragraph (d) of this section may be modified 
through other guidance (see Sec. Sec.  601.601(d) and 601.602 of this 
chapter). Additional situations in which an election may terminate under 
paragraph (e) of this section may be provided through guidance published 
in the Federal Register or in the Internal Revenue Bulletin (see Sec.  
601.601(d) of this chapter).
    (g) Examples. The examples in this paragraph (g) illustrate the 
application of this section. Unless otherwise indicated, X and Y are 
domestic C corporations; D and E are U.S. resident individuals not 
subject to any foreign income tax; and the exemption for certain small 
businesses in Sec.  1.163(j)-2(d) does not apply.
    (1) Example 1: Scope of election--(i) Facts. For the taxable year 
ending December 31, 2021, D, a sole proprietor, owned and operated a 
dairy farm and an orchard as separate farming businesses described in 
section 263A(e)(4). D filed an original Federal income tax return for 
the 2021 taxable year on August 1, 2022, and included with the return an 
election statement meeting the requirements of paragraph (d)(2) of this 
section. The election statement identified D's dairy farm business as an 
electing trade or business under this section. On March 1, 2023, D sold 
some but not all or substantially all of the assets from D's dairy farm 
business to D's neighbor, E, who is unrelated to D. After the sale, D 
continued to operate the dairy farm trade or business.
    (ii) Analysis. D's election under this section was properly made and 
is effective for the 2021 taxable year and subsequent years. D's dairy 
farm business is an excepted trade or business because D made the 
election with D's timely filed Federal income tax return. D's orchard 
business is a non-excepted trade or business, because D did not make an 
election for the orchard business to be an excepted trade or business. 
The sale of some but not all or substantially all of the assets from D's 
dairy farm business does not affect D's election under this section.
    (2) Example 2: Availability of election--(i) Facts. E, an 
individual, operates a dairy business that is a farming business under 
section 263A and also owns real property that is not part of E's dairy 
business that E leases to an unrelated party through a triple net lease. 
E's average gross receipts, excluding inherently personal amounts, for 
the three years prior to 2021 are approximately $25 million, but E is 
unsure of the exact amount.
    (ii) Analysis. Under paragraph (b)(2)(i) of this section, E may make 
an election under this section for the dairy business to be an electing 
farming business, even though E is unsure whether the small business 
exemption of Sec.  1.163(j)-2(d) applies. Additionally, under paragraph 
(b)(2)(ii) of this section, assuming the requirements of section 
163(j)(7)(C) and this section are otherwise satisfied, E may make an 
election under this section for its triple net lease property to be an 
electing real property trade or business, even though E may not be 
engaged in a trade or business under section 162 with respect to the 
real property.
    (3) Example 3: Cessation of entire trade or business--(i) Facts. X 
has a real property trade or business for which X made an election under 
this section by attaching an election statement to A's 2021 Federal 
income tax return. On March 1, 2022, X sold all of the assets used in 
its real property trade or business to Y, an unrelated party, and ceased 
to engage in the electing trade or business. On June 1, 2027, X started 
a new real property trade or business that was substantially similar to 
X's prior electing trade or business.
    (ii) Analysis. X's election under this section terminated on March 
1, 2022, under paragraph (e)(1) of this section.

[[Page 507]]

X may choose whether to make an election under this section for X's new 
real property trade or business that A started in 2027.
    (4) Example 4: Anti-abuse rule--(i) Facts. The facts are the same as 
in Example 3 in paragraph (g)(3)(i) of this section, except that X re-
started its previous real property trade or business on February 1, 
2023, when X reacquired substantially all of the assets that X had sold 
on March 1, 2022.
    (ii) Analysis. X's election under this section terminated on March, 
1, 2022, under paragraph (e)(1) of this section. On February 1, 2023, 
X's election was reinstated under paragraph (e)(4) of this section. X's 
new real property trade or business is treated as a resumption of X's 
prior electing trade or business and is therefore treated as an electing 
real property trade or business.
    (5) Example 5: Trade or business continuing after acquisition--(i) 
Facts. X has a farming business for which X made an election under this 
section by attaching an election statement to X's timely filed 2021 
Federal income tax return. Y, unrelated to X, also has a farming 
business, but Y has not made an election under this section. On July 1, 
2022, X transferred all of its assets to Y in a transaction described in 
section 368(a)(1)(D). After the transfer, Y continues to operate the 
farming trade or business acquired from X.
    (ii) Analysis. Under paragraph (e)(1) of this section, Y is subject 
to X's election under this section for the trade or business that uses 
X's assets because the sale or transfer was not in a taxable 
transaction. Y cannot revoke X's election, but X's election has no 
effect on Y's existing farming business for which Y has not made an 
election under this section.
    (6) Example 6: Trade or business merged after acquisition--(i) 
Facts. The facts are the same as in Example 5 in paragraph (g)(5)(i) of 
this section, except that Y uses the assets acquired from X in a trade 
or business that is neither a farming business (as defined in section 
263A(e)(4) or Sec.  1.263A-4(a)(4)) nor a trade or business of a 
specified agricultural or horticultural cooperative (as defined in 
section 199A(g)(4)).
    (ii) Analysis. Y is not subject to X's election for Y's farming 
business because the farming trade or business ceased to exist after the 
acquisition.
    (h) Safe harbor for REITs--(1) In general. If a REIT holds real 
property, as defined in Sec.  1.856-10, interests in one or more 
partnerships directly or indirectly holding real property (through 
interests in other partnerships or shares in other REITs), as defined in 
Sec.  1.856-10, or shares in one or more other REITs directly or 
indirectly holding real property (through interests in partnerships or 
shares in other REITs), as defined in Sec.  1.856-10, the REIT is 
eligible to make the election described in paragraph (b)(1) of this 
section to be an electing real property trade or business for purposes 
of sections 163(j)(7)(B) and 168(g)(1)(F) for all or part of its assets. 
The portion of the REIT's assets eligible for this election is 
determined under paragraph (h)(2) or (3) of this section.
    (2) REITs that do not significantly invest in real property 
financing assets. If a REIT makes the election under paragraph (h)(1) of 
this section and the value of the REIT's real property financing assets, 
as defined in paragraphs (h)(5) and (6) of this section, at the close of 
the taxable year is 10 percent or less of the value of the REIT's total 
assets at the close of the taxable year, as determined under section 
856(c)(4)(A), then all of the REIT's assets are treated as assets of an 
excepted trade or business.
    (3) REITs that significantly invest in real property financing 
assets. If a REIT makes the election under paragraph (h)(1) of this 
section and the value of the REIT's real property financing assets, as 
defined in paragraphs (h)(5) and (6) of this section, at the close of 
the taxable year is more than 10 percent of the value of the REIT's 
total assets at the close of the taxable year, as determined under 
section 856(c)(4)(A), then for the allocation of interest expense, 
interest income, and other items of expense and gross income to excepted 
and non-excepted trades or businesses, the REIT must apply the rules set 
forth in Sec.  1.163(j)-10 as modified by paragraph (h)(4) of this 
section.
    (4) REIT real property assets, interests in partnerships, and shares 
in other

[[Page 508]]

REITs--(i) Real property assets. Assets held by a REIT described in 
paragraph (h)(3) of this section that meet the definition of real 
property under Sec.  1.856-10 are treated as assets of an excepted trade 
or business.
    (ii) Partnership interests. If a REIT described in paragraph (h)(3) 
of this section holds an interest in a partnership, in applying the 
partnership look-through rule described in Sec.  1.163(j)-
10(c)(5)(ii)(A)(2), the REIT treats assets of the partnership that meet 
the definition of real property under Sec.  1.856-10 as assets of an 
excepted trade or business. This application of the definition of real 
property under Sec.  1.856-10 does not affect the characterization of 
the partnership's assets at the partnership level or for any non-REIT 
partner. However, no portion of the adjusted basis of the REIT's 
interest in the partnership is allocated to a non-excepted trade or 
business if the partnership makes an election under paragraph (h)(7) of 
this section and if all of the partnership's assets are treated as 
assets of an excepted trade or business under paragraph (h)(2) of this 
section.
    (iii) Shares in other REITs--(A) In general. If a REIT (shareholder 
REIT) described in paragraph (h)(3) of this section holds an interest in 
another REIT, then for purposes of applying the allocation rules in 
Sec.  1.163(j)-10, the partnership look-through rule described in Sec.  
1.163(j)-10(c)(5)(ii)(A)(2), as modified by paragraph (h)(4)(ii) of this 
section, applies to the assets of the other REIT (as if the other REIT 
were a partnership) in determining the portion of shareholder REIT's 
adjusted basis in the shares of the other REIT that is allocable to an 
excepted or non-excepted trade or business of shareholder REIT. However, 
no portion of the adjusted basis of shareholder REIT's shares in the 
other REIT is allocated to a non-excepted trade or business if all of 
the other REIT's assets are treated as assets of an excepted trade or 
business under paragraph (h)(2) of this section.
    (B) Information necessary. If shareholder REIT does not receive, 
either directly from the other REIT or indirectly through the analysis 
of an applicable financial statement (within the meaning of section 
451(b)(3)) of the other REIT, the information necessary to determine 
whether and to what extent the assets of the other REIT are investments 
in real property financing assets, then shareholder REIT's shares in the 
other REIT are treated as assets of a non-excepted trade or business 
under Sec.  1.163(j)-10(c).
    (iv) Tiered entities. In applying Sec.  1.163(j)-10(c)(5)(ii)(E), 
the rules in paragraphs (h)(4)(ii) and (h)(4)(iii)(A) and (B) of this 
section apply to any partnerships and other REITs within the tier.
    (5) Value of shares in other REITs--(i) In general. If a REIT 
(shareholder REIT) holds shares in another REIT, then solely for 
purposes of applying the value tests under paragraphs (h)(2) and (3) of 
this section, the value of shareholder REIT's real property financing 
assets includes the portion of the value of shareholder REIT's shares in 
the other REIT that is attributable to the other REIT's investments in 
real property financing assets. However, no portion of the value of 
shareholder REIT's shares in the other REIT is included in the value of 
shareholder REIT's real property financing assets if all of the other 
REIT's assets are treated as assets of an excepted trade or business 
under paragraph (h)(2) of this section.
    (ii) Information necessary. If shareholder REIT does not receive, 
either directly from the other REIT or indirectly through the analysis 
of an applicable financial statement (within the meaning of section 
451(b)(3)) of the other REIT, the information necessary to determine 
whether and to what extent the assets of the other REIT are investments 
in real property financing assets, then shareholder REIT's shares in the 
other REIT are treated as real property financing assets for purposes of 
paragraphs (h)(2) and (3) of this section.
    (iii) Tiered REITs. The rules in paragraphs (h)(5)(i) and (ii) of 
this section apply successively to the extent that the other REIT, and 
any other REIT in the tier, holds shares in another REIT.
    (6) Real property financing assets. For purposes of this paragraph 
(h), real property financing assets include interests, including 
participation interests, in the following: Mortgages, deeds of trust, 
and installment land contracts; mortgage pass-through certificates

[[Page 509]]

guaranteed by Government National Mortgage Association (GNMA), Federal 
National Mortgage Association (FNMA), Federal Home Loan Mortgage 
Corporation (FHLMC), or Canada Mortgage and Housing Corporation (CMHC); 
REMIC regular interests; other interests in investment trusts classified 
as trusts under Sec.  301.7701-4(c) of this chapter that represent 
undivided beneficial ownership in a pool of obligations principally 
secured by interests in real property and related assets that would be 
permitted investments if the investment trust were a REMIC; obligations 
secured by manufactured housing treated as single family residences 
under section 25(e)(10), without regard to the treatment of the 
obligations or the properties under state law; and debt instruments 
issued by publicly offered REITs.
    (7) Application of safe harbor for partnerships controlled by REITs. 
A partnership is eligible to make the election under paragraph (h)(1) of 
this section if one or more REITs own directly or indirectly at least 50 
percent of the partnership's capital and profits, the partnership meets 
the requirements of section 856(c)(2), (3), and (4) as if the 
partnership were a REIT, and the partnership satisfies the requirements 
described in paragraph (h)(1) of this section as if the partnership were 
a REIT. The portion of the partnership's assets eligible for this 
election is determined under paragraph (h)(2) or (3) of this section, 
treating the partnership as if it were a REIT.
    (8) REITs or partnerships controlled by REITs that do not apply the 
safe harbor. A REIT or a partnership that is eligible but chooses not to 
apply the safe harbor provisions of paragraph (h)(1) or (7) of this 
section, respectively, may still elect, under paragraph (b)(1) of this 
section, for one or more of its trades or businesses to be an electing 
real property trade or business, provided that such trade or business is 
otherwise eligible to elect under paragraph (b)(1) of this section. A 
REIT or partnership that makes the election under paragraph (b)(1) of 
this section without utilizing the safe harbor provisions of paragraph 
(h) of this section may not rely on any portion of paragraphs (h)(1) 
through (7) of this section.
    (i) [Reserved]
    (j) Special anti-abuse rule for certain real property trades or 
businesses--(1) In general. Except as provided in paragraph (j)(2) of 
this section, a trade or business (lessor) does not constitute a trade 
or business eligible for an election described in paragraph (b)(1) of 
this section to be an electing real property trade or business if at 
least 80 percent, determined by fair market rental value, of the real 
property used in the business is leased to a trade or business (lessee) 
under common control with the lessor, regardless of whether the 
arrangement is pursuant to a written lease or pursuant to a service 
contract or another agreement that is not denominated as a lease. For 
purposes of this paragraph (j), fair market rental value is the amount 
of rent that a prospective lessee that is unrelated to the lessor would 
be willing to pay for a rental interest in real property, taking into 
account the geographic location, size, and type of the real property. 
For purposes of this paragraph (j), two trades or businesses are under 
common control if 50 percent of the direct and indirect ownership of 
both businesses are held by related parties within the meaning of 
sections 267(b) and 707(b).
    (2) Exceptions--(i) De minimis exception. The limitation in 
paragraph (j)(1) of this section does not apply, and the lessor is 
eligible to make an election under paragraph (b)(1) of this section, if 
the lessor leases, regardless of whether the arrangement is pursuant to 
a written lease or pursuant to a service contract or another agreement 
that is not denominated as a lease, at least 90 percent of the lessor's 
real property, determined by fair market rental value, to one or more of 
the following:
    (A) A party not under common control with the lessor or lessee;
    (B) A party under common control with the lessor or lessee that has 
made an election described in paragraph (b)(1) of this section for a 
trade or business to be an electing real property trade or business or 
electing farming business, but only to the extent that the real property 
is used as part of its electing real property trade or business or 
electing farming business; or

[[Page 510]]

    (C) A party under common control with the lessor or lessee that is 
an excepted regulated utility trade or business, but only to the extent 
that the real property is used as part of its excepted regulated utility 
trade or business.
    (ii) Look-through exception. If the de minimis exception in 
paragraph (j)(2)(i) of this section does not apply because less than 90 
percent of the lessor's real property is leased to parties described in 
paragraphs (j)(2)(i)(A), (B), and (C), the lessor is eligible to make 
the election under paragraph (b)(1) of this section to the extent that 
the lessor leases the real property to parties described in paragraph 
(j)(2)(A), (B), or (C), and to the extent that the lessee subleases (or 
lessees ultimately sublease) the real property to:
    (A) A party not under common control with the lessor or lessee;
    (B) A party under common control with the lessor or lessee that has 
made an election described in paragraph (b)(1) of this section for a 
trade or business to be an electing real property trade or business or 
electing farming business to the extent that the real property is used 
as part of its electing real property trade or business or electing 
farming business; or
    (C) A party under common control with the lessor or lessee that is 
an excepted regulated utility trade or business to the extent that the 
real property is used as part of its excepted regulated utility trade or 
business.
    (iii) Inapplicability of exceptions to consolidated groups. The 
exceptions in paragraphs (j)(2)(i) and (ii) of this section do not apply 
when the lessor and lessee are members of the same consolidated group.
    (iv) Exception for certain REITs. The special anti-abuse rule in 
paragraph (j)(1) of this section does not apply to REITs or to 
partnerships making an election under paragraph (h)(7) of this section 
that lease qualified lodging facilities, as defined in section 
856(d)(9)(D), and qualified health care properties, as defined in 
section 856(e)(6)(D).
    (3) Allocations. See Sec.  1.163(j)-10(c)(3)(iii)(D) for rules 
related to the allocation of the basis of assets used in lessor trades 
or businesses described in paragraphs (j)(1) and (j)(2)(i) of this 
section.
    (4) Examples. The examples in this paragraph (j)(4) illustrate the 
application of paragraphs (j)(1), (2), and (3) of this section. Unless 
otherwise indicated, the parties are all domestic entities and are not 
members of a single consolidated group within the meaning of Sec.  
1.1502-1(h).
    (i) Example 1: Related party lease of hotel--(A) Facts. X and Y are 
under common control, as defined in paragraph (j)(1) of this section. X 
owns one piece of real property, a hotel, that X leases to Y. Y operates 
the hotel and provides hotel rooms and associated amenities to third 
party guests of the hotel. The form of the arrangement with third party 
hotel guests is a license to use rooms in the hotel and associated 
amenities. Y is a real property trade or business that has made an 
election under paragraph (b)(1) of this section.
    (B) Analysis. Because X leases at least 80 percent of X's real 
property to a party under common control, X is subject to the anti-abuse 
rule in paragraph (j)(1) of this section. However, under the de minimis 
exception under paragraph (j)(2)(i) of this section, 100 percent of the 
fair market rental value of the building is leased to a party under 
common control that has made an election to be an electing real property 
trade or business. Accordingly, X is eligible to make the election 
described in paragraph (b)(1) of this section for its entire trade or 
business.
    (ii) Example 2--(A) Facts. The facts are the same as in Example 1 in 
paragraph (j)(4)(i)(A) of this section, except that Y has not made an 
election under paragraph (b)(1) of this section, and is not otherwise 
using the real property in an excepted trade or business.
    (B) Analysis. Because X leases at least 80 percent of X's real 
property, determined by fair market rental value, to Y, a party under 
common control, X is subject to the anti-abuse rule in paragraph (j)(1) 
of this section. X is not eligible for the de minimis exception under 
paragraph (j)(2)(i) of this section because X does not lease at least 90 
percent of its real property to a party under common control, as defined 
in paragraph (j)(1) of this section,

[[Page 511]]

such as Y, and Y is not using the property in an otherwise excepted 
trade or business. However, X is eligible for the look-through exception 
under paragraph (j)(2)(ii) of this section because X leases 100 percent 
of its real property to Y, a party that is under common control, and Y 
subleases 100 percent of the real property to parties that are not under 
common control with X or Y. The fact that the license provided to hotel 
guests is not denominated as a lease does not prevent these licenses 
from being treated as a lease for purposes of paragraph (j) of this 
section. Accordingly, under the look-through exception under paragraph 
(j)(2)(ii) of this section, X is eligible to make the election described 
in paragraph (b)(1) of this section with regard to its entire trade or 
business.
    (iii) Example 3: Sublease to related party and unrelated third 
party--(A) Facts. X owns one piece of real property that X leases to Y, 
a party under common control, as defined in paragraph (j)(1) of this 
section. Y does not operate an excepted trade or business. Y subleases 
80 percent of the real property, determined by the fair market rental 
value, to a party under common control with Y that does not operate an 
excepted trade or business and 20 percent of the real property, 
determined by the fair market rental value, to an unrelated third party.
    (B) Analysis. Because X leases at least 80 percent of X's real 
property, determined by fair market rental value, to a party under 
common control, X is subject to the anti-abuse rule in paragraph (j)(1) 
of this section. X is not eligible for the de minimis exception in 
paragraph (j)(2)(i) of this section because X is not leasing at least 90 
percent of the real property, determined by fair market rental value, to 
a party under common control that operates an excepted trade or business 
and/or unrelated parties. Under the look-through exception under 
paragraph (j)(2)(ii) of this section, X is eligible to make the election 
described in paragraph (b)(1) of this section with respect to the 20 
percent of the fair market rental value of the real property subleased 
to an unrelated party because X is treated as directly leasing this 
portion to an unrelated party. X is not eligible to make the election 
described in paragraph (b)(1) of this section with respect to the 80 
percent of the building subleased to a party under common control 
because X is still treated as directly leasing this portion to a related 
party. Under Sec.  1.163(j)-10(c)(3)(iii)(D), X must allocate 80 percent 
of the basis in the real property as a non-excepted trade or business 
and 20 percent of the basis in the real property as an excepted trade or 
business.
    (iv) Example 4: Multiple subleases--(A) Facts. X owns a building 
that X leases to Y, a party under common control as defined in paragraph 
(j)(1) of this section. Y does not operate an excepted trade or 
business. Y subleases 80 percent of the building, determined by fair 
market rental value, to Z, a party under common control with both X and 
Y. Y subleases the remaining 20 percent of the building, determined by 
fair market rental value, to unrelated parties. Z subleases 50 percent 
of its leasehold interest, determined by fair market rental value, to 
parties unrelated to X, Y and Z, and uses the remaining leasehold 
interest in its retail business. Z does not operate an excepted trade or 
business.
    (B) Analysis. Because X leases at least 80 percent of X's real 
property, determined by fair market rental value, to a party under 
common control, X is subject to the anti-abuse rule in paragraph (j)(1) 
of this section. X is not eligible for the de minimis exception in 
paragraph (j)(2)(i) because X is not leasing at least 90 percent of the 
building, determined by fair market rental value, to a party under 
common control that operates an excepted trade or business and/or 
unrelated parties. Under the look-through exception under paragraph 
(j)(2)(ii) of this section, X is eligible to make the election described 
in paragraph (b)(1) of this section with respect to the 60 percent of 
the building that is subleased to unrelated parties, determined by 
adding 40 percent (50 percent of the 80 percent leasehold interest) from 
Z's sublease to an unrelated party and 20 percent from Y's sublease to 
unrelated parties (40 + 20). X is not eligible to make the election 
described in paragraph (b)(1) of

[[Page 512]]

this section with respect to the 40 percent of the building subleased to 
Z, because Z is a related party that does not operate an excepted trade 
or business.
    (v) Example 5: Lessee's Trade or Business--(A) Facts. X owns a 
building that X leases to W, a party under common control as defined in 
paragraph (j)(1) of this section. W operates the building as a widget 
manufacturing plant and does not sublease any portion of the building.
    (B) Analysis. X is not eligible to make the election described in 
paragraph (b)(1) of this section because X leases the entire building to 
a party under common control. X is not eligible for the de minimis 
exception in paragraph (j)(2)(i) of this section because X is not 
leasing at least 90 percent of the real property to a party under common 
control that operates an excepted trade or business and/or unrelated 
parties. W's trade or business cannot be an electing real property trade 
or business. X is not eligible for the look-through exception under 
paragraph (j)(2)(ii) of this section because W is not subleasing any 
part of the building.
    (k) Applicability date. This section applies to taxable years 
beginning on or after November 13, 2020. However, taxpayers and their 
related parties, within the meaning of sections 267(b) and 707(b)(1), 
may choose to apply the rules of this section to a taxable year 
beginning after December 31, 2017, so long as the taxpayers and their 
related parties consistently apply the rules of the section 163(j) 
regulations, and, if applicable, Sec. Sec.  1.263A-9, 1.263A-15, 
1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 
1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 
1.1377-1, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 
1.1502-99 (to the extent they effectuate the rules of Sec. Sec.  1.382-
2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4, to that taxable year.

[T.D. 9905, 85 FR 56760, Sept. 14, 2020]



Sec.  1.163(j)-10  Allocation of interest expense, interest income, 
and other items of expense and gross income to an excepted trade or business.

    (a) Overview--(1) In general--(i) Purposes. Except as provided in 
Sec.  1.163(j)-6(m) or Sec.  1.163(j)-9(h), this section provides the 
exclusive rules for allocating tax items that are properly allocable to 
a trade or business between excepted trades or businesses and non-
excepted trades or businesses for purposes of section 163(j). The amount 
of a taxpayer's interest expense that is properly allocable to excepted 
trades or businesses is not subject to the section 163(j) limitation. 
The amount of a taxpayer's other items of income, gain, deduction, or 
loss, including interest income, that is properly allocable to excepted 
trades or businesses is excluded from the calculation of the taxpayer's 
section 163(j) limitation. See section 163(j)(6) and (j)(8)(A)(i); see 
also Sec.  1.163(j)-1(b)(1)(i)(H), (b)(1)(ii)(F), and (b)(3). The 
general method of allocation set forth in paragraph (c) of this section 
is based on the approach that money is fungible and that interest 
expense is attributable to all activities and property, regardless of 
any specific purpose for incurring an obligation on which interest is 
paid. In no event may the amount of interest expense allocated under 
this section exceed the amount of interest paid or accrued, or treated 
as paid or accrued, by the taxpayer within the taxable year.
    (ii) Application of section. The amount of a taxpayer's tax items 
properly allocable to a trade or business, other than interest expense 
and interest income, that is properly allocable to excepted trades or 
businesses for purposes of section 163(j) is determined as set forth in 
paragraph (b) of this section. The amount of a taxpayer's interest 
expense and interest income that is properly allocable to excepted 
trades or businesses for purposes of section 163(j) generally is 
determined as set forth in paragraph (c) of this section, except as 
otherwise provided in paragraph (d) of this section. For purposes of 
this section, a taxpayer's activities are not treated as a separate 
trade or business to the extent those activities involve the provision 
of real property, goods, or services to a trade or business of the 
taxpayer (or, if the taxpayer is a member of a consolidated group, the 
consolidated group). For example, if a taxpayer engaged in a 
manufacturing trade or business has in-house legal personnel that 
provide legal services solely with respect to the taxpayer's 
manufacturing business, the taxpayer

[[Page 513]]

is not treated as also engaged in the trade or business of providing 
legal services. Similarly, if the taxpayer described in the previous 
sentence constructs or acquires real property solely for use by the 
taxpayer's manufacturing business, the taxpayer is not treated as also 
engaged in a real property trade or business.
    (2) Coordination with other rules--(i) In general. The rules of this 
section apply after a taxpayer has determined whether any interest 
expense or interest income paid, received, or accrued is properly 
allocable to a trade or business. Similarly, the rules of this section 
apply to other tax items after a taxpayer has determined whether those 
items are properly allocable to a trade or business. For instance, a 
taxpayer must apply Sec.  1.163-8T, if applicable, to determine which 
items of interest expense are investment interest under section 163(d) 
before applying the rules in paragraph (c) of this section to allocate 
interest expense between excepted and non-excepted trades or businesses. 
After determining whether its tax items are properly allocable to a 
trade or business, a taxpayer that is engaged in both excepted and non-
excepted trades or businesses must apply the rules of this section to 
determine the amount of interest expense that is business interest 
expense subject to the section 163(j) limitation and to determine which 
items are included or excluded in computing its section 163(j) 
limitation.
    (ii) Treatment of investment interest, investment income, investment 
expenses, and certain other tax items of a partnership with a C 
corporation or tax-exempt corporation as a partner. For rules governing 
the treatment of investment interest, investment income, investment 
expenses, and certain other separately stated tax items of a partnership 
with a C corporation or tax-exempt corporation as a partner, see 
Sec. Sec.  1.163(j)-4(b)(3) and 1.163(j)-6(k).
    (3) Application of allocation rules to foreign corporations and 
foreign partnerships. The rules of this section apply to foreign 
corporations and foreign partnerships.
    (4) Application of allocation rules to members of a consolidated 
group--(i) In general. As provided in Sec.  1.163(j)-4(d), the 
computations required by section 163(j) and the regulations in this part 
under section 163(j) of the Code generally are made for a consolidated 
group on a consolidated basis. In this regard, for purposes of applying 
the allocation rules of this section, all members of a consolidated 
group are treated as one corporation. Therefore, the rules of this 
section apply to the activities conducted by the group as if those 
activities were conducted by a single corporation. For example, the 
group (rather than a particular member) is treated as engaged in 
excepted or non-excepted trades or businesses. In the case of 
intercompany obligations, within the meaning of Sec.  1.1502-
13(g)(2)(ii), for purposes of allocating asset basis between excepted 
and non-excepted trades or businesses, the obligation of the member 
borrower is not considered an asset of the creditor member. Similarly, 
intercompany transactions, within the meaning of Sec.  1.1502-
13(b)(1)(i), are disregarded for purposes of this section, as are the 
resulting offsetting items, and property is allocated to a trade or 
business based on the activities of the group as if the members of the 
group were divisions of a single corporation. Further, stock of a group 
member that is owned by another member of the same group is not treated 
as an asset for purposes of this section, and the transfer of any amount 
of member stock to a non-member is treated by the group as a transfer of 
the member's assets proportionate to the amount of member stock 
transferred. Additionally, stock of a corporation that is not a group 
member is treated as owned by the group.
    (ii) Application of excepted business percentage to members of a 
consolidated group. After a consolidated group has determined the 
percentage of the group's interest expense allocable to excepted trades 
or businesses for the taxable year (and thus not subject to the section 
163(j) limitation), this exempt percentage is applied to the interest 
paid or accrued by each member during the taxable year to any lender 
that is not a group member. Therefore, except to the extent paragraph 
(d) of this section (providing rules for certain

[[Page 514]]

qualified nonrecourse indebtedness) applies, an identical percentage of 
the interest paid or accrued by each member of the group to any lender 
that is not a group member is treated as allocable to excepted trades or 
businesses, regardless of whether any particular member actually engaged 
in an excepted trade or business.
    (iii) Basis in assets transferred in an intercompany transaction. 
For purposes of allocating interest expense and interest income under 
paragraph (c) of this section, the basis of property does not include 
any gain or loss realized with respect to the property by another member 
in an intercompany transaction, as defined in Sec.  1.1502-13(b), 
whether or not the gain or loss is deferred.
    (5) Tax-exempt organizations. For tax-exempt organizations, section 
512 and the regulations in this part under section 512 of the Code 
determine the rules for allocating all income and expenses among 
multiple trades or businesses.
    (6) Application of allocation rules to disallowed disqualified 
interest. A taxpayer may apply the allocation rules of this section to 
disallowed disqualified interest by either:
    (i) Applying the allocation rules of this section to all of the 
taxpayer's disallowed disqualified interest in the taxable year(s) in 
which the disallowed disqualified interest was paid or accrued (the 
historical approach); or
    (ii) Treating all of the taxpayer's disallowed disqualified interest 
as if it were paid or accrued in the taxpayer's first taxable year 
beginning after December 31, 2017 (the effective date approach).
    (7) Examples. The following examples illustrate the principles of 
this paragraph (a).
    (i) Example 1: Items properly allocable to a trade or business--(A) 
Facts. Individual T operates Business X, a non-excepted trade or 
business, as a sole proprietor. In Year 1, T pays or accrues $40x of 
interest expense and receives $100x of gross income with respect to 
Business X that is not eligible for a section 199A deduction. T borrows 
money to buy a car for personal use, and T pays or accrues $20x of 
interest expense with respect to the car loan. T also invests in 
corporate bonds, and, in Year 1, T receives $50x of interest income on 
those bonds.
    (B) Analysis. Under paragraphs (a)(1) and (2) of this section, T 
must determine which items of income and expense, including items of 
interest income and interest expense, are properly allocable to a trade 
or business. T's $100x of gross income and T's $40x of interest expense 
with respect to Business X are properly allocable to a trade or 
business. However, the interest expense on T's car loan is personal 
interest within the meaning of section 163(h)(2) rather than interest 
properly allocable to a trade or business. Similarly, T's interest 
income from corporate bonds is not properly allocable to a trade or 
business because it is interest from investment activity. See section 
163(d)(4)(B).
    (ii) Example 2: Intercompany transaction--(A) Facts. S is a member 
of a consolidated group of which P is the common parent. P conducts an 
electing real property trade or business (Business X), and S conducts a 
non-excepted trade or business (Business Y). P leases Building V (which 
P owns) to S for use in Business Y.
    (B) Analysis. Under paragraph (a)(4)(i) of this section, a 
consolidated group is treated as a single corporation for purposes of 
applying the allocation rules of this section, and the consolidated 
group (rather than a particular member of the group) is treated as 
engaged in excepted and non-excepted trades or businesses. Thus, 
intercompany transactions are disregarded for purposes of this section. 
As a result, the lease of Building V by P to S is disregarded. Moreover, 
because Building V is used in Business Y, basis in this asset is 
allocated to Business Y rather than Business X for purposes of these 
allocation rules, regardless of which member (P or S) owns the building.
    (iii) Example 3: Intercompany sale of natural gas--(A) Facts. S is a 
member of a consolidated group of which P is the common parent. S drills 
for natural gas and is not an excepted regulated utility trade or 
business. S sells most of its natural gas production to P, which 
produces electricity at its natural gas-fired power plants, and S sells 
the rest of its natural gas production to third

[[Page 515]]

parties at market rates. P is an excepted regulated utility trade or 
business to the extent that it is engaged in a trade or business 
described in Sec.  1.163(j)-1(b)(15)(i).
    (B) Analysis. Intercompany transactions are disregarded for purposes 
of this section. As a result, the intercompany sales of natural gas by S 
to P are disregarded. Moreover, the assets of S and P are allocated 
between the excepted and non-excepted trades or businesses of the P 
group based on the assets used in each trade or business. Assets of S 
may be allocated to the P group's excepted trade or business to the 
extent those assets are used in the trade or business of the furnishing 
or sale of electrical energy. Likewise, assets of P may be allocated to 
the P group's non-excepted trade or business to the extent those assets 
are used in the trade or business of natural gas production.
    (iv) Example 4: Disallowed disqualified interest--(A) Facts. S is a 
member of a consolidated group of which P is the common parent. P and S 
are the only members of an affiliated group under old section 
163(j)(6)(C). S operates a farm equipment leasing business (Business X) 
that is not an excepted trade or business. P is engaged in an electing 
farming business (Business Y). Entering its first taxable year beginning 
after December 31, 2017, the P group has disallowed disqualified 
interest of $120x, all of which the P group paid or accrued in earlier 
taxable years in which it only operated Business X. The P group also 
incurs $100x of interest expense during its 2018 taxable year, of which 
$25x (25 percent of $100x) is business interest expense properly 
allocable to Business X and $75x (75 percent of $100x) is properly 
allocable to Business Y under paragraph (c) of this section.
    (B) Analysis. Under paragraph (a)(6) of this section, the P group 
may allocate disallowed disqualified interest to Business X and Business 
Y by either applying the allocation rules of this section in the taxable 
years in which the disallowed disqualified interest was paid or accrued 
(the historical approach) or by treating such interest as though it were 
paid or accrued in the P group's first taxable year beginning after 
December 31, 2017 (the effective date approach). Accordingly, if the P 
group chooses to rely on the historical approach, it allocates all $120x 
of disallowed disqualified interest to Business X (a non-excepted trade 
or business), and all $120x of disallowed disqualified interest is 
subject to the section 163(j) limitation. If, instead, the P group 
chooses to rely on the effective date approach, it allocates its $120x 
of disallowed disqualified interest in the same proportion as its $100x 
of business interest expense that was paid or accrued in its 2018 
taxable year. Of the $120x of disallowed disqualified interest, $30x (25 
percent of $120x) is allocated to Business X and $90x (75 percent of 
$120x) is allocated to Business Y. The $90x of disallowed disqualified 
interest that is properly allocable to Business Y (an excepted trade or 
business) is not subject to the section 163(j) limitation.
    (b) Allocation of tax items other than interest expense and interest 
income--(1) In general. Except as otherwise provided in Sec.  1.163(j)-
6(m) or Sec.  1.163(j)-9(h), for purposes of calculating ATI, tax items 
other than interest expense and interest income are allocated to a 
particular trade or business in the manner described in this paragraph 
(b). It is not necessary to allocate items under this paragraph (b) for 
purposes of calculating ATI if all of the taxpayer's items subject to 
allocation under this paragraph (b) are allocable to excepted trades or 
businesses, or if all of those items are allocable to non-excepted 
trades or businesses.
    (2) Gross income other than dividends and interest income. A 
taxpayer's gross income other than dividends and interest income is 
allocated to the trade or business that generated the gross income.
    (3) Dividends--(i) Look-through rule. If a taxpayer receives a 
dividend, within the meaning of section 316, that is not investment 
income, within the meaning of section 163(d), and if the taxpayer 
satisfies the minimum ownership threshold in paragraph (c)(7) of this 
section, then, solely for purposes of allocating amounts received as a 
dividend during the taxable year to excepted or non-excepted trades or 
businesses under this paragraph (b), the

[[Page 516]]

dividend income is treated as allocable to excepted or non-excepted 
trades or businesses based upon the relative amounts of the payor 
corporation's adjusted basis in the assets used in its trades or 
businesses, determined pursuant to paragraph (c) of this section. If at 
least 90 percent of the payor corporation's adjusted basis in its assets 
during the taxable year, determined pursuant to paragraph (c) of this 
section, is allocable to either excepted trades or businesses or to non-
excepted trades or businesses, all of the taxpayer's dividend income 
from the payor corporation for the taxable year is treated as allocable 
to either excepted or non-excepted trades or businesses, respectively.
    (ii) Inapplicability of the look-through rule. If a taxpayer 
receives a dividend that is not investment income, within the meaning of 
section 163(d), and if the taxpayer does not satisfy the minimum 
ownership threshold in paragraph (c)(7) of this section, then the 
taxpayer must treat the dividend as allocable to a non-excepted trade or 
business.
    (4) Gain or loss from the disposition of non-consolidated C 
corporation stock, partnership interests, or S corporation stock--(i) 
Non-consolidated C corporations. (A) If a taxpayer recognizes gain or 
loss upon the disposition of stock in a non-consolidated C corporation 
that is not property held for investment, within the meaning of section 
163(d)(5), and if the taxpayer looks through to the assets of the C 
corporation under paragraph (c)(5)(ii) of this section for the taxable 
year, then the taxpayer must allocate gain or loss from the disposition 
of stock to excepted or non-excepted trades or businesses based upon the 
relative amounts of the C corporation's adjusted basis in the assets 
used in its trades or businesses, determined pursuant to paragraph (c) 
of this section. If at least 90 percent of the C corporation's adjusted 
basis in its assets during the taxable year, determined pursuant to 
paragraph (c) of this section, is allocable to either excepted trades or 
businesses or to non-excepted trades or businesses, all of the 
taxpayer's gain or loss from the disposition is treated as allocable to 
either excepted or non-excepted trades or businesses, respectively.
    (B) If a taxpayer recognizes gain or loss upon the disposition of 
stock in a non-consolidated C corporation that is not property held for 
investment, within the meaning of section 163(d)(5), and if the taxpayer 
does not look through to the assets of the C corporation under paragraph 
(c)(5)(ii) of this section for the taxable year, then the taxpayer must 
treat the gain or loss from the disposition of stock as allocable to a 
non-excepted trade or business.
    (C) For rules governing the transfer of stock of a member of a 
consolidated group, see paragraph (a)(4)(i) of this section.
    (ii) Partnerships and S corporations. (A) If a taxpayer recognizes 
gain or loss upon the disposition of interests in a partnership or stock 
in an S corporation that owns--
    (1) Non-excepted assets and excepted assets;
    (2) Investment assets; or
    (3) Both;
    (B) The taxpayer determines a proportionate share of the amount 
properly allocable to a non-excepted trade or business in accordance 
with the allocation rules set forth in paragraph (c)(5)(ii)(A) or 
(c)(5)(ii)(B)(3) of this section, as appropriate, and includes such 
proportionate share of gain or loss in the taxpayer's ATI. However, if 
at least 90 percent of the partnership's or S corporation's adjusted 
basis in its assets during the taxable year, determined pursuant to 
paragraph (c) of this section, is allocable to either excepted trades or 
businesses or to non-excepted trades or businesses, all of the 
taxpayer's gain or loss from the disposition is treated as allocable to 
either excepted or non-excepted trades or businesses, respectively. This 
rule also applies to tiered passthrough entities by looking through each 
passthrough entity tier (for example, an S corporation that is the 
partner of the highest-tier partnership would look through each lower-
tier partnership), subject to paragraph (c)(5)(ii)(D) of this section. 
With respect to a partner that is a C corporation or tax-exempt 
corporation, a partnership's investment assets are taken into account 
and treated as non-excepted trade or business assets. For

[[Page 517]]

purposes of this paragraph, a passthrough entity means a partnership, S 
corporation, or any other entity (domestic or foreign) that is not a 
corporation if all items of income and deduction of the entity are 
included in the income of its owners or beneficiaries.
    (5) Expenses, losses, and other deductions--(i) Expenses, losses, 
and other deductions that are definitely related to a trade or business. 
Expenses (other than interest expense), losses, and other deductions 
(collectively, deductions for purposes of this paragraph (b)(5)) that 
are definitely related to a trade or business are allocable to the trade 
or business to which they relate. A deduction is considered definitely 
related to a trade or business if the item giving rise to the deduction 
is incurred as a result of, or incident to, an activity of the trade or 
business or in connection with property used in the trade or business 
(see Sec.  1.861-8(b)(2)). If a deduction is definitely related to one 
or more excepted trades or businesses and one or more non-excepted 
trades or businesses, the deduction is apportioned between the excepted 
and non-excepted trades or businesses based upon the relative amounts of 
the taxpayer's adjusted basis in the assets used in those trades or 
businesses, as determined under paragraph (c) of this section.
    (ii) Other deductions. Deductions that are not described in 
paragraph (b)(5)(i) of this section are ratably apportioned based on the 
gross income of each trade or business.
    (6) Treatment of investment items and certain other items of a 
partnership with a C corporation partner. Any investment income, 
investment expense, or other item that a partnership receives, pays, or 
accrues and that is treated as properly allocable to a trade or business 
of a C corporation partner under Sec.  1.163(j)-4(b)(3)(i) is treated as 
properly allocable to a non-excepted trade or business of the C 
corporation partner, except that any item with respect to property or 
activities for which an election has been made by the partnership under 
Sec.  1.163(j)-9(b) is treated as properly allocable to an excepted 
trade or business. See, for example, an election for activities 
described in Sec.  1.163(j)-9(b)(2)(ii) or an election under Sec.  
1.163(j)-9(h).
    (7) Examples: Allocation of income and expense. The following 
examples illustrate the principles of this paragraph (b):
    (i) Example 1: Allocation of income and expense between excepted and 
non-excepted trades or businesses--(A) Facts. T conducts an electing 
real property trade or business (Business Y), which is an excepted trade 
or business. T also operates a lumber yard (Business Z), which is a non-
excepted trade or business. In Year 1, T receives $100x of gross rental 
income from real property leasing activities. T also pays or accrues 
$60x of expenses in connection with its real property leasing activities 
and $20x of legal services performed on behalf of both Business Y and 
Business Z. T receives $60x of gross income from lumber yard customers 
and pays or accrues $50x of expenses related to the lumber yard 
business. For purposes of expense allocations under paragraphs (b) and 
(c) of this section, T has $240x of adjusted basis in its Business Y 
assets and $80x of adjusted basis in its Business Z assets.
    (B) Analysis. Under paragraph (b)(2) of this section, for Year 1, 
$100x of rental income is allocated to Business Y, and $60x of income 
from lumber yard customers is allocated to Business Z. Under paragraph 
(b)(5)(i) of this section, $60x of expenses paid or accrued in 
connection with real property leasing activities are allocated to 
Business Y, and $50x of expenses related to the lumber yard are 
allocated to Business Z. The $20x of remaining expenses for legal 
services performed on behalf of both Business Y and Business Z are 
allocated according to the relative amounts of T's basis in the assets 
used in each business. The total amount of T's basis in the assets used 
in Businesses Y and Z is $320x, of which 75 percent ($240x/$320x) is 
used in Business Y and 25 percent ($80x/$320x) is used in Business Z. 
Accordingly, $15x of the expenses for legal services are allocated to 
Business Y and $5x are allocated to Business Z.
    (ii) Example 2: Allocation of partnership items from investment 
activity--(A)

[[Page 518]]

Facts. U, a domestic C corporation, directly conducts an electing real 
property trade or business. U also has an interest in PRS, a partnership 
that holds real property for investment. PRS's investment in real 
property is not a trade or business under section 162 or a real property 
trade or business under section 469. During the taxable year, PRS sells 
some of its real property to third parties and allocates $80x of income 
to U from these sales. In addition, PRS incurs deductible expenses 
related to its investment in real property and allocates $9x of these 
deductible expenses to U.
    (B) Analysis. Under paragraph (b)(6) of this section, any investment 
income or investment expense that a partnership receives, pays, or 
accrues and that is treated as properly allocable to a trade or business 
of a C corporation partner is treated as properly allocable to a non-
excepted trade or business of the C corporation partner. Because PRS 
generates its income and expense from investment activity that is not a 
trade or business under section 162 or a real property trade or business 
under section 469, U's allocation of $80x of income and $9x of 
deductible expense from PRS is treated as properly allocable to a non-
excepted trade or business.
    (c) Allocating interest expense and interest income that is properly 
allocable to a trade or business--(1) General rule--(i) In general. 
Except as otherwise provided in this section, Sec.  1.163(j)-6(m), or 
Sec.  1.163(j)-9(h), the amount of a taxpayer's interest expense and 
interest income that is properly allocable to a trade or business is 
allocated to the taxpayer's excepted or non-excepted trades or 
businesses for purposes of section 163(j) based upon the relative 
amounts of the taxpayer's adjusted basis in the assets, as determined 
under paragraph (c)(5) of this section, used in its excepted or non-
excepted trades or businesses. The taxpayer must determine the adjusted 
basis in its assets as of the close of each determination date, as 
defined in paragraph (c)(6) of this section, in the taxable year and 
average those amounts to determine the relative amounts of asset basis 
for its excepted and non-excepted trades or businesses for that year. It 
is not necessary to allocate interest expense or interest income under 
this paragraph (c) for purposes of determining a taxpayer's business 
interest expense and business interest income if all of the taxpayer's 
interest income and expense is allocable to excepted trades or 
businesses (in which case the taxpayer is not subject to the section 
163(j) limitation) or if all of the taxpayer's interest income and 
expense is allocable to non-excepted trades or businesses.
    (ii) De minimis exception. If at least 90 percent of the taxpayer's 
basis in its assets for the taxable year is allocable to either excepted 
or non-excepted trades or businesses pursuant to this paragraph (c), 
then all of the taxpayer's interest expense and interest income for that 
year that is properly allocable to a trade or business is treated as 
allocable to either excepted or non-excepted trades or businesses, 
respectively.
    (2) Example. The following example illustrates the principles of 
paragraph (c)(1) of this section:
    (i) Facts. T is a calendar-year C corporation engaged in an electing 
real property trade or business, the business of selling wine, and the 
business of selling hand-carved wooden furniture. In Year 1, T has $100x 
of interest expense that is deductible except for the potential 
application of section 163(j). Based upon determinations made on the 
determination dates in Year 1, T's average adjusted basis in the assets 
used in the electing real property trade or business (an excepted trade 
or business) in Year 1 is $800x, and T's total average adjusted basis in 
the assets used in the other two businesses (which are non-excepted 
trades or businesses) in Year 1 is $200x.
    (ii) Analysis. $80x (($800x/($800x + $200x)) x $100x) of T's 
interest expense for Year 1 is allocable to T's electing real property 
trade or business and is not business interest expense subject to the 
section 163(j) limitation. The remaining $20x of T's interest expense is 
business interest expense for Year 1 that is subject to the section 
163(j) limitation.
    (3) Asset used in more than one trade or business--(i) General rule. 
If an asset is

[[Page 519]]

used in more than one trade or business during a determination period, 
as defined in paragraph (c)(6) of this section, the taxpayer's adjusted 
basis in the asset is allocated to each trade or business using the 
permissible methodology under this paragraph (c)(3) that most reasonably 
reflects the use of the asset in each trade or business during that 
determination period. An allocation methodology most reasonably reflects 
the use of the asset in each trade or business if it most properly 
reflects the proportionate benefit derived from the use of the asset in 
each trade or business. A taxpayer is not required to use the same 
allocation methodology for each type of asset used in a trade a 
business. Instead, a taxpayer may use different allocation methodologies 
for different types of assets used in a trade or business. If none of 
the permissible methodologies set forth in paragraph (c)(3)(ii) of this 
section reasonably reflects the use of the asset in each trade or 
business, the taxpayer's basis in the asset is not taken into account 
for purposes of this paragraph (c).
    (ii) Permissible methodologies for allocating asset basis between or 
among two or more trades or businesses. Subject to the special rules in 
paragraphs (c)(3)(iii) and (c)(5) of this section, a taxpayer's basis in 
an asset used in two or more trades or businesses during a determination 
period may be allocated to those trades or businesses based upon--
    (A) The relative amounts of gross income that an asset generates, 
has generated, or may reasonably be expected to generate, within the 
meaning of Sec.  1.861-9T(g)(3), with respect to the trades or 
businesses;
    (B) If the asset is land or an inherently permanent structure, the 
relative amounts of physical space used by the trades or businesses; or
    (C) If the trades or businesses generate the same unit of output, 
the relative amounts of output of those trades or businesses (for 
example, if an asset is used in two trades or businesses, one of which 
is an excepted regulated utility trade or business, and the other of 
which is a non-excepted regulated utility trade or business, the 
taxpayer may allocate basis in the asset based upon the relative amounts 
of kilowatt-hours generated by each trade or business).
    (iii) Special rules--(A) Consistent allocation methodologies--(1) In 
general. Except as otherwise provided in paragraph (c)(3)(iii)(A)(2) of 
this section, a taxpayer must maintain the same allocation methodology 
for a period of at least five taxable years.
    (2) Consent to change allocation methodology. If a taxpayer has used 
the same allocation methodology for at least five taxable years, the 
taxpayers may change its method of allocation under paragraphs (c)(3)(i) 
and (ii) of this section without the consent of the Commissioner. If a 
taxpayer has used the same allocation methodology for less than five 
taxable years, and if the taxpayer determines that a different 
allocation methodology properly reflects the proportionate benefit 
derived from the use of assets in its trades or businesses, the taxpayer 
may change its method of allocation under paragraphs (c)(3)(i) and (ii) 
of this section only with the consent of the Commissioner. To obtain 
consent, a taxpayer must submit a request for a letter ruling under the 
applicable administrative procedures, and consent will be granted only 
in extraordinary circumstances.
    (B) De minimis exception. If at least 90 percent of the taxpayer's 
basis in an asset would be allocated to either excepted trades or 
businesses or non-excepted trades or businesses during a determination 
period pursuant to this paragraph (c)(3), the taxpayer's entire basis in 
the asset for the determination period must be allocated to either 
excepted or non-excepted trades or businesses, respectively. This rule 
applies before the application of paragraph (c)(1)(ii) of this section.
    (C) Allocations of excepted regulated utility trades or businesses--
(1) In general. Except as provided in the de minimis rule in paragraph 
(c)(3)(iii)(C)(3) of this section, a taxpayer is engaged in an excepted 
regulated utility trade or business only to the extent that the taxpayer 
is engaged in an excepted regulated utility trade or business described 
in Sec.  1.163(j)-1(b)(15)(i)(A), (B), or (C), and any remaining utility 
trade or business is a non-excepted trade or business. Thus, for 
example, electricity

[[Page 520]]

sold by a utility trade or business at rates not established or approved 
by an entity described in Sec.  1.163(j)-1(b)(15)(i)(A)(2) and not 
subject to an election under Sec.  1.163(j)-1(b)(15)(iii) must be 
treated as electricity sold by a non-excepted regulated utility trade or 
business. The taxpayer must allocate under this paragraph (c) the basis 
of assets used in the utility trade or business between its excepted and 
non-excepted trades or businesses.
    (2) Permissible method for allocating asset basis for utility trades 
or businesses. In the case of a utility trade or business described in 
paragraph (c)(3)(iii)(C)(1) of this section, and except as provided in 
the de minimis rule in paragraph (c)(3)(iii)(C)(3) of this section, the 
method described in paragraph (c)(3)(ii)(C) of this section is the only 
permissible method under this paragraph (c)(3) for allocating the 
taxpayer's basis in assets used in both the excepted and non-excepted 
trades or businesses of selling or furnishing the items described in 
Sec.  1.163(j)-1(b)(15)(i)(A)(1).
    (3) De minimis rule for excepted utility trades or businesses. If a 
taxpayer is engaged in a utility trade or business described in 
paragraph (c)(3)(iii)(C)(1) of this section, and if at least 90 percent 
of the items described in Sec.  1.163(j)-1(b)(15)(i)(A)(1) are furnished 
or sold by trades or businesses described in Sec.  1.163(j)-
1(b)(15)(i)(A), (B) or (C), the taxpayer's entire trade or business is 
an excepted regulated utility trade or business, and paragraph 
(c)(3)(iii)(C)(2) of this section does not apply. This rule applies 
before the application of paragraph (c)(3)(iii)(B) of this section.
    (4) Example. The following example illustrates the principles of 
this paragraph (c)(3)(iii)(C):
    (i) Facts. X, a C corporation, is engaged in the trade or business 
of generating electrical energy. During each determination period in the 
taxable year, 80 percent of the megawatt-hours generated in the 
electricity generation trade or business is sold at rates negotiated 
with the purchaser, and with respect to which X filed a schedule of 
rates with a public utility commission. The public utility commission 
has the authority to take action on the filed schedule of rates, but if 
no action is taken, the rules governing the public utility commission 
explicitly state that the public utility commission is deemed to have 
approved the rates. The public utility has taken no action with respect 
to the negotiated rate. The remaining 20 percent of the megawatt-hours 
is sold on the wholesale market at rates not established or subject to 
approval by a regulator described in Sec.  1.163(j)-1(b)(15)(i)(A)(2). X 
has not made an election under Sec.  1.163(j)-1(b)(15)(iii). None of the 
assets used in X's utility generation trade or business are used in any 
other trade or business.
    (ii) Analysis. For purposes of section 163(j), under paragraph 
(c)(3)(iii)(C)(1) of this section, 80 percent of X's electricity 
generation business is an excepted regulated utility trade or business, 
because the rate for the sale of the electricity was subject to approval 
by a regulator described in Sec.  1.163(j)-1(b)(15)(i)(A)(2). The 
remaining 20 percent of X's business is a non-excepted utility trade or 
business. Under paragraph (c)(3)(iii)(C)(2) of this section, X must 
allocate 80 percent of the basis of the assets used in its utility 
business to excepted trades or business and the remaining 20 percent of 
the basis in the assets to non-excepted trades or businesses.
    (D) Special allocation rule for real property trades or businesses 
subject to special anti-abuse rule--(1) In general. In the case of a 
trade or business that leases real property subject to an arrangement 
described in Sec.  1.163(j)-9(j)(1), including trades or businesses to 
which the look-through exception in Sec.  1.163(j)-9(j)(2)(ii) applies, 
the taxpayer must allocate under this paragraph (c)(3) the basis of 
property used in both the excepted and non-excepted portions of its 
trade or business, as determined under Sec.  1.163(j)-9(j)(3).
    (2) Allocation methodology for real property. For purposes of this 
paragraph (c)(3)(iii)(D), a taxpayer must allocate the basis of real 
property leased under an arrangement described in Sec.  1.163(j)-9(j)(1) 
or (j)(2)(i) between the excepted and non-excepted portions of the real 
property trade or business

[[Page 521]]

based on the relative fair market rental value of the real property that 
is attributable to the excepted and non-excepted portions of the trade 
or business, respectively.
    (3) Example. The following example illustrates the principles of 
this paragraph (c)(3)(iii)(D):
    (i) Facts. X and Y are domestic C corporations under common control 
within the meaning of section 267(b), but neither X nor Y are members of 
a consolidated group. The small business exemption in Sec.  1.163(j)-
2(d) does not apply to X or Y. X owns an office building and leases the 
entire building to Y. Y subleases 80 percent of the office building, 
measured by fair market rental value, to a related party. Y subleases 
the remaining 20 percent of the building to unrelated third parties. X 
also owns depreciable scaffolding equipment, which it uses to clean all 
of the building's windows as part of its leasing arrangement with Y.
    (ii) Analysis. Under Sec.  1.163(j)-9(j)(2)(ii), X is eligible to 
make an election for 20 percent of its business of leasing the office 
building to be an electing real property trade or business. Assuming X 
makes such an election, X must allocate the basis of assets used in both 
the excepted and non-excepted portions of its leasing trade or business 
under this paragraph (c). Under paragraph (c)(3)(iii)(D)(2) of this 
section, X must allocate the basis of the office building based on the 
relative fair market value attributable to the excepted and non-excepted 
portions of its leasing business. Therefore, X must allocate 20 percent 
of the basis of the building to the excepted portion of its leasing 
business, and it must allocate the remaining 80 percent of the building 
to the non-excepted portion of its leasing business. Under paragraph 
(c)(3)(iii)(D)(2) of this section, X may use one of the allocation 
methods described in paragraph (c)(3)(ii) of this section to allocate 
the basis of its scaffolding equipment between the excepted and non-
excepted portions of its leasing trade or business.
    (4) Disallowed business interest expense carryforwards; floor plan 
financing interest expense. Disallowed business interest expense 
carryforwards (which were treated as allocable to a non-excepted trade 
or business in a prior taxable year) are not re-allocated between non-
excepted and excepted trades or businesses in a succeeding taxable year. 
Instead, the carryforwards continue to be treated as allocable to a non-
excepted trade or business. Floor plan financing interest expense also 
is not subject to allocation between excepted and non-excepted trades or 
businesses (see Sec.  1.163(j)-1(b)(19)) and is always treated as 
allocable to non-excepted trades or businesses.
    (5) Additional rules relating to basis--(i) Calculation of adjusted 
basis--(A) Non-depreciable property other than land. Except as otherwise 
provided in paragraph (c)(5)(i)(E) of this section, for purposes of this 
section, the adjusted basis of an asset other than land with respect to 
which no deduction is allowable under section 167, former section 168, 
or section 197, as applicable, is the adjusted basis of the asset for 
determining gain or loss from the sale or other disposition of that 
asset as provided in Sec.  1.1011-1. Self-created intangible assets are 
not taken into account for purposes of this paragraph (c).
    (B) Depreciable property other than inherently permanent structures. 
For purposes of this section, the adjusted basis of any tangible asset 
with respect to which a deduction is allowable under section 167, other 
than inherently permanent structures, is determined by using the 
alternative depreciation system under section 168(g) before any 
application of the additional first-year depreciation deduction (for 
example, under section 168(k) or (m)), and the adjusted basis of any 
tangible asset with respect to which a deduction is allowable under 
former section 168, other than inherently permanent structures, is 
determined by using the taxpayer's method of computing depreciation for 
the asset under former section 168. The depreciation deduction with 
respect to the property described in this paragraph (c)(5)(i)(B) is 
allocated ratably to each day during the period in the taxable year to 
which the depreciation relates. A change to the alternative depreciation 
system should be determined in a manner similar to that in Sec.  
1.168(i)-4(d)(4) or (d)(5)(ii)(B), as applicable.

[[Page 522]]

    (C) Special rule for land and inherently permanent structures. 
Except as otherwise provided in paragraph (c)(5)(i)(E) of this section, 
for purposes of this section, the adjusted basis of any asset that is 
land, including nondepreciable improvements to land, or an inherently 
permanent structure is its unadjusted basis.
    (D) Depreciable or amortizable intangible property and depreciable 
income forecast method property. For purposes of this section, the 
adjusted basis of any intangible asset with respect to which a deduction 
is allowable under section 167 or 197, as applicable, is determined in 
accordance with section 167 or 197, as applicable, and the adjusted 
basis of any asset described in section 167(g)(6) for which a deduction 
is allowable under section 167 is determined in accordance with section 
167(g). The adjusted basis of any intangible asset under this paragraph 
(c)(5)(i)(D) is determined before any application of the additional 
first-year depreciation deduction. The depreciation or amortization 
deduction with respect to the property described in this paragraph 
(c)(5)(i)(D) is allocated ratably to each day during the period in the 
taxable year to which the depreciation or amortization relates.
    (E) Assets not yet used in a trade or business. Assets that have 
been acquired or that are under development but that are not yet used in 
a trade or business are not taken into account for purposes of this 
paragraph (c). For example, construction works in progress (such as 
buildings, airplanes, or ships) are not taken into account for purposes 
of this paragraph (c). Similarly, land acquired by a taxpayer for 
construction of a building by the taxpayer to be used in a trade or 
business is not taken into account for purposes of under this paragraph 
(c) until the building is placed in service. This rule does not apply to 
interests in a partnership or stock in a corporation.
    (F) Trusts established to fund specific liabilities. Trusts required 
to fund specific liabilities (for example, pension trusts, and nuclear 
decommissioning funds (including, but not limited to, those funds for 
which an election is made under section 468A)) are not taken into 
account for purposes of this paragraph (c).
    (G) Inherently permanent structure. For purposes of this section, 
the term inherently permanent structure has the meaning provided in 
Sec.  1.856-10(d)(2).
    (ii) Partnership interests; stock in non-consolidated C 
corporations--(A) Partnership interests--(1) Calculation of asset basis. 
For purposes of this section, a partner's interest in a partnership is 
treated as an asset of the partner. For these purposes, the partner's 
adjusted basis in a partnership interest is reduced, but not below zero, 
by the partner's share of partnership liabilities, as determined under 
section 752, and is further reduced as provided in paragraph 
(c)(5)(ii)(A)(2)(iii) of this section. If a partner elects or is 
required to apply the rules in this paragraph (c)(5)(ii)(A) to look 
through to a partnership's basis in the partnership's assets, the 
partner's basis in the partnership interest is adjusted to the extent of 
the partner's share of any adjustments to the basis of the partnership's 
assets required pursuant to the rules in paragraph (c)(5)(i) of this 
section.
    (2) Allocation of asset basis--(i) In general. For purposes of 
determining the extent to which a partner's adjusted basis in its 
partnership interest is allocable to an excepted or non-excepted trade 
or business, the partner may look through to such partner's share of the 
partnership's basis in the partnership's assets, taking into account any 
adjustments under sections 734(b) and 743(b), and adjusted to the extent 
required under paragraph (d)(4) of this section, except as otherwise 
provided in paragraph (c)(5)(ii)(D) of this section. For purposes of the 
preceding sentence, such partner's share of partnership assets is 
determined using a reasonable method taking into account special 
allocations under section 704(b). Notwithstanding paragraph (c)(7) of 
this section, if a partner's direct and indirect interest in a 
partnership is greater than or equal to 80 percent of the partnership's 
capital or profits, the partner must apply the rules in this paragraph 
(c)(5)(ii)(A)(2) to look through to the partnership's basis in the 
partnership's assets. If a partner elects or is required to apply the 
rules in this paragraph (c)(5)(ii)(A)(2) to look through to a

[[Page 523]]

partnership's basis in the partnership's assets, the partner allocates 
the basis of its partnership interest between excepted and non-excepted 
trades or businesses based on the ratio in which the partner's share of 
the partnership's adjusted tax basis in its trade or business assets is 
allocated between excepted and non-excepted trade or business assets.
    (ii) De minimis rule. If, after applying paragraph 
(c)(5)(ii)(A)(2)(iii) of this section, at least 90 percent of a 
partner's share of a partnership's basis in its assets (including 
adjustments under sections 734(b) and 743(b)) is allocable to either 
excepted trades or businesses or non-excepted trades or businesses, 
without regard to assets not properly allocable to a trade or business, 
the partner's entire basis in its partnership interest is treated as 
allocable to either excepted or non-excepted trades or businesses, 
respectively. For purposes of the preceding sentence, such partner's 
share of partnership assets is determined using a reasonable method 
taking into account special allocations under section 704(b).
    (iii) Partnership assets not properly allocable to a trade or 
business. For purposes of applying paragraphs (c)(5)(ii)(A)(2)(i) and 
(ii) of this section to a partner that is a C corporation or tax-exempt 
corporation, such partner's share of a partnership's assets that are not 
properly allocable to a trade or business is treated as properly 
allocable to a non-excepted trade or business of such partner. However, 
if the partnership made an election under Sec.  1.163(j)-9(b) or Sec.  
1.163(j)-9(h) with respect to an asset or activity, the assets (or 
assets related to such activities) are treated as properly allocable to 
an excepted trade or business of such partner. See, for example, an 
election under Sec.  1.163(j)-9(h) for an asset or an election under 
Sec.  1.163(j)-9(b) with respect to activities described in Sec.  
1.163(j)-9(b)(2)(ii). For a partner other than a C corporation or tax-
exempt corporation, a partnership's assets that are not properly 
allocable to a trade or business are treated as neither excepted nor 
non-excepted trade or business assets; instead, such partner's adjusted 
basis in its partnership interest is decreased by that partner's share 
of the excess of the partnership's basis in those assets over the 
partnership's debt that is traced to such assets in accordance with 
Sec.  1.163-8T, and it is increased by that partner's share of the 
excess of the partnership's debt that is traced to such assets in 
accordance with Sec.  1.163-8T over the partnership's basis in those 
assets. For purposes of the preceding sentence, the partnership's asset 
basis in property not allocable to a trade or business is adjusted 
pursuant to the rules in paragraph (c)(5)(i) of this section. For 
purposes of this paragraph (c)(5)(ii)(A)(2)(iii), such partner's share 
of a partnership's assets is determined under a reasonable method taking 
into account special allocations under section 704(b).
    (iv) Inapplicability of partnership look-through rule. If a partner, 
other than a C corporation or a tax-exempt corporation, chooses not to 
look through to the partnership's basis in the partnership's assets 
under paragraph (c)(5)(ii)(A)(2)(i) of this section or is precluded by 
paragraph (c)(5)(ii)(D) of this section from applying such partnership 
look-through rule, the partner generally will treat its basis in the 
partnership interest as either an asset held for investment or a non-
excepted trade or business asset as determined under section 163(d). If 
a partner that is a C corporation or a tax-exempt corporation chooses 
not to look through to the partnership's basis in the partnership's 
assets under paragraph (c)(5)(ii)(A)(2)(i) of this section or is 
precluded by paragraph (c)(5)(ii)(D) of this section from applying such 
partnership look-through rule, the taxpayer must treat its entire basis 
in the partnership interest as allocable to a non-excepted trade or 
business.
    (B) Stock in domestic non-consolidated corporations--(1) In general. 
For purposes of this section, if a taxpayer owns stock in a domestic C 
corporation that is not a member of the taxpayer's consolidated group, 
or if the taxpayer owns stock in an S corporation, the stock is treated 
as an asset of the taxpayer.
    (2) Domestic non-consolidated C corporations--(i) Allocation of 
asset basis. If a shareholder satisfies the minimum ownership threshold 
in paragraph (c)(7) of this section for stock in a domestic

[[Page 524]]

non-consolidated C corporation, and if dividends paid on such stock 
would not be included in the shareholder's investment income under 
section 163(d)(4)(B), then, for purposes of determining the extent to 
which the shareholder's basis in the stock is allocable to an excepted 
or non-excepted trade or business, the shareholder must look through to 
the corporation's basis in the corporation's assets, adjusted to the 
extent required under paragraph (d)(4) of this section, except as 
otherwise provided in paragraph (c)(5)(ii)(D) of this section. If a 
shareholder does not satisfy the minimum ownership threshold in 
paragraph (c)(7) of this section for stock in a domestic non-
consolidated C corporation, but the shareholder's direct and indirect 
interest in such corporation is greater than or equal to 80 percent by 
value, and if dividends paid on such stock would not be included in the 
shareholder's investment income under section 163(d)(4)(B), then, for 
purposes of determining the extent to which the shareholder's basis in 
the stock is allocable to an excepted or non-excepted trade or business, 
the shareholder may look through to the corporation's basis in the 
corporation's assets, adjusted to the extent required under paragraph 
(d)(4) of this section, except as otherwise provided in paragraph 
(c)(5)(ii)(D) of this section. For purposes of the preceding sentence, 
indirect stock ownership is determined by applying the constructive 
ownership rules of section 318(a).
    (ii) De minimis rule. If at least 90 percent of the domestic non-
consolidated C corporation's basis in the corporation's assets is 
allocable to either excepted trades or businesses or non-excepted trades 
or businesses, the shareholder's entire interest in the corporation's 
stock is treated as allocable to either excepted or non-excepted trades 
or businesses, respectively.
    (iii) Inapplicability of corporate look-through rule. If a 
shareholder other than a C corporation or a tax-exempt corporation is 
ineligible to look through or chooses not to look through to a 
corporation's basis in its assets under paragraph (c)(5)(ii)(B)(2)(i) of 
this section, the shareholder generally will treat its entire basis in 
the corporation's stock as an asset held for investment. If a 
shareholder that is a C corporation or a tax-exempt corporation is 
ineligible to look through or chooses not to look through to a 
corporation's basis in its assets under paragraph (c)(5)(ii)(B)(2)(i) of 
this section, the shareholder must treat its entire basis in the 
corporation's stock as allocable to a non-excepted trade or business.
    (iv) Use of inside basis for purposes of C corporation look-through 
rule. This paragraph (c)(5)(ii)(B)(2)(iv) applies if a shareholder meets 
the requirements to look through the stock of a domestic non-
consolidated C corporation under paragraph (c)(5)(ii)(B)(2)(i) of this 
section, determined without applying the constructive ownership rules of 
section 318(a). If this paragraph (c)(5)(ii)(B)(2)(iv) applies, then 
solely for purposes of allocating asset basis under paragraph 
(c)(5)(ii)(B)(2)(i) of this section, and except as otherwise provided in 
paragraph (c)(5)(ii)(D) of this section, the shareholder may look 
through to such shareholder's pro rata share of the C corporation's 
basis in its assets, taking into account the modifications in paragraph 
(c)(5)(i) of this section with respect to the C corporation's assets, 
and adjusted to the extent required under paragraph (d)(4) of this 
section (asset basis look-through approach). If a shareholder applies 
the asset basis look-through approach, it must do so for all domestic 
non-consolidated C corporations for which the shareholder is eligible to 
use this approach, and it must report its use of this approach on the 
information statement described in paragraph (c)(6)(iii) of this 
section. The shareholder also must continue to use the asset basis look-
through approach in all future taxable years in which the shareholder is 
eligible to use this approach.
    (3) S corporations--(i) Calculation of asset basis. For purposes of 
this section, a shareholder's share of stock in an S corporation is 
treated as an asset of the shareholder. Additionally, for these 
purposes, the shareholder's adjusted basis in a share of S corporation 
stock is adjusted to take into account the modifications in paragraph 
(c)(5)(i) of this section with respect to the assets of the S 
corporation (for example, a shareholder's adjusted basis in its S 
corporation stock is increased by the

[[Page 525]]

shareholder's share of depreciation with respect to an inherently 
permanent structure owned by the S corporation).
    (ii) Allocation of asset basis. For purposes of determining the 
extent to which a shareholder's basis in its stock of an S corporation 
is allocable to an excepted or non-excepted trade or business, the 
shareholder may look through to such shareholder's share of the S 
corporation's basis in the S corporation's assets, allocated on a pro 
rata basis, adjusted to the extent required under paragraph (d)(4) of 
this section, except as otherwise provided in paragraph (c)(5)(ii)(D) of 
this section. Notwithstanding paragraph (c)(7) of this section, if a 
shareholder's direct and indirect interest in an S corporation is 
greater than or equal to 80 percent of the S corporation's stock by vote 
and value, the shareholder must apply the rules in this paragraph 
(c)(5)(ii)(B)(3) to look through to the S corporation's basis in the S 
corporation's assets. For these purposes, indirect stock ownership is 
determined by applying the constructive ownership rules of section 
318(a).
    (iii) De minimis rule. If at least 90 percent of a shareholder's 
share of an S corporation's basis in its assets is allocable to either 
excepted trades or businesses or non-excepted trades or businesses, the 
shareholder's entire basis in its S corporation stock is treated as 
allocable to either excepted or non-excepted trades or businesses, 
respectively.
    (iv) Inapplicability of S corporation look-through rule. If a 
shareholder chooses not to look through to the S corporation's basis in 
the S corporation's assets under paragraph (c)(5)(ii)(B)(3)(ii) of this 
section or is precluded by paragraph (c)(5)(ii)(D) of this section from 
applying such S corporation look-through rule, the shareholder will 
treat its basis in the S corporation stock as either an asset held for 
investment or a non-excepted trade or business asset as determined under 
section 163(d).
    (C) Stock in relevant foreign corporations--(1) In general. The 
rules applicable to domestic non-consolidated C corporations in 
paragraph (c)(5)(ii)(B) of this section also apply to relevant foreign 
corporations (as defined in Sec.  1.163(j)-1(b)(33)).
    (2) Special rule for CFC utilities. Solely for purposes of applying 
the rules in paragraph (c)(5)(ii)(B) of this section, a utility trade or 
business conducted by an applicable CFC is treated as an excepted 
regulated utility trade or business, but only to the extent that the 
applicable CFC sells or furnishes the items described in Sec.  1.163(j)-
1(b)(15)(i)(A)(1) pursuant to rates established or approved by an entity 
described in Sec.  1.163(j)-1(b)(15)(i)(A)(2), a foreign government, a 
public service or public utility commission or other similar body of any 
foreign government, or the governing or ratemaking body of a foreign 
electric cooperative. For purposes of this paragraph (c)(5)(ii)(C)(2), 
the term foreign government means any foreign government, any political 
subdivision of a foreign government, or any wholly owned agency or 
instrumentality of any one of the foregoing within the meaning of Sec.  
1.1471-6(b).
    (D) Limitations on application of look-through rules--(1) 
Inapplicability of look-through rule to partnerships or non-consolidated 
C corporations to which the small business exemption applies. A taxpayer 
may not apply the look-through rules in paragraphs (b)(3) and 
(c)(5)(ii)(A), (B), and (C) of this section to a partnership, S 
corporation, or non-consolidated C corporation that is eligible for the 
small business exemption under section 163(j)(3) and Sec.  1.163(j)-
2(d)(1), unless the partnership, S corporation, or non-consolidated C 
corporation elects under Sec.  1.163(j)-9 for a trade or business to be 
an electing real property trade or business or an electing farming 
business.
    (E) Tiered entities. If a taxpayer applies the look-through rules of 
this paragraph (c)(5)(ii), the taxpayer must do so for all lower-tier 
entities with respect to which the taxpayer satisfies, directly or 
indirectly, the minimum ownership threshold in paragraph (c)(7) of this 
section, subject to the limitation in paragraph (c)(5)(ii)(D) of this 
section, beginning with the lowest-tier entity.
    (2) Limitation on application of look-through rule to C 
corporations. Except as provided in Sec.  1.163(j)-9(h)(4)(iii) and (iv)

[[Page 526]]

(for a REIT or a partnership making the election under Sec.  1.163(j)-
9(h)(1) or (7), respectively), for purposes of applying the look-through 
rules in paragraph (c)(5)(ii)(B) and (C) of this section to a non-
consolidated C corporation (upper-tier entity), that upper-tier entity 
may not apply these look-through rules to a lower-tier non-consolidated 
C corporation if a principal purpose for borrowing funds at the upper-
tier entity level or adding an upper-tier or lower-tier entity to the 
ownership structure is increasing the amount of the taxpayer's basis 
allocable to excepted trades or businesses. For example, P wholly and 
directly owns S1 (the upper-tier entity), which wholly and directly owns 
S2. Each of S1 and S2 is a non-consolidated C corporation to which the 
small business exemption does not apply, and S2 is engaged in an 
excepted trade or business. With a principal purpose of increasing the 
amount of basis allocable to its excepted trades or businesses, P has S1 
(rather than S2) borrow funds from a third party. S1 may not look 
through the stock of S2 (and may not apply the asset basis look-through 
rule described in paragraph (c)(5)(ii)(B)(2)(iv) of this section) for 
purposes of P's allocation of its basis in its S1 stock between excepted 
and non-excepted trades or businesses; instead, S1 must treat its stock 
in S2 as an asset used in a non-excepted trade or business for that 
purpose. However, S1 may look through the stock of S2 for purposes of 
S1's allocation of its basis in its S2 stock between excepted and non-
excepted trades or businesses.
    (iii) Cash and cash equivalents and customer receivables. Except as 
otherwise provided in the last sentence of this paragraph (c)(5)(iii), a 
taxpayer's basis in its cash and cash equivalents and customer 
receivables is not taken into account for purposes of this paragraph 
(c). This rule also applies to a lower-tier entity if a taxpayer looks 
through to the assets of that entity under paragraph (c)(5)(ii) of this 
section. For purposes of this paragraph (c)(5)(iii), the term cash and 
cash equivalents includes cash, foreign currency, commercial paper, any 
interest in an investment company registered under the Investment 
Company Act of 1940 (1940 Act) and regulated as a money market fund 
under 17 CFR 270.2a-7 (Rule 2a-7 under the 1940 Act), any obligation of 
a government, and any derivative that is substantially secured by an 
obligation of a government, or any similar asset. For purposes of this 
paragraph (c)(5)(iii), a derivative is a derivative described in section 
59A(h)(4)(A), without regard to section 59A(h)(4)(C). For purposes of 
this paragraph (c)(5)(iii), the term government means the United States 
or any agency or instrumentality of the United States; a State, a 
territory, a possession of the United States, the District of Columbia, 
or any political subdivision thereof within the meaning of section 103 
and Sec.  1.103-1; or any foreign government, any political subdivision 
of a foreign government, or any wholly owned agency or instrumentality 
of any one of the foregoing within the meaning of Sec.  1.1471-6(b). 
This paragraph (c)(5)(iii) does not apply to an entity that qualifies as 
a financial services entity as described in Sec.  1.904-4(e)(3).
    (iv) Deemed asset sale. Solely for purposes of determining the 
amount of basis allocable to excepted and non-excepted trades or 
businesses under this section, an election under section 336, 338, or 
754, as applicable, is deemed to have been made for any acquisition of 
corporate stock or partnership interests with respect to which the 
taxpayer demonstrates, in the information statement required by 
paragraph (c)(6)(iii)(B) of this section, that the acquisition qualified 
for such an election and that, immediately before the acquisition, the 
acquired entity had a regulatory liability for deferred taxes recorded 
on its books with respect to property predominantly used in an excepted 
regulated utility trade or business. Any additional basis taken into 
account under this rule is reduced ratably over a 15-year period 
beginning with the month of the acquisition and is not subject to the 
anti-abuse rule in paragraph (c)(8) of this section.
    (v) Other adjustments. The Commissioner may make appropriate 
adjustments to prevent a taxpayer from intentionally and artificially 
increasing its basis in assets attributable to an excepted trade or 
business.

[[Page 527]]

    (6) Determination dates; determination periods; reporting 
requirements--(i) Determination dates and determination periods--(A) 
Quarterly determination periods. For purposes of this section, and 
except as otherwise provided in paragraph (c)(6)(i)(B) of this section, 
the term determination date means the last day of each quarter of the 
taxpayer's taxable year (and the last day of the taxpayer's taxable 
year, if the taxpayer has a short taxable year), and the term 
determination period means the period beginning the day after one 
determination date and ending on the next determination date.
    (B) Annual determination periods. If a taxpayer satisfies the 
requirements of the last sentence of this paragraph (c)(6)(i)(B), the 
taxpayer may allocate asset basis for a taxable year based on the 
average of adjusted asset basis at the beginning of the year and the end 
of the year (annual determination method). For these purposes, the term 
determination date means the last day of the taxpayer's taxable year, 
and the term determination period has the same meaning as provided in 
paragraph (c)(6)(i)(A) of this section. A taxpayer may use the annual 
determination method for a taxable year only if the taxpayer 
demonstrates that its total adjusted basis (as determined under 
paragraph (c)(5) of this section) at the end of the year in its assets 
used in its excepted trades or businesses, as a percentage of the 
taxpayer's total adjusted basis at the end of such year in all of its 
assets used in a trade or business, does not differ by more than 20 
percent from such percentage at the beginning of the year.
    (ii) Application of look-through rules. If a taxpayer that applies 
the look-through rules of paragraph (c)(5)(ii) of this section has a 
different taxable year than the partnership or non-consolidated C 
corporation to which the taxpayer is applying those rules, then, for 
purposes of this paragraph (c)(6), the taxpayer must use the most recent 
asset basis figures from the partnership or non-consolidated C 
corporation. For example, assume that PS1 is a partnership with a May 31 
taxable year, and that C (a calendar-year C corporation that is 
ineligible to use the annual determination method for the taxable year) 
is a partner in PS1. PS1's determination dates are February 28, May 31, 
August 31, and November 30. In turn, C's determination dates are March 
31, June 30, September 30, and December 31. If C looks through to PS1's 
basis in its assets under paragraph (c)(5)(ii) of this section, then, 
for purposes of determining the amount of C's asset basis that is 
attributable to its excepted and non-excepted businesses on March 31, C 
must use PS1's asset basis calculations for February 28.
    (iii) Reporting requirements--(A) Books and records. A taxpayer must 
maintain books of account and other records and data as necessary to 
substantiate the taxpayer's use of an asset in an excepted trade or 
business and to substantiate any adjustments to asset basis for purposes 
of applying this paragraph (c). One indication that a particular asset 
is used in a particular trade or business is if the taxpayer maintains 
separate books and records for all of its excepted and non-excepted 
trades or businesses and can show the asset in the books and records of 
a particular excepted or non-excepted trade or business. For rules 
governing record retention, see Sec.  1.6001-1.
    (B) Information statement. Except as otherwise provided in 
publications, forms, instructions, or other guidance, each taxpayer that 
is making an allocation under this paragraph (c), including any taxpayer 
that satisfies the de minimis rule in paragraph (c)(1)(ii) of this 
section, must prepare a statement titled ``Section 163(j) Asset Basis 
Calculations'' containing the information described in paragraphs 
(c)(6)(iii)(B)(1) through (7) of this section and must attach the 
statement to its timely filed Federal income tax return for the taxable 
year:
    (1) The taxpayer's adjusted basis in the assets used in its excepted 
and non-excepted businesses, determined as set forth in this section, 
including detailed information for the different groups of assets 
identified in paragraphs (c)(5)(i) and (ii) and (d) of this section;
    (2) The determination dates on which asset basis was measured during 
the taxable year;
    (3) The names and taxpayer identification numbers (TINs) of all 
entities

[[Page 528]]

for which basis information is being provided, including partnerships 
and corporations if the taxpayer that owns an interest in a partnership 
or corporation looks through to the partnership's or corporation's basis 
in the partnership's or corporation's assets under paragraph (c)(5)(ii) 
of this section. If the taxpayer is a member of a consolidated group, 
the name and TIN of the agent for the group, as defined in Sec.  1.1502-
77, must be provided, but the taxpayer need not provide the names and 
TINs of all other consolidated group members;
    (4) Asset basis information for corporations or partnerships if the 
taxpayer looks through to the corporation's or partnership's basis in 
the corporation's or partnership's assets under paragraph (c)(5)(ii) of 
this section;
    (5) A summary of the method or methods used to determine asset basis 
in property used in both excepted and non-excepted businesses, as well 
as information regarding any deemed sale under paragraph (c)(5)(iv) of 
this section;
    (6) Whether the taxpayer used the historical approach or the 
effective date approach for all of its disallowed disqualified interest; 
and
    (7) If the taxpayer changed its methodology for allocating asset 
basis between or among two or more trades or businesses under paragraph 
(c)(3)(ii) of this section, a statement that the taxpayer has changed 
the allocation methodology and a description of the new methodology or, 
if the taxpayer is required to request consent for the allocation 
methodology change under paragraph (c)(3)(iii)(A)(2) of this section, a 
statement that the request has been or will be filed and a description 
of the methodology change.
    (iv) Failure to file statement. If a taxpayer fails to file the 
statement described in paragraph (c)(6)(iii) of this section or files a 
statement that does not comply with the requirements of paragraph 
(c)(6)(iii) of this section, the Commissioner may treat the taxpayer as 
if all of its interest expense is properly allocable to a non-excepted 
trade or business, unless the taxpayer shows that there was reasonable 
cause for failing to comply with, and the taxpayer acted in good faith 
with respect to, the requirements of paragraph (c)(6)(iii) of this 
section, taking into account all pertinent facts and circumstances.
    (7) Ownership threshold for look-through rules--(i) Corporations--
(A) Asset basis. For purposes of this section, a shareholder must look 
through to the assets of a domestic non-consolidated C corporation or a 
relevant foreign corporation under paragraph (c)(5)(ii) of this section 
if the shareholder's direct and indirect interest in the corporation 
satisfies the ownership requirements of section 1504(a)(2). For purposes 
of this paragraph (c)(7)(i)(A), indirect stock ownership is determined 
by applying the constructive ownership rules of section 318(a). A 
shareholder may look through to the assets of an S corporation under 
paragraph (c)(5)(ii) of this section for purposes of allocating the 
shareholder's basis in its stock in the S corporation between excepted 
and non-excepted trades or businesses regardless of the shareholder's 
direct and indirect interest in the S corporation.
    (B) Dividends. A shareholder must look through to the activities of 
a domestic non-consolidated C corporation or a relevant foreign 
corporation under paragraph (b)(3) of this section if the shareholder's 
direct interest in the corporation satisfies the ownership requirements 
of section 1504(a)(2). A shareholder may look through to the activities 
of a domestic non-consolidated C corporation or an applicable CFC under 
paragraph (b)(3) of this section if the shareholder's direct interest in 
the corporation is greater than or equal to 80 percent by value. A 
shareholder may look through to the activities of an S corporation under 
paragraph (b)(3) of this section regardless of the shareholder's direct 
interest in the S corporation.
    (ii) Partnerships. A partner may look through to the assets of a 
partnership under paragraph (c)(5)(ii) of this section for purposes of 
allocating the partner's basis in its partnership interest between 
excepted and non-excepted trades or businesses regardless of the 
partner's direct and indirect interest in the partnership.
    (iii) Inapplicability of look-through rule. For circumstances in 
which a taxpayer that satisfies the ownership

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threshold in this paragraph (c)(7) may not apply the look-through rules 
in paragraphs (b)(3) and (c)(5)(ii) of this section, see paragraph 
(c)(5)(ii)(D) of this section.
    (8) Anti-abuse rule. If a principal purpose for the acquisition, 
disposition, or change in use of an asset was to artificially shift the 
amount of basis allocable to excepted or non-excepted trades or 
businesses on a determination date, the additional basis or change in 
use will not be taken into account for purposes of this section. For 
example, if an asset is used in a non-excepted trade or business for 
most of the taxable year, and if the taxpayer begins using the asset in 
an excepted trade or business towards the end of the year with a 
principal purpose of shifting the amount of basis in the asset that is 
allocable to the excepted trade or business, the change in use is 
disregarded for purposes of this section. A purpose may be a principal 
purpose even though it is outweighed by other purposes (taken together 
or separately). In determining whether a taxpayer has a principal 
purpose described in this paragraph (c)(8), factors to be considered 
include, for example, the following: The business purpose for the 
acquisition, disposition, or change in use; the length of time the asset 
was used in a trade or business; whether the asset was acquired from a 
related person; and whether the taxpayer's aggregate basis in its assets 
increased or decreased temporarily on or around a determination date. A 
principal purpose is presumed to be present in any case in which the 
acquisition, disposition, or change in use lacks a substantial business 
purpose and increases the taxpayer's basis in assets used in its 
excepted trades or businesses by more than 10 percent during the taxable 
year.
    (d) Direct allocations--(1) In general. It is not necessary to 
allocate interest expense under this paragraph (d) if all of the 
taxpayer's interest expense is allocable to excepted trades or 
businesses or if all of the taxpayer's interest expense is allocable to 
non-excepted trades or businesses.
    (2) Qualified nonrecourse indebtedness. For purposes of this 
section, a taxpayer with qualified nonrecourse indebtedness must 
directly allocate interest expense from the indebtedness to the 
taxpayer's assets in the manner and to the extent provided in Sec.  
1.861-10T(b). For purposes of this paragraph (d)(2), the term qualified 
nonrecourse indebtedness has the meaning provided in Sec.  1.861-10T(b), 
except that the term cash flow from the property (within the meaning of 
Sec.  1.861-10T(b)(3)(i)) includes revenue derived from the sale or 
lease of inventory or similar property with respect to an excepted 
regulated utility trade or business or a non-excepted regulated utility 
trade or business.
    (3) Assets used in more than one trade or business. If an asset is 
used in more than one trade or business, the taxpayer must apply the 
rules in paragraph (c)(3) of this section to determine the extent to 
which interest that is directly allocated under this paragraph (d) is 
allocable to excepted or non-excepted trades or businesses.
    (4) Adjustments to basis of assets to account for direct 
allocations. In determining the amount of a taxpayer's basis in the 
assets used in its excepted and non-excepted trades or businesses for 
purposes of paragraph (c) of this section, adjustments must be made to 
reflect direct allocations under this paragraph (d). These adjustments 
consist of reductions in the taxpayer's basis in its assets for purposes 
of paragraph (c) of this section to reflect assets to which interest 
expense is directly allocated under this paragraph (d). The amount of 
the taxpayer's basis in these assets must be reduced, but not below 
zero, by the amount of qualified nonrecourse indebtedness secured by 
these assets. These adjustments must be made before the taxpayer 
averages the adjusted basis in its assets as determined on each 
determination date during the taxable year.
    (5) Example: Direct allocation of interest expense--(i) Facts. T 
conducts an electing real property trade or business (Business X) and 
operates a retail store that is a non-excepted trade or business 
(Business Y). In Year 1, T issues Note A to a third party in exchange 
for $1,000x for the purpose of acquiring Building B. Note A is qualified 
nonrecourse indebtedness (within the meaning of Sec.  1.861-10T(b)) 
secured by Building B. T then uses those funds to

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acquire Building B for $1,200x, and T uses Building B in Business X. 
During Year 1, T pays $500x of interest, of which $100x is interest 
payments on Note A. For Year 1, T's basis in its assets used in Business 
X (as determined under paragraph (c) of this section) is $3,600x 
(excluding cash and cash equivalents), and T's basis in its assets used 
in Business Y (as determined under paragraph (c) of this section) is 
$800x (excluding cash and cash equivalents). Each of Business X and 
Business Y also has $100x of cash and cash equivalents.
    (ii) Analysis. Because Note A is qualified nonrecourse indebtedness 
that is secured by Building B, in allocating interest expense between 
Businesses X and Y, T first must directly allocate the $100x of interest 
expense it paid with respect to Note A to Business X in accordance with 
paragraph (d)(2) of this section. Thereafter, T must allocate the 
remaining $400x of interest expense between Businesses X and Y under 
paragraph (c) of this section. After excluding $1,000x of T's basis in 
Building B to reflect the amount of Note A (see paragraph (d)(4) of this 
section), and without regard to T's $200x of cash and cash equivalents 
(see paragraph (c)(5)(iii) of this section), T's basis in its assets 
used in Businesses X and Y is $2,600x and $800x (76.5 percent and 23.5 
percent), respectively. Thus, $306x of the remaining $400x of interest 
expense would be allocated to Business X, and $94x would be allocated to 
Business Y.
    (e) Examples. The examples in this paragraph (e) illustrate the 
principles of this section. For purposes of these examples, no taxpayer 
is eligible for the small business exemption under section 163(j)(3) and 
Sec.  1.163(j)-2(d), no taxpayer has floor plan financing interest 
expense, and no taxpayer has qualified nonrecourse indebtedness within 
the meaning of Sec.  1.861-10T(b).
    (1) Example 1: Interest allocation within a consolidated group--(i) 
Facts. S is a member of a consolidated group of which P is the common 
parent. P conducts an electing real property trade or business (Business 
X), and S conducts a non-excepted trade or business (Business Y). In 
Year 1, P pays or accrues (without regard to section 163(j)) $35x of 
interest expense and receives $10x of interest income, and S pays or 
accrues (without regard to section 163(j)) $115x of interest expense and 
receives $5x of interest income (for a total of $150x of interest 
expense and $15x of interest income). For purposes of this example, 
assume that, pursuant to paragraph (c) of this section, $30x of the P 
group's interest expense and $3x of the P group's interest income is 
allocable to Business X, and the remaining $120x of interest expense and 
$12x of interest income is allocable to Business Y.
    (ii) Analysis. Under paragraph (a)(4) of this section, 20 percent of 
the P group's Year 1 interest expense ($30x/$150x) and interest income 
($3x/$15x) is allocable to an excepted trade or business. Thus, $7x 
($35x x 20 percent) of P's interest expense and $2x ($10x x 20 percent) 
of P's interest income is allocable to an excepted trade or business. 
The remaining $28x of P's interest expense is business interest expense 
subject to the section 163(j) limitation, and the remaining $8x of P's 
interest income is business interest income that increases the group's 
section 163(j) limitation. In turn, $23x ($115x x 20 percent) of S's 
interest expense and $1x ($5x x 20 percent) of S's interest income is 
allocable to an excepted trade or business. The remaining $92x of S's 
interest expense is business interest expense subject to the section 
163(j) limitation, and the remaining $4x of S's interest income is 
business interest income that increases the group's section 163(j) 
limitation.
    (2) Example 2: Interest allocation within a consolidated group with 
assets used in more than one trade or business--(i) Facts. S is a member 
of a consolidated group of which P is the common parent. P conducts an 
electing real property trade or business (Business X), and S conducts a 
non-excepted trade or business (Business Y). In Year 1, P pays or 
accrues (without regard to section 163(j)) $50x of interest expense, and 
S pays or accrues $100x of interest expense (without regard to section 
163(j)). P leases 40 percent of space in Building V (which P owns) to S 
for use in Business Y, and P leases the remaining 60 percent of space in 
Building V to third parties. For purposes of allocating interest expense 
under paragraph (c) of this section, the P group's basis in its

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assets (excluding Building V) used in Businesses X and Y is $180x and 
$620x, respectively. The P group's basis in Building V for purposes of 
allocating interest expense under paragraph (c) of this section is 
$200x.
    (ii) Analysis. Under paragraph (c)(3)(ii) of this section, the P 
group's basis in Building V ($200x) is allocated to excepted and non-
excepted trades or businesses in accordance with the use of space by 
Business Y (40 percent) and Business X (the remainder, or 60 percent). 
Accordingly, $120x of the basis in Building V is allocated to excepted 
trades or businesses (60 percent x $200x), and $80x is allocated to non-
excepted trades or businesses (40 percent x $200x). After allocating the 
basis in Building V, the P group's total basis in the assets used in 
excepted and non-excepted trades or businesses is $300x and $700x, 
respectively. Under paragraphs (a)(4) and (c) of this section, 30 
percent ($300x/$1,000x) of the P group's Year 1 interest expense is 
properly allocable to an excepted trade or business. Thus, $15x ($50x x 
30 percent) of P's interest expense is properly allocable to an excepted 
trade or business, and the remaining $35x of P's interest expense is 
business interest expense subject to the section 163(j) limitation. In 
turn, $30x ($100x x 30 percent) of S's interest expense is properly 
allocable to an excepted trade or business, and the remaining $70x of 
S's interest expense is business interest expense subject to the section 
163(j) limitation.
    (3) Example 3: Application of look-through rules--(i) Facts. (A) 
Each of Corp A, Corp B, Corp C, and Corp D is a domestic calendar-year 
corporation that is not a member of a consolidated group. Corp A owns 
100 percent of the stock of Corp C; the basis of Corp A's stock in Corp 
C is $500x. Corp C owns 10 percent of the interests in PS1 (a domestic 
partnership), and Corp B owns the remaining 90 percent. Corp C's basis 
in its PS1 interests is $25x; Corp B's basis in its PS1 interests is 
$225x. PS1 owns 100 percent of the stock of Corp D; the basis of PS1's 
stock in Corp D is $1,000x. Corp A and Corp B are owned by unrelated, 
non-overlapping shareholders.
    (B) In 2021, Corp C was engaged solely in a non-excepted trade or 
business. That same year, PS1's only activity was holding Corp D stock. 
In turn, Corp D was engaged in both an electing farming business and a 
non-excepted trade or business. Under the allocation rules in paragraph 
(c) of this section, 50 percent of Corp D's asset basis in 2021 was 
allocable to the electing farming business, and the remaining 50 percent 
was allocable to the non-excepted trade or business.
    (C) Corp A and Corp B each paid or accrued (without regard to 
section 163(j)) $150x of interest expense allocable to a trade or 
business. Corp A's trade or business was an excepted trade or business, 
and Corp B's trade or business was a non-excepted trade or business. 
Corp A's basis in the assets used in its trade or business was $100x, 
and Corp B's basis in the assets used in its trade or business was 
$112.5x.
    (ii) Analysis. (A) As provided in paragraph (c)(5)(ii)(E) of this 
section, if a taxpayer applies the look-through rules of paragraph 
(c)(5)(ii) of this section, the taxpayer must begin with the lowest-tier 
entity to which it is eligible to apply the look-through rules. Corp A 
directly owns 100 percent of the stock of Corp C; thus, Corp A satisfies 
the 80 percent minimum ownership threshold with respect to Corp C. Corp 
A also owns 10 percent of the interests in PS1. There is no minimum 
ownership threshold for partnerships; thus, Corp A may apply the look-
through rules to PS1. However, Corp A does not directly or indirectly 
own at least 80 percent of the stock of Corp D; thus, Corp A cannot look 
through its indirect interest in Corp D. In turn, Corp B directly owns 
90 percent of the interests in PS1, and Corp B indirectly owns at least 
80 percent of the stock of Corp D. Thus, Corp B must apply the look-
through rules to PS1 and Corp D.
    (B) From Corp A's perspective, PS1 is not engaged in a trade or 
business for purposes of section 163(j); instead, PS1 is merely holding 
its Corp D stock as an investment. Under paragraph (c)(5)(ii)(A)(2) of 
this section, if a partnership is not engaged in a trade or business, 
then its C corporation partner must treat its entire basis in the 
partnership interest as allocable to a non-excepted trade or business. 
Thus, for purposes of Corp A's application of

[[Page 532]]

the look-through rules, Corp C's entire basis in its PS1 interest ($25x) 
is allocable to a non-excepted trade or business. Corp C's basis in its 
other assets also is allocable to a non-excepted trade or business (the 
only trade or business in which Corp C is engaged). Thus, under 
paragraph (c) of this section, Corp A's $500x basis in its Corp C stock 
is allocable entirely to a non-excepted trade or business. Corp A's 
$100x basis in its other business assets is allocable to an excepted 
trade or business. Thus, \5/6\ (or $125x) of Corp A's $150x of interest 
expense is properly allocable to a non-excepted trade or business and is 
business interest expense subject to the section 163(j) limitation, and 
the remaining $25x of Corp A's $150x of interest expense is allocable to 
an excepted trade or business and is not subject to the section 163(j) 
limitation.
    (C) From Corp B's perspective, PS1 must look through its stock in 
Corp D to determine the extent to which PS1's basis in the stock is 
allocable to an excepted or non-excepted trade or business. Half of Corp 
D's basis in its assets is allocable to an excepted trade or business, 
and the other half is allocable to a non-excepted trade or business. 
Thus, from Corp B's perspective, $500x of PS1's basis in its Corp D 
stock (PS1's only asset) is allocable to an excepted trade or business, 
and the other half is allocable to a non-excepted trade or business. 
Corp B's basis in its PS1 interests is $225x. Applying the look-through 
rules to Corp B's PS1 interests, $112.5x of Corp B's basis in its PS1 
interests is allocable to an excepted trade or business, and $112.5x of 
Corp B's basis in its PS1 interests is allocable to a non-excepted trade 
or business. Since Corp B's basis in the assets used in its non-excepted 
trade or business also was $112.5x, two-thirds of Corp B's interest 
expense ($100x) is properly allocable to a non-excepted trade or 
business and is business interest expense subject to the section 163(j) 
limitation, and one-third of Corp B's interest expense ($50x) is 
allocable to an excepted trade or business and is not subject to the 
section 163(j) limitation.
    (4) Example 4: Excepted and non-excepted trades or businesses in a 
consolidated group--(i) Facts. P is the common parent of a consolidated 
group of which A and B are the only other members. A conducts an 
electing real property trade or business (Business X), and B conducts a 
non-excepted trade or business (Business Y). In Year 1, A pays or 
accrues (without regard to section 163(j)) $50x of interest expense and 
earns $70x of gross income in the conduct of Business X, and B pays or 
accrues (without regard to section 163(j)) $100x of interest expense and 
earns $150x of gross income in the conduct of Business Y. B owns 
Building V, which it uses in Business Y. For purposes of allocating the 
P group's Year 1 business interest expense between excepted and non-
excepted trades or businesses under paragraph (c) of this section, the P 
group's basis in its assets (other than Building V) used in Businesses X 
and Y is $180x and $620x, respectively, and the P group's basis in 
Building V is $200x. At the end of Year 1, B sells Building V to a third 
party and realizes a gain of $60x in addition to the $150x of gross 
income B earned that year from the conduct of Business Y.
    (ii) Analysis. (A) Under paragraphs (a)(4) and (c) of this section, 
the P group's basis in its assets used in its trades or businesses is 
allocated between the P group's excepted trade or business (Business X) 
and its non-excepted trade or business (Business Y) as though these 
trades or businesses were conducted by a single corporation. Under 
paragraph (c) of this section, the P group's basis in its assets used in 
Businesses X and Y is $180x and $820x, respectively. Accordingly, 18 
percent ($180x/$1,000x) of the P group's total interest expense ($150x) 
is properly allocable to an excepted trade or business ($27x), and the 
remaining 82 percent of the P group's total interest expense is business 
interest expense properly allocable to a non-excepted trade or business 
($123x).
    (B) To determine the P group's section 163(j) limitation, paragraph 
(a) of this section requires that certain items of income and deduction 
be allocated to the excepted and non-excepted trades or businesses of 
the P group as though these trades or businesses were conducted by a 
single corporation. In Year 1, the P group's excepted trade or

[[Page 533]]

business (Business X) has gross income of $70x, and the P group's non-
excepted trade or business (Business Y) has gross income of $150x. 
Because Building V was used exclusively in Business Y, the $60x of gain 
from the sale of Building V in Year 1 is attributed to Business Y under 
paragraph (b)(2) of this section. The P group's section 163(j) 
limitation is $63x (30 percent x $210x), which allows the P group to 
deduct $63x of its $123x of business interest expense allocated to the P 
group's non-excepted trades or businesses. The group's $27x of interest 
expense that is allocable to excepted trades or businesses may be 
deducted without limitation under section 163(j).
    (iii) Intercompany transaction. The facts are the same as in Example 
4 in paragraph (e)(4)(i) of this section, except that A owns Building V 
and leases it to B in Year 1 for $20x for use in Business Y, and A sells 
Building V to a third party for a $60 gain at the end of Year 1. Under 
paragraphs (a)(4) and (c) of this section, all members of the P group 
are treated as a single corporation. As a result, the P group's basis in 
its assets used in its trades or businesses is allocated between the P 
group's excepted trade or business (Business X) and its non-excepted 
trade or business (Business Y) as though these trades or businesses were 
conducted by a single corporation. A lease between two divisions of a 
single corporation would produce no rental income or expense. Thus, the 
$20x of rent paid by B to A does not affect the P group's ATI. Moreover, 
under paragraph (c) of this section, Building V is an asset used in the 
P group's non-excepted trade or business (Business Y). Accordingly, 
although A owns Building V, the basis in Building V is added to the P 
group's basis in assets used in Business Y for purposes of allocating 
interest expense under paragraph (c) of this section. In the same vein, 
when A sells Building V to a third party at a gain of $60x, the gain is 
included in the P group's ATI because Building V was used in a non-
excepted trade or business of the P group (Business Y) prior to its 
sale.
    (5) Example 5: Captive activities--(i) Facts. S and T are members of 
a consolidated group of which P is the common parent. P conducts an 
electing real property trade or business (Business X), S conducts a non-
excepted trade or business (Business Y), and T provides transportation 
services to Businesses X and Y but does not have any customers outside 
of the P group. For Year 1, T provides transportation services using a 
single bus with a basis of $120x.
    (ii) Analysis. Under paragraph (a)(4) of this section, activities 
conducted by a consolidated group are treated as though those activities 
were conducted by a single corporation. Because the activities of T are 
limited to providing intercompany transportation services, T does not 
conduct a trade or business for purposes of section 163(j). Under 
paragraph (c)(3) of this section, business interest expense is allocated 
to excepted and non-excepted trades or businesses based on the relative 
basis of the assets used in those businesses. The basis in T's only 
asset, a bus, is therefore allocated between Business X and Business Y 
according to the use of T's bus by these businesses. Business X uses 
one-third of T's services, and Business Y uses two-thirds of T's 
services. Thus, $40x of the basis of T's bus is allocated to Business X, 
and $80x of the basis of T's bus is allocated to Business Y.
    (6) Example 6: Constructive ownership--(i) Facts. P, S, T, and U are 
domestic C corporations that are not members of a consolidated group. P 
directly owns 80 percent of the stock of each of S and T as measured by 
total voting power and value; an unrelated third party, X, owns the 
remaining 20 percent. In turn, S and T directly own 15 percent and 80 
percent, respectively, of the stock of U as measured by total voting 
power and value; P directly owns the remaining 5 percent. P conducts 
both excepted and non-excepted trades or businesses. S and T conduct 
only non-excepted trades or businesses, and U conducts both excepted and 
non-excepted trades or businesses.
    (ii) Analysis. Under paragraph (c)(7)(i)(A) of this section, a 
shareholder must look through to the assets of a domestic non-
consolidated C corporation for purposes of allocating the shareholder's 
basis in its stock in the corporation between excepted and non-

[[Page 534]]

excepted trades or businesses if the shareholder's direct and indirect 
interest in the corporation satisfies the ownership requirements of 
section 1504(a)(2). For purposes of paragraph (c)(7)(i)(A) of this 
section, a shareholder's stock ownership is determined by applying the 
constructive ownership rules of section 318(a). P directly owns 80 
percent of each of S and T as measured by total voting power and value; 
thus, P must look through to the assets of S and T when allocating the 
basis in its stock of S and T. P directly owns 5 percent of the stock of 
U as measured by total voting power and value, and P constructively owns 
the other 95 percent; thus, P also must look through to U's assets when 
allocating the basis in its U stock. S directly owns 15 percent of the 
stock of U, and S constructively owns only 5 percent through P; thus, S 
cannot look through to U's assets when allocating the basis in its U 
stock. T directly owns 80 percent of the stock of U, and T 
constructively owns an additional 5 percent; thus, T must look through 
to U's assets when allocating the basis in its U stock.
    (iii) Dividend. The facts are the same as in paragraph (e)(6)(i) of 
this section, except that U distributes a $160x dividend pro rata to its 
shareholders. Thus, P receives $8x (5 percent of $160x) of the U 
dividend, S receives $24x (15 percent of $160x), and T receives $128x 
(80 percent of $160x). Under paragraph (c)(7)(i)(B) of this section, if 
a shareholder's direct interest in a corporation satisfies the ownership 
requirements of section 1504(a)(2), the shareholder must look through to 
the activities of a domestic non-consolidated C corporation in 
determining whether dividend income is from an excepted or non-excepted 
trade or business. The constructive ownership rules do not apply in 
allocating dividends under paragraph (c)(7)(i)(B) of this section. P 
directly owns 5 percent of the stock of U as measured by vote and value, 
and S directly owns 15 percent of the stock of U as measured by vote and 
value; thus, neither P nor S is required to apply the look-through rules 
in allocating its dividend income from U, and all such income is 
allocable to non-excepted trades or businesses. T directly owns 80 
percent of the stock of U as measured by vote and value; thus, T must 
allocate its U dividend in accordance with the activities of U's 
excepted and non-excepted trades or businesses.
    (7) Example 7: Dispositions with a principal purpose of shifting 
basis--(i) Facts. U and V are members of a consolidated group of which P 
is the common parent. U conducts an electing farming business (Business 
F), and V conducts a farm equipment leasing business (Business L) that 
is a non-excepted trade or business. After the end of a farming season, 
the P group, with a principal purpose of shifting basis from Business L 
to Business F, has V sell to U all off-lease farming equipment that 
previously was leased out as part of Business L. Immediately before the 
start of the next season, U sells the farming equipment back to V for 
use in Business L.
    (ii) Analysis. Under paragraph (c)(8) of this section, in the case 
of a disposition of assets undertaken with a principal purpose of 
artificially shifting the amount of basis allocable to excepted or non-
excepted trades or businesses on a determination date, the additional 
basis or change in use will not be taken into account. Because V's sale 
of farming equipment to U for storage in Business F's facilities is 
undertaken with a principal purpose of shifting basis from Business L to 
Business F, the additional basis Business F receives from these 
transactions will not be taken into account for purposes of this 
section. Instead, the basis of the farming equipment will be allocated 
as though the farming equipment continued to be used in Business L.
    (f) Applicability dates--(1) In general. This section applies to 
taxable years beginning on or after November 13, 2020. However, 
taxpayers and their related parties, within the meaning of sections 
267(b) and 707(b)(1), may choose to apply the rules of this section to a 
taxable year beginning after December 31, 2017, so long as the taxpayers 
and their related parties consistently apply the rules of the section 
163(j) regulations, and, if applicable, Sec. Sec.  1.263A-9, 1.263A-15, 
1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 
1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 
1.1377-1, 1.1502-

[[Page 535]]

13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 1.1502-99 (to the 
extent they effectuate the rules of Sec. Sec.  1.382-2, 1.382-5, 1.382-
6, and 1.383-1), and 1.1504-4, to that taxable year. Accordingly, for 
purposes of Sec.  1.163(j)-10(c)(5), taxpayers make any change to the 
alternative depreciation system as of November 13, 2020, or if relying 
on the provisions of Sec.  1.163(j)-10 in regulation project REG-106089-
18 (83 FR 67490), as of December 28, 2018.
    (2) Paragraph (c)(5)(ii)(D)(2). The rules contained in paragraph 
(c)(5)(ii)(D)(2) of this section apply for taxable years beginning on or 
after March 22, 2021. However, taxpayers may choose to apply the rules 
in paragraph (c)(5)(ii)(D)(2) of this section to a taxable year 
beginning after December 31, 2017, and before March 22, 2021, provided 
that those taxpayers and their related parties consistently apply all of 
the rules in the section 163(j) regulations as contained in T.D. 9905 
(Sec. Sec.  1.163(j)-0 through 1.163(j)-11, effective November 13, 2020) 
as modified by T.D. 9943 (effective January 13, 2021), and, if 
applicable, Sec. Sec.  1.263A-9, 1.263A-15, 1.381(c)(20)-1, 1.382-1, 
1.382-2, 1.382-5, 1.382-6, 1.383-0, 1.383-1, 1.469-9, 1.704-1, 1.882-5, 
1.1362-3, 1.1368-1, 1.1377-1, 1.1502-13, 1.1502-21, 1.1502-79, 1.1502-91 
through 1.1502-99 (to the extent they effectuate the rules of Sec. Sec.  
1.382-2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4 contained in T.D. 
9905 as modified by T.D. 9943, to that taxable year and each subsequent 
taxable year.

[T.D. 9905, 85 FR 56760, Sept. 14, 2020, as amended at T.D. 9943, 86 FR 
5539, Jan. 19, 2021]



Sec.  1.163(j)-11  Transition rules.

    (a) Overview. This section provides transition rules regarding the 
section 163(j) limitation. Paragraph (b) of this section provides rules 
regarding the application of the section 163(j) limitation to a 
corporation that joins a consolidated group during a taxable year of the 
group beginning before January 1, 2018 and is subject to the section 
163(j) limitation at the time of its change in status. Paragraph (c) of 
this section provides rules regarding the treatment of carryforwards of 
disallowed disqualified interest.
    (b) Application of section 163(j) limitation if a corporation joins 
a consolidated group during a taxable year of the group beginning before 
January 1, 2018--(1) In general. If a corporation (S) joins a 
consolidated group during a taxable year of the group beginning before 
January 1, 2018, and if S is subject to the section 163(j) limitation at 
the time of its change in status, then section 163(j) will apply to S's 
short taxable year that ends on the day of S's change in status, but 
section 163(j) will not apply to S's short taxable year that begins the 
next day (when S is a member of the acquiring consolidated group). Any 
business interest expense paid or accrued (without regard to section 
163(j)) by S in its short taxable year ending on the day of S's change 
in status for which a deduction is disallowed under section 163(j) will 
be carried forward to the acquiring group's first taxable year beginning 
after December 31, 2017. Those disallowed business interest expense 
carryforwards may be subject to limitation under other provisions of 
these regulations (see, for example, Sec.  1.163(j)-5(c), (d), (e), and 
(f)).
    (2) Example. Acquiring Group is a consolidated group with a fiscal 
year end of November 30; Target is a stand-alone calendar-year C 
corporation. On May 31, 2018, Acquiring Group acquires Target in a 
transaction that is not an ownership change for purposes of section 382. 
Acquiring Group is not subject to the section 163(j) limitation during 
its taxable year beginning December 1, 2017. As a result of the 
acquisition, Target has a short taxable year beginning January 1, 2018 
and ending May 31, 2018. Target is subject to the section 163(j) 
limitation during this short taxable year. However, Target (as a member 
of Acquiring Group) is not subject to the section 163(j) limitation 
during Acquiring Group's taxable year ending November 30, 2018. Any 
disallowed business interest expense carryforwards from Target's taxable 
year ending May 31, 2018, will not be available for use in Acquiring 
Group's taxable year ending November 30, 2018. However, that disallowed 
business interest expense is carried forward to Acquiring Group's 
taxable year beginning December 1, 2018, and can be deducted by the 
group,

[[Page 536]]

subject to the separate return limitation year (SRLY) limitation. See 
Sec.  1.163(j)-5(d).
    (c) Treatment of disallowed disqualified interest--(1) In general. 
Disallowed disqualified interest is carried forward to the taxpayer's 
first taxable year beginning after December 31, 2017. Disallowed 
disqualified interest is subject to disallowance as a disallowed 
business interest expense carryforward under section 163(j) and Sec.  
1.163(j)-2 to the extent the interest is properly allocable to a non-
excepted trade or business under Sec.  1.163(j)-10. Disallowed 
disqualified interest that is properly allocable to an excepted trade or 
business is not subject to the section 163(j) limitation. See Sec.  
1.163(j)-10(a)(6) for rules governing the allocation of disallowed 
disqualified interest between excepted and non-excepted trades or 
businesses.
    (2) Earnings and profits. A taxpayer may not reduce its earnings and 
profits in a taxable year beginning after December 31, 2017, to reflect 
any disallowed disqualified interest carryforwards to the extent the 
payment or accrual of the disallowed disqualified interest reduced the 
earnings and profits of the taxpayer in a prior taxable year.
    (3) Disallowed disqualified interest of members of an affiliated 
group--(i) Scope. This paragraph (c)(3)(i) applies to corporations that 
were treated as a single taxpayer under old section 163(j)(6)(C) and 
that had disallowed disqualified interest.
    (ii) Allocation of disallowed disqualified interest to members of 
the affiliated group--(A) In general. Each member of the affiliated 
group is allocated its allocable share of the affiliated group's 
disallowed disqualified interest as provided in paragraph (c)(3)(ii)(B) 
of this section.
    (B) Definitions. The following definitions apply for purposes of 
paragraph (c)(3)(ii) of this section.
    (1) Allocable share of the affiliated group's disallowed 
disqualified interest. The term allocable share of the affiliated 
group's disallowed disqualified interest means, with respect to any 
member of an affiliated group for the member's last taxable year 
beginning before January 1, 2018, the product of the total amount of the 
disallowed disqualified interest of all members of the affiliated group 
under old section 163(j)(6)(C) and the member's disallowed disqualified 
interest ratio.
    (2) Disallowed disqualified interest ratio. The term disallowed 
disqualified interest ratio means, with respect to any member of an 
affiliated group for the member's last taxable year beginning before 
January 1, 2018, the ratio of the exempt related person interest expense 
of the member for the last taxable year beginning before January 1, 
2018, to the sum of the amounts of exempt related person interest 
expense for all members of the affiliated group.
    (3) Exempt related person interest expense. The term exempt related 
person interest expense means interest expense that is, or is treated 
as, paid or accrued by a domestic C corporation, or by a foreign 
corporation with income, gain, or loss that is effectively connected, or 
treated as effectively connected, with the conduct of a trade or 
business in the United States, to--
    (i) Any person related to the taxpayer, within the meaning of 
sections 267(b) or 707(b)(1), applying the constructive ownership and 
attribution rules of section 267(c), if no U.S. tax is imposed with 
respect to the interest under subtitle A of the Code, determined without 
regard to net operating losses or net operating loss carryovers, and 
taking into account any applicable treaty obligation of the United 
States. For this purpose, interest that is subject to a reduced rate of 
tax under any treaty obligation of the United States applicable to the 
recipient is treated as, in part, subject to the statutory tax rate 
under sections 871 or 881 and, in part, not subject to tax, based on the 
proportion that the rate of tax under the treaty bears to the statutory 
tax rate. Thus, for purposes of section 163(j), if the statutory tax 
rate is 30 percent, and pursuant to a treaty U.S. tax is instead limited 
to a rate of 10 percent, two-thirds of the interest is considered 
interest not subject to U.S. tax under subtitle A of the Code;
    (ii) A person that is not related to the taxpayer, within the 
meaning of section 267(b) or 707(b)(1), applying the constructive 
ownership and attribution rules of section 267(c), with respect to

[[Page 537]]

indebtedness on which there is a disqualified guarantee, within the 
meaning of paragraph (6)(D) of old section 163(j), of such indebtedness, 
and no gross basis U.S. tax is imposed with respect to the interest. For 
purposes of this paragraph (c)(3)(ii)(B)(3)(ii), a gross basis U.S. tax 
means any tax imposed by this subtitle A of the Code that is determined 
by reference to the gross amount of any item of income without any 
reduction for any deduction allowed by subtitle A of the Code. Interest 
that is subject to a gross basis U.S. tax that is eligible for a reduced 
rate of tax under any treaty obligation of the United States applicable 
to the recipient is treated as, in part, subject to the statutory tax 
rate under section 871 or 881 and, in part, not subject to a gross basis 
U.S. tax, based on the proportion that the rate of tax under the treaty 
bears to the statutory tax rate. Thus, for purposes of section 163(j), 
if the statutory tax rate is 30 percent, and pursuant to a treaty U.S. 
tax is instead limited to a rate of 10 percent, two-thirds of the 
interest is considered interest not subject to a gross basis U.S. tax 
under subtitle A of the Code; or
    (iii) A REIT, directly or indirectly, to the extent that the 
domestic C corporation, or a foreign corporation with income, gain, or 
loss that is effectively connected, or treated as effectively connected, 
with the conduct of a trade or business in the United States, is a 
taxable REIT subsidiary, as defined in section 856(l), with respect to 
the REIT.
    (iii) Treatment of carryforwards. The amount of disallowed 
disqualified interest allocated to a taxpayer pursuant to paragraph 
(c)(3)(ii) of this section is treated in the same manner as described in 
paragraph (c)(1) of this section.
    (4) Application of section 382--(i) Ownership change occurring 
before November 13, 2020--(A) Pre-change loss. For purposes of section 
382(d)(3), unless the rules of Sec.  1.382-2(a)(7) apply, disallowed 
disqualified interest is not a pre-change loss under Sec.  1.382-2(a) 
subject to a section 382 limitation with regard to an ownership change 
on a change date occurring before November 13, 2020. But see section 
382(h)(6)(B) (regarding built-in deduction items).
    (B) Loss corporation. For purposes of section 382(k)(1), unless the 
rules of Sec.  1.382-2(a)(7) apply, disallowed disqualified interest is 
not a carryforward of disallowed interest described in section 
381(c)(20) with regard to an ownership change on a change date occurring 
before November 13, 2020. But see section 382(h)(6) (regarding built-in 
deductions).
    (ii) Ownership change occurring on or after November 13, 2020--(A) 
Pre-change loss. For rules governing the treatment of disallowed 
disqualified interest as a pre-change loss for purposes of section 382 
with regard to an ownership change on a change date occurring on or 
after November 13, 2020, see Sec. Sec.  1.382-2(a)(2) and 1.382-6(c)(3).
    (B) Loss corporation. For rules governing when disallowed 
disqualified interest causes a corporation to be a loss corporation with 
regard to an ownership change occurring on or after November 13, 2020, 
see Sec.  1.382-2(a)(1)(i)(A).
    (5) Treatment of excess limitation from taxable years beginning 
before January 1, 2018. No amount of excess limitation under old section 
163(j)(2)(B) may be carried forward to taxable years beginning after 
December 31, 2017.
    (6) Example: Members of an affiliated group--(i) Facts. A, B, and C 
are calendar-year domestic C corporations that are members of an 
affiliated group (within the meaning of section 1504(a)) that was 
treated as a single taxpayer under old section 163(j)(6)(C) and the 
proposed regulations in this part under old section 163(j) (see formerly 
proposed Sec.  1.163(j)-5). For the taxable year ending December 31, 
2017, the separately determined amounts of exempt related person 
interest expense of A, B, and C were $0, $600x, and $150x, respectively 
(for a total of $750x). The affiliated group has $200x of disallowed 
disqualified interest in that year.
    (ii) Analysis. The affiliated group's disallowed disqualified 
interest expense for the 2017 taxable year ($200x) is allocated among A, 
B, and C based on the ratio of each member's exempt related person 
interest expense to the group's exempt related person interest expense. 
Because A has no exempt related person interest expense, no disallowed 
disqualified interest is allocated to A. Disallowed disqualified 
interest of $160x is

[[Page 538]]

allocated to B (($600x/$750x) x $200x), and disallowed disqualified 
interest of $40x is allocated to C (($150x/$750x) x $200x). Thus, B and 
C have $160x and $40x, respectively, of disallowed disqualified interest 
that is carried forward to the first taxable year beginning after 
December 31, 2017. No excess limitation that was allocated to A, B, or C 
under old section 163(j) will carry forward to a taxable year beginning 
after December 31, 2017.
    (iii) Carryforward of disallowed disqualified interest to 2018 
taxable year. The facts are the same as in the Example in paragraph 
(c)(7)(i) of this section, except that, for the taxable year ending 
December 31, 2018, A, B, and C are members of a consolidated group that 
has a section 163(j) limitation of $140x, current-year business interest 
expense (as defined in Sec.  1.163(j)-1(b)(9)) of $80x, and no excepted 
trade or business. Under paragraph (c)(1) of this section, disallowed 
disqualified interest is carried to the taxpayer's first taxable year 
beginning after December 31, 2017, and is subject to disallowance under 
section 163(j) and Sec.  1.163(j)-2. Under Sec.  1.163(j)-
5(b)(3)(ii)(D)(1), a consolidated group that has section 163(j) 
limitation remaining for the current year after deducting all current-
year business interest expense deducts each member's disallowed 
disqualified interest carryforwards from prior taxable years, starting 
with the earliest taxable year, on a pro rata basis (subject to certain 
limitations). In accordance with paragraph (c)(1) of this section, the 
rule in Sec.  1.163(j)-5(b)(3)(ii)(D)(1) applies to disallowed 
disqualified interest carried forward to the taxpayer's first taxable 
year beginning after December 31, 2017. Accordingly, after deducting 
$80x of current-year business interest expense in 2018, the group may 
deduct $60x of its $200x disallowed disqualified interest carryforwards. 
Under paragraph (c)(3) of this section, B has $160x of disallowed 
disqualified interest carryforwards, and C has $40x of disallowed 
disqualified interest carryforwards. Thus, $48x (($160x/$200x) x $60x) 
of B's disallowed disqualified interest carryforwards, and $12x (($40x/
$200x) x $60x) of C's disallowed disqualified interest carryforwards, 
are deducted by the consolidated group in the 2018 taxable year.
    (d) Applicability date. This section applies to taxable years 
beginning on or after November 13, 2020. However, taxpayers and their 
related parties, within the meaning of sections 267(b) and 707(b)(1), 
may choose to apply the rules of this section to a taxable year 
beginning after December 31, 2017, so long as the taxpayers and their 
related parties consistently apply the rules of the section 163(j) 
regulations, and, if applicable, Sec. Sec.  1.263A-9, 1.263A-15, 
1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 
1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 
1.1377-1, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 
1.1502-99 (to the extent they effectuate the rules of Sec. Sec.  1.382-
2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4, to that taxable year.

[T.D. 9905, 85 FR 56760, Sept. 14, 2020]



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

[[Page 539]]

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 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 taxes. Except as provided in Sec.  1.901-1(c)(2) 
and (3), foreign income taxes, as defined in Sec.  1.901-2(a), paid or 
accrued (as the case may be, depending on the taxpayer's method of 
accounting for such taxes) in a taxable year, if the taxpayer chooses to

[[Page 540]]

take to any extent the benefits of section 901, relating to the credit 
for taxes of foreign countries and possessions of the United States, for 
taxes that are paid or accrued (according to the taxpayer's method of 
accounting for such taxes) in such taxable year.
    (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.
    (i) Applicability dates. Paragraph (d) of this section applies to 
foreign taxes paid or accrued in taxable years beginning on or after 
December 28, 2021.

[T.D. 6780, 29 FR 18145, Dec. 22, 1964, as amended by T.D. 7767, 46 FR 
11263, Feb. 6, 1981; T.D. 9959, 87 FR 317, Jan. 4, 2022]



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.
    (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

[[Page 541]]

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 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

[[Page 542]]

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 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

[[Page 543]]

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.
    (j) Safe harbor for payments made by individuals in exchange for 
State or local tax credits--(1) In general. An individual who itemizes 
deductions and who makes a payment to or for the use of an entity 
described in section 170(c) in consideration for a State or local tax 
credit may treat as a payment of State or local tax for purposes of 
section 164 the portion of such payment for which a charitable 
contribution deduction under section 170 is disallowed under Sec.  
1.170A-1(h)(3). This treatment as payment of a State or local tax is 
allowed in the taxable year in which the payment is made to the extent 
that the resulting credit is applied, consistent with applicable State 
or local law, to offset the individual's State or local tax liability 
for such taxable year or the preceding taxable year.
    (2) Credits carried forward. To the extent that a State or local tax 
credit described in paragraph (j)(1) of this section is not applied to 
offset the individual's applicable State or local tax liability for the 
taxable year of the payment or the preceding taxable year, any excess 
State or local tax credit permitted to be carried forward may be treated 
as a payment of State or local tax under section 164(a) in the taxable 
year or years for which the carryover credit is applied in accordance 
with State or local law.
    (3) Limitation on individual deductions. Nothing in this paragraph 
(j) may be construed as permitting a taxpayer who applies this safe 
harbor to avoid the limitation of section 164(b)(6) for any amount paid 
as a tax or treated under this paragraph (j) as a payment of tax.
    (4) No safe harbor for transfers of property. The safe harbor 
provided in this paragraph (j) applies only to a payment of cash or cash 
equivalent.
    (5) Coordination with other deductions. An individual who deducts a 
payment under section 164 may not also deduct the same payment under any 
other Code section.
    (6) Examples. In the following examples, the taxpayer is an 
individual who itemizes deductions for Federal income tax purposes.
    (i) Example 1. In year 1, Taxpayer A makes a payment of $500 to an 
entity described in section 170(c). In return for the payment, A 
receives a dollar-for-dollar State income tax credit. Prior to 
application of the credit, A's State income tax liability for year 1 was 
more than $500. A applies the $500 credit to A's year 1 State income tax 
liability. Under paragraph (j)(1) of this section, A treats the $500 
payment as a payment of State income tax in year 1. To determine A's 
deduction amount, A must apply the provisions of section 164 applicable 
to payments of State and local taxes, including the limitation in 
section 164(b)(6). See paragraph (j)(3) of this section.
    (ii) Example 2. In year 1, Taxpayer B makes a payment of $7,000 to 
an entity described in section 170(c). In return for the payment, B 
receives a dollar-for-dollar State income tax credit, which under State 
law may be carried forward for three taxable years. Prior to application 
of the credit, B's State income tax liability for year 1 was $5,000; B 
applies $5,000 of the $7,000 credit to B's year 1 State income tax 
liability. Under paragraph (j)(1) of this section, B treats $5,000 of 
the $7,000 payment as a payment of State income tax in year 1. Prior to 
application of the remaining credit, B's State income tax liability for 
year 2 exceeds $2,000. B applies the excess credit of $2,000 to B's year 
2 State income tax liability. For year 2, under paragraph (j)(2) of this 
section, B treats the $2,000 as a payment of State income tax under 
section 164. To determine B's deduction amounts in years 1 and 2, B must 
apply the provisions of section 164 applicable to payments of State and 
local taxes, including the limitation under section 164(b)(6). See 
paragraph (j)(3) of this section.
    (iii) Example 3. In year 1, Taxpayer C makes a payment of $7,000 to 
an entity described in section 170(c). In return for the payment, C 
receives a local real property tax credit equal to 25 percent of the 
amount of this payment ($1,750).

[[Page 544]]

Prior to application of the credit, C's local real property tax 
liability in year 1 was more than $1,750. C applies the $1,750 credit to 
C's year 1 local real property tax liability. Under paragraph (j)(1) of 
this section, for year 1, C treats $1,750 of the $7,000 payment as a 
payment of local real property tax for purposes of section 164. To 
determine C's deduction amount, C must apply the provisions of section 
164 applicable to payments of State and local taxes, including the 
limitation under section 164(b)(6). See paragraph (j)(3) of this 
section.
    (7) Applicability date. This paragraph (j) applies to payments made 
to section 170(c) entities on or after June 11, 2019. However, a 
taxpayer may choose to apply this paragraph (j) to payments made to 
section 170(c) entities after August 27, 2018.

[T.D. 6780, 29 FR 18146, Dec. 22, 1964, as amended by T.D. 9907, 85 FR 
48473, Aug. 11, 2020]



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 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

[[Page 545]]

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 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--

[[Page 546]]

    (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 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.

[[Page 547]]

    (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 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.

[[Page 548]]

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 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

[[Page 549]]

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 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

[[Page 550]]

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.
    (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.

[[Page 551]]

    (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 
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

[[Page 552]]

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 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

[[Page 553]]

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 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

[[Page 554]]

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 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

[[Page 555]]

    (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;
    (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

[[Page 556]]

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.
    (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

[[Page 557]]

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 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,

[[Page 558]]

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 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

[[Page 559]]

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 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

[[Page 560]]

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
                                                               ---------
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--

[[Page 561]]

    (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 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

[[Page 562]]

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.
    (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.

[[Page 563]]

    (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.
    (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.................................

[[Page 564]]

 
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 to take disaster loss deduction for preceding year.

    (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 (Stafford Act). A federally declared 
disaster includes both a major disaster declared under section 401 of 
the Stafford Act and an emergency declared under section 501 of the 
Stafford Act.
    (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.

[[Page 565]]

    (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 wants to make a 
section 165(i) election with respect to that loss, the taxpayer must 
file an amended Federal income tax return to remove the previously 
deducted loss on or before the date that the taxpayer makes the section 
165(i) election for the 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 wants to revoke that election, the 
taxpayer must file an amended Federal income tax return to remove the 
loss for the preceding year on or before the date the taxpayer files the 
Federal income tax return or amended Federal income tax 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 either on an 
original Federal income tax return for the preceding year or an amended 
Federal income tax return for the preceding year in the manner specified 
by guidance issued pursuant to 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) Applicability dates--(1) In general. Except as provided in 
paragraph (h)(2) of this section, this section applies to elections and 
revocations that are made on or after October 16, 2019.
    (2) Paragraph (b)(1) of this section. The second sentence of 
paragraph (b)(1) of this section applies to elections and revocations 
that are made on or after June 11, 2021.

[T.D. 9878, 84 FR 55245, Oct. 16, 2019, as amended by T.D. 9950, 86 FR 
31150, June 11, 2021]



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 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

[[Page 566]]

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 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

[[Page 567]]

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 
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

[[Page 568]]

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 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

[[Page 569]]

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.
    (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

[[Page 570]]

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 
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

[[Page 571]]

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 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

[[Page 572]]

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 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

[[Page 573]]

    (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 
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.

[[Page 574]]

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 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

[[Page 575]]

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.
    (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

[[Page 576]]

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 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

[[Page 577]]

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, 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

[[Page 578]]

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 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

[[Page 579]]

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 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

[[Page 580]]

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 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

[[Page 581]]

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 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

[[Page 582]]

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:
[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

[[Page 583]]

 
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, $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

[[Page 584]]

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. 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

[[Page 585]]

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 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

[[Page 586]]

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, 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

[[Page 587]]

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 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]

[[Page 588]]



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 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.

[[Page 589]]

    (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 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

[[Page 590]]

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 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

[[Page 591]]

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 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

[[Page 592]]

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 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

[[Page 593]]

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 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''),

[[Page 594]]

(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.
    (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

[[Page 595]]

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 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

[[Page 596]]

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 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

[[Page 597]]

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 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

[[Page 598]]

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 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

[[Page 599]]

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.
    (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

[[Page 600]]

    (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 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

[[Page 601]]

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 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

[[Page 602]]

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.
    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

[[Page 603]]

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 (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.

[[Page 604]]

    (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, 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),

[[Page 605]]

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 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.


[[Page 606]]

    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.

    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.


[[Page 607]]

    (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 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

[[Page 608]]

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 
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

[[Page 609]]

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 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

[[Page 610]]

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 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

[[Page 611]]

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, 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

[[Page 612]]

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 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,

[[Page 613]]

$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 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

[[Page 614]]

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 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,

[[Page 615]]

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 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

[[Page 616]]

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 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.

[[Page 617]]

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:

    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

[[Page 618]]

(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 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

[[Page 619]]

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.


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''.

[[Page 620]]

    (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.
    (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

[[Page 621]]

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 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

[[Page 622]]

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 (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

[[Page 623]]

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 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

[[Page 624]]

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 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

[[Page 625]]

    (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 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

[[Page 626]]

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 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

[[Page 627]]

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 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

[[Page 628]]

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 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

[[Page 629]]

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 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

[[Page 630]]

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 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

[[Page 631]]

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;
    (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

[[Page 632]]

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 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

[[Page 633]]

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 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

[[Page 634]]

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 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

[[Page 635]]

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 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,

[[Page 636]]

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 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

[[Page 637]]

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.
    (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.)

[[Page 638]]

    (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 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

[[Page 639]]

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.

    (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.

[[Page 640]]

    (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 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

[[Page 641]]

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 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.

[[Page 642]]

    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 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.

[[Page 643]]

    (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 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

[[Page 644]]

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 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

[[Page 645]]

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 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)

[[Page 646]]

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 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

[[Page 647]]

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) and Sec.  1.168(k)-1 or Sec.  1.168(k)-
2, as applicable, 50-percent bonus depreciation property under section 
168(k)(4) or Sec.  1.168(k)-1 or Sec.  , 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.
    (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:

[[Page 648]]

    (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 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

[[Page 649]]

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. 
The language ``or Sec.  1.168(k)-2, as applicable,'' in the third 
sentence in paragraph (b)(1) of this section applies to computer 
software that is qualified property under section 168(k)(2) and placed 
in service by a taxpayer during or after the taxpayer's taxable year 
that includes September 24, 2019. However, a taxpayer may choose to 
apply the language ``or Sec.  1.168(k)-2, as applicable,'' in the third 
sentence in paragraph (b)(1) of this section for computer software that 
is qualified property under section 168(k)(2) and acquired and placed in 
service after September 27, 2017, by the taxpayer during taxable years 
ending on or after September 28, 2017. A taxpayer may rely on the 
language ``or Sec.  1.168(k)-2, as applicable,'' in the third sentence 
in paragraph (b)(1) of this section in regulation project REG-104397-18 
(2018-41 I.R.B. 558) (see Sec.  601.601(d)(2)(ii)(b) of this chapter) 
for computer software that is qualified property under section 168(k)(2) 
and acquired and placed in service after September 27, 2017, by the 
taxpayer during taxable years ending on or after September 28, 2017, and 
ending before the taxpayer's taxable year that includes September 24, 
2019..

[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; T.D. 9874, 
84 FR 50125, Sept. 24, 2019]



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

[[Page 650]]

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.
    (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

[[Page 651]]

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


[[Page 652]]

    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 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.


[[Page 653]]


                                                       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
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

[[Page 654]]

 
1958.........................................................     1,500      \1/15\          100         1,500
                                                              --------------------------------------------------
 
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

[[Page 655]]

 
96.3........................................................      .0206
96.2........................................................      .0206
96.1........................................................      .0206
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

[[Page 656]]

 
82.7........................................................      .0239
82.6........................................................      .0239
82.5........................................................      .0240
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
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[[Page 657]]

 
69.1........................................................      .0285
69.0........................................................      .0286
68.9........................................................      .0286
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
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[[Page 658]]

 
55.5........................................................      .0354
55.4........................................................      .0355
55.3........................................................      .0355
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

[[Page 659]]

 
41.9........................................................      .0466
41.8........................................................      .0467
41.7........................................................      .0468
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

[[Page 660]]

 
28.3........................................................      .0682
28.2........................................................      .0685
28.1........................................................      .0687
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

[[Page 661]]

 
14.7........................................................      .1273
14.6........................................................      .1281
14.5........................................................      .1289
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

[[Page 662]]

 
1.1.........................................................      .9167
1.0.........................................................     1.0000
------------------------------------------------------------------------

    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 663]]


                                                             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 664]]

    (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 665]]

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 666]]

    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 667]]

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 668]]

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 669]]

    (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 670]]

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 671]]


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 672]]

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 673]]

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 674]]

``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 675]]

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 676]]

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 677]]

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 678]]

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 679]]

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 680]]

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 681]]

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 682]]



(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 683]]

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 684]]

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 685]]

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 686]]

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 687]]

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 688]]

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 689]]

 
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 690]]

    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 691]]

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 692]]

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 693]]

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 694]]

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, 
section 181, 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).
    (5) Qualified improvement property. (i) Is any improvement that is 
section 1250 property to an interior portion of a building, as defined 
in Sec.  1.48-1(e)(1), that is nonresidential real property, as defined 
in section 168(e)(2)(B), if the improvement is placed in service by the 
taxpayer after the date the building was first placed in service by any 
person and if--
    (A) For purposes of section 168(e)(6), the improvement is made by 
the taxpayer and is placed in service by the taxpayer after December 31, 
2017;
    (B) For purposes of section 168(k)(3) as in effect on the day before 
amendment by section 13204(a)(4)(B) of the Tax Cuts and Jobs Act, Public 
Law 115-97 (131 Stat. 2054 (December 22, 2017)) (``Act''), the 
improvement is acquired by the taxpayer before September 28, 2017, the 
improvement is placed in service by the taxpayer before January 1, 2018, 
and the improvement meets the original use requirement in section 
168(k)(2)(A)(ii) as in effect on the day before amendment by section 
13201(c)(1) of the Act; or
    (C) For purposes of section 168(k)(3) as in effect on the day before 
amendment by section 13204(a)(4)(B) of the Act, the improvement is 
acquired by the taxpayer after September 27, 2017; the improvement is 
placed in service by the taxpayer after September 27, 2017, and before 
January 1, 2018; and the improvement meets the requirements in section 
168(k)(2)(A)(ii) as amended by section 13201(c)(1) of the Act; and
    (ii) Does not include any qualified improvement for which an 
expenditure is attributable to--
    (A) The enlargement, as defined in Sec.  1.48-12(c)(10), of the 
building;
    (B) Any elevator or escalator, as defined in Sec.  1.48-1(m)(2); or
    (C) The internal structural framework, as defined in Sec.  1.48-
12(b)(3)(iii), of the building.
    (b) Applicability date--(1) In general. Except as provided in 
paragraph (b)(2) of this section, this section is applicable on or after 
February 27, 2004.
    (2) Application of paragraph (a)(5) of this section and addition of 
``section 181'' in paragraph (a)(3) of this section--(i) In general. 
Except as provided in paragraphs (b)(2)(ii) through (iv) of this 
section, paragraph (a)(5) of this section and the language ``section 
181,'' in the second sentence in paragraph (a)(3) of this section are 
applicable on or after September 24, 2019.
    (ii) Early application of paragraph (a)(5) of this section and 
addition of ``section 181'' in paragraph (a)(3) of this section. A 
taxpayer may choose to apply paragraph (a)(5) of this section and the 
language ``section 181,'' in the second sentence in paragraph (a)(3) of 
this section for the taxpayer's taxable years ending on or after 
September 28, 2017.
    (iii) Early application of regulation project REG-104397-18. A 
taxpayer may rely on the provisions of paragraph (a)(5) of this section 
in regulation project REG-104397-18 (2018-41 I.R.B 558) (see Sec.  
601.601(d)(2)(ii)(b) of this chapter) for the taxpayer's taxable years 
ending on or after September 28, 2017, and ending before the taxpayer's 
taxable year that includes September 24, 2019.
    (iv) Addition of language in paragraph (a)(5)(i)(A) of this section. 
The language

[[Page 695]]

``is made by the taxpayer and'' in paragraph (a)(5)(i)(A) of this 
section applies to property placed in service by the taxpayer after 
December 31, 2017.

[T.D. 9314, 72 FR 9248, Mar. 1, 2007, as amended by T.D. 9874, 84 FR 
50126, Sept. 24, 2019; T.D. 9916, 85 FR 71752, Nov. 10, 2020]



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 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

[[Page 696]]

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). Further, 
see Sec.  1.168(k)-2(g)(1) for rules relating to qualified property 
under section 168(k), as amended by the Tax Cuts and Jobs Act, Public 
Law 115-97 (131 Stat. 2054 (December 22, 2017)), 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 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

[[Page 697]]

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 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

[[Page 698]]

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 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

[[Page 699]]

each recovery year, or portion thereof, that falls within the 
transferee's taxable year. However, see Sec.  1.168(k)-2(g)(1)(iii) for 
a special rule regarding the allocation of the additional first year 
depreciation deduction in the case of certain contributions of property 
to a partnership under section 721.
    (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 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

[[Page 700]]

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. The last 
sentences in paragraphs (b)(3)(ii) and (b)(7)(ii) of this section apply 
to qualified property under section 168(k)(2) placed in service by a 
taxpayer during or after the taxpayer's taxable year that includes 
September 24, 2019. However, a taxpayer may choose to apply the last 
sentences in paragraphs (b)(3)(ii) and (b)(7)(ii) of this section to 
qualified property under section 168(k)(2) acquired and placed in 
service after September 27, 2017, by the taxpayer during taxable years 
ending on or after September 28, 2017. A taxpayer may rely on the last 
sentences in paragraphs (b)(3)(ii) and (b)(7)(ii) of this section in 
regulation project REG-104397-18 (2018-41 I.R.B. 558) (see Sec.  
601.601(d)(2)(ii)(b) of this chapter) for qualified property under 
section 168(k)(2) acquired and placed in service after September 27, 
2017, by the taxpayer during taxable years ending on or after September 
28, 2017, and ending before the taxpayer's taxable year that includes 
September 24, 2019.
    (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; T.D. 9874, 
84 FR 50127, Sept. 24, 2019]



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

[[Page 701]]

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--
    (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

[[Page 702]]

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.

    (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.

[[Page 703]]

    (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).
    (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

[[Page 704]]

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--
    (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

[[Page 705]]

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.
    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

[[Page 706]]

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 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

[[Page 707]]

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 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

[[Page 708]]

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 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) 
and the distinct asset determination under Sec.  1.1031(a)-3(a)(4) do 
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

[[Page 709]]

(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 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),

[[Page 710]]

(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 
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

[[Page 711]]

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 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

[[Page 712]]

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):

    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%).

[[Page 713]]

    (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).

    (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

[[Page 714]]

    (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--
    (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--

[[Page 715]]

    (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.
    (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

[[Page 716]]

(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 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

[[Page 717]]

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                =   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

[[Page 718]]

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.
    (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

[[Page 719]]

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), 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.

[[Page 720]]

    (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 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

[[Page 721]]

(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 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. Except as 
provided in paragraph (m)(5) of this section, 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) Application of paragraph (e)(2)(viii)(A). The language ``and the 
distinct asset determination under Sec.  1.1031(a)-3(a)(4) do not 
apply.'' in the last sentence of paragraph (e)(2)(viii)(A) of this 
section applies on or after December 2, 2020. Paragraph (e)(2)(viii)(A) 
of this section as contained in 26 CFR part 1 edition revised as of 
April 1, 2020, applies before December 2, 2020.
    (6) 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; T.D. 9935, 85 FR 
77378, Dec. 2, 2020]



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)-

[[Page 722]]

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 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

[[Page 723]]

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.
    (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

[[Page 724]]

    (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.
    (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)-1(f)(6)(iii) or 1.168(k)-2(g)(6)(iii), as 
applicable, and 1.1400L(b)-1(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

[[Page 725]]

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)-
1(f)(6)(ii)or 1.168(k)-2(g)(6)(ii), as applicable, and 1.1400L(b)-
1(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 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

[[Page 726]]

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 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)-1(f)(6)(iv) or 1.168(k)-
2(g)(6)(iv), as applicable, and 1.1400L(b)-1(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)-1(f)(6)(iv) or 1.168(k)-2(g)(6)(iv), as applicable, 
and 1.1400L(b)-1(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

[[Page 727]]

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 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

[[Page 728]]

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 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

[[Page 729]]

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 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

[[Page 730]]

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, 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

[[Page 731]]

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)).
    (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. Except as provided in paragraph 
(g)(2) of this section, 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

[[Page 732]]

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) Qualified property under section 168(k) acquired and placed in 
service after September 27, 2017--(i) In general. The language ``or 
Sec.  1.168(k)-2(g)(6)(iii), as applicable'' in paragraph (b)(1) of this 
section, the language ``or Sec.  1.168(k)-2(g)(6)(ii), as applicable'' 
in paragraph (c) of this section, and the language ``or Sec.  1.168(k)-
2(g)(6)(iv), as applicable'' in paragraphs (d)(3)(i)(C) and (d)(4)(i) of 
this section applies to any change in use of MACRS property, which is 
qualified property under section 168(k)(2), by a taxpayer during or 
after the taxpayer's taxable year that includes September 24, 2019.
    (ii) Early application. A taxpayer may choose to apply the language 
``or Sec.  1.168(k)-2(g)(6)(iii), as applicable'' in paragraph (b)(1) of 
this section, the language ``or Sec.  1.168(k)-2(g)(6)(ii), as 
applicable'' in paragraph (c) of this section, and the language ``or 
Sec.  1.168(k)-2(g)(6)(iv), as applicable'' in paragraphs (d)(3)(i)(C) 
and (d)(4)(i) of this section for any change in use of MACRS property, 
which is qualified property under section 168(k)(2) and acquired and 
placed in service after September 27, 2017, by the taxpayer during 
taxable years ending on or after September 28, 2017.
    (iii) Early application of regulation project REG-104397-18. A 
taxpayer may rely on the language ``or Sec.  1.168(k)-2(f)(6)(iii), as 
applicable'' in paragraph (b)(1) of this section, the language ``or 
Sec.  1.168(k)-2(f)(6)(ii), as applicable'' in paragraph (c) of this 
section, and the language ``or Sec.  1.168(k)-2(f)(6)(iv), as 
applicable'' in paragraphs (d)(3)(i)(C) and (d)(4)(i) of this section in 
regulation project REG-104397-18 (2018-41 I.R.B. 558) (see Sec.  
601.601(d)(2)(ii)(b) of this chapter) for any change in use of MACRS 
property, which is qualified property under section 168(k)(2) and 
acquired and placed in service after September 27, 2017, by the taxpayer 
during taxable years ending on or after September 28, 2017, and ending 
before the taxpayer's taxable year that includes September 24, 2019.
    (3) 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 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

[[Page 733]]

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; T.D. 9874, 84 FR 50127, Sept. 24, 2019]



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.
    (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.

[[Page 734]]

    (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 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

[[Page 735]]

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 
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

[[Page 736]]

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 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

[[Page 737]]

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 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

[[Page 738]]

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 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

[[Page 739]]

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 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

[[Page 740]]

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 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

[[Page 741]]

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 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

[[Page 742]]

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 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

[[Page 743]]

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, 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), Sec.  1.168(k)-2(g)(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), Sec.  1.168(k)-2(g)(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

[[Page 744]]

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), Sec.  1.168(k)-2(g)(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 $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

[[Page 745]]

$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 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

[[Page 746]]

depreciation property and Sec.  1.1400L(b)-1(f)(5) for replacement MACRS 
property that is qualified New York Liberty Zone property. Further, see 
Sec.  1.168(k)-2(g)(5)(iv) for replacement MACRS property that is 
qualified property under section 168(k), as amended by the Tax Cuts and 
Jobs Act, Public Law 115-97 (131 Stat. 2054 (December 22, 2017)).
    (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 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

[[Page 747]]

- 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 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

[[Page 748]]

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)).

    (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

[[Page 749]]

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). Further, see Sec.  1.168(k)-2(g)(5) for 
qualified property under section 168(k), as amended by the Tax Cuts and 
Jobs Act, Public Law 115-97 (131 Stat. 2054 (December 22, 2017)).
    (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 
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

[[Page 750]]

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 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 paragraphs 
(k)(3) and (4) 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--

[[Page 751]]

    (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 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).
    (4) Qualified property under section 168(k) acquired and placed in 
service after September 27, 2017--(i) In general. The language 
``1.168(k)-2(g)(5),'' in paragraphs (d)(3)(ii)(B) and (E) of this 
section and the final sentence in paragraphs (d)(4) and (h) of this 
section

[[Page 752]]

apply to a like-kind exchange or an involuntary conversion of MACRS 
property, which is qualified property under section 168(k)(2), for which 
the time of replacement occurs on or after September 24, 2019.
    (ii) Early application. A taxpayer may choose to apply the language 
``1.168(k)-2(g)(5),'' in paragraphs (d)(3)(ii)(B) and (E) of this 
section and the final sentence in paragraphs (d)(4) and (h) of this 
section to a like-kind exchange or an involuntary conversion of MACRS 
property, which is qualified property under section 168(k)(2), for which 
the time of replacement occurs on or after September 28, 2017.
    (iii) Early application of regulation project REG-104397-18. A 
taxpayer may rely on the language ``1.168(k)-2(f)(5),'' in paragraphs 
(d)(3)(ii)(B) and (E) of this section and the final sentence in 
paragraphs (d)(4) and (h) of this section in regulation project REG-
104397-18 (2018-41 I.R.B. 558) (see Sec.  601.601(d)(2)(ii)(b) of this 
chapter) for a like-kind exchange or an involuntary conversion of MACRS 
property, which is qualified property under section 168(k)(2), for which 
the time of replacement occurs on or after September 28, 2017, and 
occurs before September 24, 2019.

[T.D. 9314, 72 FR 9251, Mar. 1, 2007, as amended by T.D. 9874, 84 FR 
50127, Sept. 24, 2019]



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

[[Page 753]]

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 (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

[[Page 754]]

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).
    (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

[[Page 755]]

    (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 
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) and the distinct asset determination under Sec.  1.1031(a)-
3(a)(4) do 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

[[Page 756]]

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 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

[[Page 757]]

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 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

[[Page 758]]

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 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

[[Page 759]]

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.
    (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

[[Page 760]]

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 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

[[Page 761]]

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 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

[[Page 762]]

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 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

[[Page 763]]

$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 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. Except as 
provided in paragraph (j)(5) of this section, 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) Application of paragraph (c)(4)(i). The language ``and the 
distinct asset determination under Sec.  1.1031(a)-3(a)(4) do not 
apply.'' in the last sentence of paragraph (c)(4)(i) of this section 
applies on or after December 2, 2020. Paragraph (c)(4)(i) of this 
section as contained in 26 CFR part 1 edition revised as of April 1, 
2020, applies before December 2, 2020.
    (6) 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

[[Page 764]]

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; T.D. 9935, 85 FR 77378, Dec. 2, 2020]



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:

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


[[Page 765]]

    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).

    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.

[[Page 766]]

          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:
[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

[[Page 767]]

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 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.

[[Page 768]]

    (iii) Once the discrete portions of the building that constitute 
tax-exempt use property have been identified, an appropriate allocation 
of basis must be made to such discrete portions. See A-4 for rules 
regarding how to make such allocation.
    (iv) The application of these rules is illustrated by the following 
example:

    Example. A building, constructed in 1985, is leased in its entirety 
to a tax-exempt entity (E) pursuant to a 25-year lease. The building has 
25,000 square feet of net rentable floor space and consists of an 
auditorium (15,000 square feet), a retail shop (10,000 square feet), 
plus common area of 5,000 square feet. E uses the auditorium 80 percent 
of the time in its exempt activity and 20 percent of the time in an 
unrelated trade or business subject to tax under section 511. The retail 
shop is used 90 percent of the time in an unrelated trade or business 
subject to tax under section 511 and 10 percent of the time in an exempt 
activity. Thus, the auditorium is tax-exempt use property; the retail 
shop is not. An appropriate allocation of basis to the auditorium must 
be made. See A-4.

                     Definition of Tax-Exempt Entity

    Q-10. What elections must be made in order to avoid the ``5-year 
lookback'' rule of section 168(j)(4)(E)(i)?
    A-10. Only organizations which were exempt from tax under section 
501(a) as organizations described in section 501(c)(12) (and which are 
no longer tax-exempt) may avoid the 5-year lookback rule of section 
168(j)(4)(E)(i). In order to avoid the 5-year lookback rule with respect 
to any property, two elections are required. First, the organization 
must elect not to be exempt from tax under section 501(a) during the 
tax-exempt use period (as defined in section 168(j)(4)(E)(ii)(II)) with 
respect to the property. Second, the organization must elect to be taxed 
on the exempt arbitrage profits as provided in section 31(g)(16) of the 
Tax Reform Act of 1984. See Temp. Treas. Reg. 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.

[[Page 769]]

    Q-14. What is ``peripheral equipment'' as that term is used in 
section 168(j)(5)(C)(i)(I)?
    A-14. Peripheral equipment means tangible personal property such as 
auxiliary machines, whether on-line or off-line, that are designed to be 
placed under the control of the central processing unit of the computer. 
Some examples of peripheral equipment are: card readers, card punches, 
magnetic tape feeds, high speed printers, optical character readers, 
tape cassettes, mass storage units, paper tape equipment, keypunches, 
data entry devices, teleprinters, terminals, tape drives, disc drives, 
disc files, disc packs, visual image projector tubes, card sorters, 
plotters, and collators. Peripheral equipment does not include equipment 
not included in Asset Depreciation Range (ADR) 00.12 listed in section 3 
of Rev. Proc. 83-35, 1983-1 C.B. 745, 746. Peripheral equipment also 
does not include any equipment that is an integral part of property that 
is not a user-programmable device, any video games or other devices used 
by the user primarily for amusement or entertainment purposes, or any 
typewriters, calculators, adding or accounting machines, copiers, 
duplicating equipment, or similar equipment.
    Q-15. What does ``high technology telephone station equipment'' mean 
as that term is used in section 168(j)(5)(C)(i)(II)?
    A-15. High technology telephone station equipment includes only 
tangible personal property described in asset depreciation range (ADR) 
class 48.13 listed in section 3 of Rev. Proc. 83-35, 1983-1 C.B. 745, 
758 that has a high technology content and which, because of such high 
technology content, can reasonably be expected to become obsolete before 
the expiration of its physical useful life. For example, telephone 
booths and telephones which include only a standard dialing feature are 
not high technology equipment. However, telephones with features such as 
an abbreviated dialing short program, an automatic callback, or 
conference call feature may qualify as high technology equipment. High 
technology telephone station equipment may include terminal equipment 
including such extra features but not terminal equipment used in 
conjunction with features offered through central office capacity. There 
are no current plans to utilize the regulatory authority provided in 
section 168(j)(5)(C)(iv).
    Q-16. What is ``high technology medical equipment'' as that term is 
used in section 168 (j)(5)(C)(i)(III)?
    A-16. High technology medical equipment is any electronic, 
electromechanical, or computer-based high technology equipment which is 
tangible personal property used in the screening, monitoring, 
observation, diagnosis, or treatment of human patients in a laboratory, 
medical, or hospital environment. High technology medical equipment 
includes only equipment that has a high technology content and which, 
because of such high technology content, can reasonably be expected to 
become obsolete before the expiration of its physical useful life. High 
technology medical equipment may include computer axial tomography 
(C.A.T.) scanners, nuclear magnetic resonance equipment, clinical 
chemistry analyzers, drug monitors, diagnostic ultrasound scanners, 
nuclear cameras, radiographic and fluoroscopic systems, Holter monitors, 
and bedside monitors. Incidental use of any such equipment for othe 
purposes, such as research, will not prevent it from qualifying as high 
technology medical equipment. There are no current plans to utilize the 
regulatory authority provided in section 168(j)(5)(C)(iv).

                               Lease Term

    Q-17. What is included in determining the length of a lease term?
    A-17. (i) The lease term starts when the property is first made 
available to the lessee under the lease. The lease term includes not 
only the stated duration, but also any additional period of time which 
is within the ``realistic contemplation of the parties at the time the 
property is first put into service. Hokanson v. Commissioner, 730 F.2d 
1245, 1248 (9th Cir. 1984). A subsequent period of time is included in 
the term of the original lease if the circumstances indicate that the 
parties, upon entering into the original lease, had informally agreed 
that there would be an extension of the original lease.

[[Page 770]]

    (ii) With respect to personal property, the lease term includes all 
periods for which the tax-exempt lessee or a related party (as defined 
under section 168(j)(7)) has a legally enforceable option to renew the 
lease, or the lessor has a legally enforceable option to compel its 
renewal by the tax-exempt entity or a related party. This is true 
regardless of the renewal terms of the lease agreement or whether the 
lease is in fact renewed.
    (iii) With respect to real property, the lease term includes all 
periods for which the tax-exempt lessee or a related party (as defined 
under section 168(j)(7)) has a legally enforceable option to renew the 
lease, or the lessor has a legally enforceable option to compel its 
renewal by the tax-exempt entity or a related party, unless the option 
to renew is at fair market value, determined at the time of renewal. The 
Hokanson facts and circumstances test (see (i) above) may cause the term 
of a fair market value renewal option to be treated as part of the 
original lease term.
    (iv) Successive leases that are part of the same transaction or a 
series of related transactions concerning the same or substantially 
similar property shall be treated as one lease. This rule applies if at 
substantially the same time or as part of one arrangement the parties 
enter into multiple leases covering the same or substantially similar 
property, each having a different term. If so, then the original lease 
term will be treated as running through the term of the lease that has 
the last expiration date of the multiple leases. The multiple lease rule 
will not apply merely because the parties enter into a new lease at fair 
market rental value at the end of the original lease term.
    (v) The application of the above rules is illustrated by the 
following examples:

    Example 1. On December 30, 1984, X, a taxable corporation, and Y, a 
tax-exempt entity, enter into a requirements contract for a period of 3 
years. The requirements contract sets the terms and conditions under 
which X and Y will do business on those occasions when X actually leases 
items of personal property to Y. The requirements contract imposes no 
obligation on either party to actually enter into a lease agreement. 
Pursuant to this requirements contract, on January 1, 1985, X and Y 
enter into three separate leases. Under the leases, Y obtained the use 
of three identical items of personal property, each for a term of six 
months beginning on January 1, 1985. On March 1, 1985, Y entered into a 
fourth lease for the use of a fourth item of personal property 
substantially similar to the other three items for a term of 20 months 
beginning on that date. The mere fact that all 4 leases were entered 
into pursuant to the same requirements contract and involved the same or 
substantially similar property does not require aggregation of the terms 
of such leases under section 168(j)(6)(B).
    Example 2. Assume the same facts as in example (1) except that, 
instead of the 4 leases entered into in example (1), on January 1, 1985, 
pursuant to the requirements contract, X and Y enter into a lease for an 
item of personal property for one year. On January 10, 1986, after the 
end of the one-year lease term, X and Y enter into a second lease with 
respect to the same or substantially similar equipment. Assuming that 
the requirements contract itself is not a lease and assuming that the 
parties did not have any informal or implicit understanding (other than 
the general expectation of doing some business in the future) to enter 
into the second lease when the first lease was entered into, these two 
leases are not aggregated. The mere fact that the parties entered into 
two leases under the requirements contract does not result in the 
application of the section 168(j)(6)(B) rules for successive leases.
    Example 3. The facts are the same as in example (2) except that the 
parties did have an understanding, informal or otherwise, at the time of 
the first lease that they would enter into a second lease of the same 
personal property. The terms of the leases are aggregated.
    Example 4. The facts are the same as in example (2) except that, 
instead of the leases entered into in example (2), on January 1, 1985, X 
and Y enter into two separate leases, each for a term of one year. One 
lease is for the period beginning on January 1, 1985 and ending on 
December 31, 1985. The other lease is for the period beginning on 
January 1, 1986 and ending on December 31, 1986. Both leases involve the 
same or substantially similar personal property. Under the successive 
lease rule, the terms of both leases are aggregated for purposes of 
determining the term of either lease under section 168(j)(6)(B). This 
result occurs because the two leases were entered into as part of the 
same transaction, and they relate to the same or substantially similar 
personal property.

                         Service Contract Issues

    Q-18. How is the treatment of service contracts affected by the 
service contract rules set forth in section 7701(e)?

[[Page 771]]

    A-18. If a contract which purports to be a service contract is 
treated as a lease under section 7701(e), such contract is to be treated 
as a lease for all purposes of Chapter 1 of the Internal Revenue Code 
(including, for example, section 168(j) and section 48(a) (4) and (5)).
    Q-19. Does a contract to provide heating, maintenance, etc. services 
in low-income housing come within the low-income housing exception in 
section 7701(e)(5) to the service contract rules set forth in section 
7701(e)?
    A-19. No. Although certain low-income housing operated by or for an 
organization described in paragraphs (3) or (4) of section 501(c) is not 
subject to the service contract rules in section 7701(e), a contract, 
for instance, to provide heating services to low-income housing units, 
such as by installing and operating a furnace, does not constitute 
``low-income housing'' within the meaning of section 7701(e)(5). Thus, 
the rules of section 7701(e) apply to such contracts in determining 
whether they are properly treated as leases.

                           Partnership Issues

    Q-20. Do the provisions applicable to property leased to 
partnerships, set forth in section 168(j)(8), and the provisions 
applicable to property owned by partnerships, set forth in section 
168(j)(9), apply to pass-through entities other than partnerships?
    A-20. Yes. Rules similar to those provided in paragraphs (8), 
(9)(A), (9)(B), and (9)(C) of section 168(j) and those provided in Q & 
A's 21-26 apply to pass-through entities other than partnerships.
    Q-21. What rules apply to property owned by a partnership in which 
one or more partners is a tax-exempt entity?
    A-21. If property is owned by a partnership having both taxable and 
tax-exempt entities as partners, and any allocation to a tax-exempt 
entity partner is not a ``qualified allocation'' under section 
168(j)(9)(B), then such entity's proportionate share of the property is 
to be treated as tax-exempt use property for all purposes. However, the 
property will not be tax-exempt use property if it is predominantly used 
by the partnership in an activity which, with respect to the tax-exempt 
entity, is an unrelated trade or business. An activity is an unrelated 
trade or business with respect to a tax-exempt entity if such entity's 
distributive share of the partnership's gross income from the activity 
is includible in computing its unrelated business taxable income under 
section 512(c) (determined without regard to the debt-financed income 
rules of section 514). A tax-exempt entity partner's proportionate share 
of property of a partnership equals such partner's share of that item of 
the partnership's income or gain (excluding income or gain allocated 
under section 704(c)) in which the tax-exempt entity has the highest 
share. If the tax-exempt entity partner's share of any item of income or 
gain (excluding income or gain allocated under section 704(c)) may vary 
during the period it is a partner, the previous sentence shall be 
applied with reference to the highest share of any such item that it may 
receive at any time during such period. The application of these rules 
is illustrated by the following example:

    Example. A partnership (P) operates a factory, which consists of a 
building and various items of machinery. P has one tax-exempt entity (E) 
as a partner, and E's proportionate share is 10 percent (i.e., 10 
percent is the largest share of any item of income or gain that E may 
receive during the time E is a partner). Unless P's allocations to E are 
qualified under section 168(j)(9)(B), 10 percent of each item of 
partnership property (including the building) is tax-exempt use 
property, notwithstanding the 35 percent threshold test of section 
168(j)(3)(B)(iii) that is otherwise applicable to 18-year real property. 
However, the property will not be tax-exempt use property if it is 
predominantly used by the partnership in an activity which, with respect 
to E, is an unrelated trade or business (determined without regard to 
the debt-financed income rules of section 514).

    Q-22. What consititutes a ``qualified allocation'' under section 
168(j)(9)(B)?
    A-22. (i) A ``qualified allocation'' means any allocation to a tax-
exempt entity which is consistent with such entity's being allocated the 
same share (i.e., the identical percentage) of each and every item of 
partnership income, gain, loss, deduction, credit, and basis during the 
entire period such entity is a partner. Except as provided in A-23, an 
allocation is not qualified if it does not have substantial economic 
effect

[[Page 772]]

under section 704(b). However, for purposes of the two preceding 
sentences, items allocated under section 704(c) (relating to contributed 
property) are not taken into account. An allocation is not a ``qualified 
allocation'' under section 168(j)(9)(B) if the partnership agreement 
provides for, or the partners have otherwise formally or informally 
agreed to, any change (regardless of whether such change is contingent 
upon the happening of one or more events) in the tax-exempt entity's 
distributive share of income, gain, loss, deduction, credit, or basis at 
any time during the entire period the tax-exempt entity is a partner.
    (ii) A change in a tax-exempt entity's distributive share of income, 
gain, loss, deduction, credit, or basis which occurs as a result of a 
sale or redemption of a partnership interest (or portion thereof) or a 
contribution of cash or property to the partnership shall be disregarded 
in determining whether the partnership allocations are qualified, 
provided that such transaction is based on fair market value at the time 
of the transaction and that the allocations are qualified after the 
change. For this purpose, the consideration determined by the parties 
dealing at arm's length and with adverse interests normally will be 
deemed to satisfy the fair market value requirement. In addition, a 
change in a tax-exempt entity's distributive share which occurs as a 
result of a partner's default (other than a prearranged default) under 
the terms of the partnership agreement will be disregarded, provided 
that the allocations are qualified after the change, and that the change 
does not have the effect of avoiding the restrictions of section 
168(j)(9). Any of the above-described transactions between existing 
partners (and parties related to them) will be closely scrutinized.

    Example 1. A, a taxable entity, and B, a tax-exempt entity, form a 
partnership in 1985. A contributes $800,000 to the partnership; B 
contributes $200,000. The partnership agreement allocates 95 percent of 
each item of income, gain, loss, deduction, credit, and basis to A; B's 
share of each of these items is 5 percent. Liquidation proceeds are, 
throughout the term of the partnership, to be distributed in accordance 
with the partner's capital account balances, and any partner with a 
deficit in his capital account following the distribution of liquidation 
proceeds is required to restore the amount of such deficit to the 
partnership. Assuming that these allocations have substantial economic 
effect within the meaning of section 704(b)(2), they are qualified 
because B's distributive share of each item of income, gain, loss, 
deduction, credit, and basis will remain the same during the entire 
period that B is a partner. The fact that the liquidation proceeds may 
be distributed in a ratio other than 95 percent/5 percent does not cause 
the allocations not to be qualified.
    Example 2. A, B, and E are members of a partnership formed on July 
1, 1984. On that date the partnership places in service a building and 
section 1245 class property. A and B are taxable entities; E is a tax-
exempt entity. The partnership agreement provides that during the first 
5 years of the partnership, A and B are each allocated 40 percent of 
each item of income, gain, loss, deduction, credit, and basis; E is 
allocated 20 percent. Thereafter, A, B, and E are each allocated 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

[[Page 773]]

loss attributable to nonrecourse debt, and allocations of percentage 
depletion in excess of basis). Since allocations in either of these 
categories cannot be tested under the substantial economic effect test, 
these allocations, in order to be qualified, must comply with the 
relevant Code or regulation section that governs the particular 
allocation (e.g., in the case of an allocation of basis of an oil and 
gas property, section 613A(c)(7)(D)).
    Q-24. Will the Internal Revenue Service issue letter rulings on the 
issue of whether an allocation is a ``qualified allocation'' for 
purposes of section 168(j)(9)?
    A-24. The Internal Revenue Service will accept requests for rulings 
on the question of whether an allocation is a ``qualified allocation'' 
for purposes of section 168(j)(9). Such requests should be submitted in 
accordance with the appropriate revenue procedure. One requirement of a 
qualified allocation is that such allocation must have substantial 
economic effect under section 704(b)(2). Currently, the Service will not 
rule on the question of whether an allocation has substantial economic 
effect under section 704(b)(2). Therefore, unless and until this policy 
is changed, a ruling request regarding a qualified allocation must 
contain a representation that the subject allocation has substantial 
economic effect (or complies with A-23, if applicable).
    Q-25. Do priority cash distributions which constitute guaranteed 
payments under section 707(c) disqualify an otherwise qualified 
allocation?
    A-25. Priority cash distributions to partners which constitute 
guaranteed payments will not disqualify an otherwise qualified 
allocation if the priority cash distributions are reasonable in amount 
(e.g., equal to the Federal short-term rate described in section 
1274(d)) and are made in equal priorities to all partners in proportion 
to their capital in the partnership. Other guaranteed payments will be 
closely scrutinized and, in appropriate cases, will disqualify an 
otherwise qualified allocation.

    Example. A and B form Partnership AB to operate a manufacturing 
business. A is a tax-exempt entity; B is a taxable person. A contributes 
$500,000 to the partnership; B contributes $100,000. The partnership 
agreement provides that A and B are each entitled to cash distributions 
each year, in equal priority, in an amount equal to 8 percent of their 
capital contribution. Assume that these payments are reasonable in 
amount and constitute guaranteed payments under section 707(c). Without 
taking into consideration the guaranteed payments, all allocations 
constitute qualified allocations under section 168(j)(9)(B) and A-22. 
These guaranteed payments will not disqualify such allocations.

    Q-26. Can property be treated as tax-exempt use property under both 
the general rule of section 168(j)(3) and the partnership provisions of 
section 168(j)(9)?
    A-26. Yes. For example, a tax-exempt entity may be a partner in a 
partnership that owns a building 60 percent of which is tax-exempt use 
property because it is leased to an unrelated tax-exempt entity under a 
25-year lease. The status of the remaining 40 percent depends on whether 
or not allocations under the partnership agreement are qualified under 
section 168(j)(9). If the allocations are not qualified under section 
168(j)(9), the tax-exempt entity's proportionate share (as determined 
under section 168(j)(9)(C)) of the remaining 40 percent will be tax-
exempt use property. For example, if the tax-exempt entity's 
proportionate share is 30 percent, then 12 percent of the remaining 40 
percent (i.e., .30 times .40) is tax-exempt use property and a total of 
72 percent of the property (60 percent + 12 percent) is tax-exempt use 
property.

                        Effective Date Questions

    Q-27. Does an amendment to a lease (or sublease) to a tax-exempt 
entity of property which, pursuant to the effective date provisions of 
section 31(g) of TRA, is not subject to section 168(j) cause such 
property to be subject to the provisions of section 168(j)?
    A-27. An amendment to such a lease (or sublease) does not cause such 
property to be subject to the provisions of section 168(j) unless the 
amendment increases the term of the lease (or sublease). However, if the 
amendment increases the amount of property subject to the lease, the 
additional property must be tested independently under the effective 
date provisions of section

[[Page 774]]

31(g) of TRA. See A-31 for special rules regarding improvements to 
property.

    Example. On May 1, 1983, X, a taxable entity, and E, a tax-exempt 
entity, enter into a lease whereby X will lease to E the top 4 floors of 
a ten-story building for a lease term of 25 years. In 1985, the lease is 
amended to provide that E will lease an additional floor for the balance 
of the lease term. At that time the annual rent due under the lease is 
increased. Pursuant to the provisions of section 31(g)(2)(A) of TRA, 
section 168(j) does not apply to the lease to E of the top 4 floors of 
the building. Assuming that no other provision of section 31(g) of TRA 
provides otherwise, the floor added to the lease in 1985 is subject to 
the provisions of section 168(j).

    Q-28. If property which is not subject to section 168(j) by virtue 
of the effective date provisions of section 31(g) of TRA is sold, 
subject to the lease to the tax-exempt entity, what are the 
consequences?
    A-28. Property to which section 168(j) does not apply by virtue of 
the effective date provisions set forth in section 31(g) (2), (3), and 
(4) of TRA will not become subject to section 168(j) merely by reason of 
a transfer of the property subject to the lease by the lessor (or a 
transfer of the contract to acquire, construct, reconstruct, or 
rehabilitate the property), so long as the lessee (or party obligated to 
lease) does not change. For purposes of the preceding sentence, the term 
``transfer'' includes the sale-leaseback by a taxable lessor of its 
interest in the property, subject to the underlying lease to the tax-
exempt entity. However, if property is transferred to a partnership or 
other pass-through entity after the effective date of section 168(j)(9) 
(see section 31(g) of TRA), such property is subject to the provisions 
of section 168(j)(9).
    Q-29. Can property which was leased to a tax-exempt entity after May 
23, 1983 and acquired by a partnership before October 22, 1983 be tax-
exempt use property?
    A-29. Yes. Because the property was leased to a tax-exempt entity 
after May 23, 1983, it may be tax-exempt use property under section 
168(j)(3) and section 31(g)(1) of TRA. However, if the partnership 
included a tax-exempt entity as a partner, section 168(j)(9) would be 
inapplicable under section 31(g)(3)(B) of TRA because the partnership 
acquired the property before October 22, 1983.
    Q-30. What is a binding contract for purposes of the transitional 
rules in section 31(g) of TRA?
    A-30. (i) A contract is binding only if it is enforceable under 
State law against the taxpayer or a predecessor and does not limit 
damages to a specified amount, as for example, by a liquidated damages 
provision. A contract that limits damages to an amount equal to at least 
5 percent of the total contract price will not be treated as limiting 
damages for this purpose. In determining whether a contract limits 
damages, the fact that there may be little or no damages because the 
contract price does not significantly differ from fair market value will 
not be taken into account. For example, if a taxpayer entered into an 
irrevocable contract to purchase an asset for $100 and the contract 
contained no provision for liquidated damages, the contract is 
considered binding notwithstanding the fact that the property had a fair 
market value of $99 and under local law the seller would only recover 
the difference in the event the purchaser failed to perform. If the 
contract provided for a refund of the purchase price in lieu of any 
damages allowable by law in the event of breach or cancellation, the 
contract is not considered binding.
    (ii) A contract is binding even if subject to a condition, so long 
as the condition is not within the control of either party or a 
predecessor in interest. A contract will not be treated as ceasing to be 
binding merely because the parties make insubstantial changes in its 
terms or because any term is to be determined by a standard beyond the 
control of either party. A contract which imposes significant 
obligations on the taxpayer (or a predecessor) will be treated as 
binding notwithstanding the fact that insubstantial terms remain to be 
negotiated by the parties to the contract.
    (iii) A binding contract to acquire a component part of a larger 
piece of property will not be treated as a binding contract to acquire 
the larger piece of property. For example, if a tax-exempt entity 
entered into a binding contract on May 1, 1983 to acquire a new

[[Page 775]]

aircraft engine, there would be a binding contract to acquire only the 
engine, not the entire aircraft.
    Q-31. If an improvement is made to a property that is 
``grandfathered'' (i.e., property that is not subject to section 168(j) 
because of the effective date provisions of section 31(g) of TRA), to 
what extent will such improvement be grandfathered?
    A-31. Section 31(g)(20)(B) provides that a ``substantial 
improvement'' to property is treated as a separate property for purposes 
of the effective date provisions of section 31(g) of TRA. As a result, a 
``substantial improvement'' will not be grandfathered unless such 
``substantial improvement'' is grandfathered under a provision other 
than section 31(g)(20)(B). A property that is grandfathered will not 
become subject to section 168(j) merely because an improvement is made 
to such property, regardless of whether the improvement is a 
``substantial improvement''. If an improvement other than a 
``substantial improvement'' is made to property (other than land) that 
is grandfathered, that improvement also will be grandfathered. The 
determination of whether new construction constitutes an improvement to 
property or the creation of a new separate property will be based on all 
facts and circumstances. Furthermore, any improvement to land will be 
treated as a separate property.

    Example. On January 3, 1983, T, a taxable entity, entered into a 
lease of a parking lot to E, a tax-exempt entity. On January 1, 1985, T 
begins construction of a building for use by E on the site of the 
parking lot. The building is completed and placed in service in November 
1985. The building is treated as a separate property, and is thus 
subject to the provisions of section 168(j), unless the building is 
grandfathered under a provision other than section 31(g)(20)(B) of TRA.

    Q-32. What is ``significant official governmental action'' for 
purposes of the section 31(g)(4) transitional rule of TRA?
    A-32. (i) ``Significant official governmental action'' involves 
three separate requirements. First, the action must be an official 
action. Second, the action must be specific action with respect to a 
particular project. Third, the action must be taken by a governmental 
entity having authority to commit the tax-exempt entity to the project, 
to provide funds for it, or to approve the project under State or local 
law.
    (ii) The first requirement of official action means that the 
governing body must adopt a resolution or ordinance, or take similar 
official action, on or before November 1, 1983. The action qualifies 
only if it conforms with Federal, State, and local law (as applicable) 
and is a proper exercise of the powers of the governing body. Moreover, 
the action must not have been withdrawn. There must be satisfactory 
written evidence of the action that was in existence on or before 
November 1, 1983. Satisfactory written evidence includes a formal 
resolution or ordinance, minutes of meetings, and binding contracts with 
third parties pursuant to which third parties are to render services in 
furtherance of the project.
    (iii) The second requirement of specific action is directed at the 
substance of the action taken. The action must be a specific action with 
respect to a particular project in which the governing body indicates an 
intent to have the project (or the design work for it) proceed. This 
requires that a specific project have been formulated and that the 
significant official action be a step toward consummation of the 
project. If the action does not relate to a specific project or merely 
directs that a proposal or recommendation be formulated, it will not 
qualify. The following set of actions with respect to a particular 
project constitute specific action: the hiring of bond counsel or bond 
underwriters necessary to assist in the issuance and sale of bonds to 
finance a particular project or the adoption of an inducement resolution 
relating to bonds to be issued for such a project; applying for an Urban 
Development Action Grant on behalf of the project described in the 
application, receiving such a grant concerning the project, or the 
recommendation of a city planning authority to proceed with a project; 
the enactment of a State law authorizing the sale, lease, or 
construction of the property; the appropriation of funds for the 
property or authorization of a feasibility study or a development 
services contract with respect to it; the approval of financing 
arrangements by a regulatory agency; the enactment of

[[Page 776]]

a State law designed to provide funding for a project; the certification 
of a building as a historic structure by a State agency and the 
Department of the Interior; or the endorsement of the application for a 
certification of need with respect to a medical facility by a regulatory 
agency other than the agency empowered to issue such a certificate.
    (iv) The third requirement for significant official governmental 
action is that the action must be taken by a Federal, State, or local 
governing body having authority to commit the tax-exempt entity to the 
project, to provide funds for it, or to approve the project under 
applicable law.

If the chief executive or another representative of a governing body has 
such authority, action by such representative would satisfy the 
requirement of this (iv). A governing body may have the authority to 
commit the tax-exempt entity to a project notwithstanding the fact that 
the project cannot be consummated without other governmental action 
being taken. For example, a city council will be treated as having 
authority to commit a city to do a sale-leaseback of its city hall 
notwithstanding the fact that State law needs to be amended to permit 
such a transaction. Similarly, if a local project cannot be completed 
without Federal approval, either legislative or administrative, the 
obtaining of such approval satisfies the requirements of this (iv).
    (v) Routine governmental action at a local level will not qualify as 
significant official governmental action. Routine governmental action 
includes the granting of building permits or zoning changes and the 
issuance of environmental impact statements.
    (vi) In order to qualify under the transitional rule of TRA section 
31(g)(4), a sale and leaseback pursuant to a binding contract entered 
into before January 1, 1985 must be part of the project as to which 
there was significant official governmental action. Except as provided 
in the following sentence, where there has been significant official 
governmental action on or before November 1, 1983 with respect to the 
construction, reconstruction or rehabilitation of a property, the sale 
and leaseback of such property pursuant to a binding contract entered 
into before January 1, 1985 will be treated as part of the project which 
was the subject of the significant official governmental action. 
However, if the construction, reconstruction or rehabilitation was 
substantially completed prior to January 1, 1983, the sale and leaseback 
of such property will be treated as a separate project, unless the sale 
and leaseback was contemplated at the time of the significant official 
governmental action. Nevertheless, where the sale and leaseback is 
treated as a separate project, section 31(g)(4) may apply if there was 
significant official governmental action on or before November 1, 1983, 
with respect to such sale and leaseback. The application of this 
provision is illustrated by the following example:

    Example. In the summer of 1927, the Board of Aldermen of City C 
passed a resolution authorizing the design and contruction of a new city 
hall and appropriated the funds necessary for such project. Construction 
was completed in 1928. At the time of the significant official 
governmental action, City C had no plan to enter into a sale-leaseback 
arrangement with respect to the facility. On December 15, 1984, City C 
entered into a binding sale-leaseback arrangement concerning the city 
hall. This transaction will not qualify for exclusion from section 
168(j) under the section 31(g)(4) of TRA since construction of the 
facility in question was substantially completed before January 1, 1983. 
If, however, there had been significant official governmental action on 
or before November 1, 1983 with respect to the sale-leaseback project, 
then the transitional rule of section 31(g)(4) of TRA would apply.

[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 major paragraphs contained in Sec. Sec.  
1.168(k)-1 and 1.168(k)-2.

     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.

[[Page 777]]

    (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.
    (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.

[[Page 778]]

    (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.

   Sec.  1.168(k)-2 Additional first year depreciation deduction for 
    property acquired and placed in service after September 27, 2017.

    (a) Scope and definitions.
    (1) Scope.
    (2) Definitions.
    (b) Qualified property.
    (1) In general.
    (2) Description of qualified property.
    (i) In general.
    (ii) Property not eligible for additional first year depreciation 
deduction.
    (iii) Examples.
    (3) Original use or used property acquisition requirements.
    (i) In general.
    (ii) Original use.
    (A) In general.
    (B) Conversion to business or income-producing use.
    (C) Fractional interests in property.
    (iii) Used property acquisition requirements.
    (A) In general.
    (B) Property was not used by the taxpayer at any time prior to 
acquisition.
    (C) Special rules for a series of related transactions.
    (iv) Application to partnerships.
    (A) Section 704(c) remedial allocations.
    (B) Basis determined under section 732.
    (C) Section 734(b) adjustments.
    (D) Section 743(b) adjustments.
    (v) Application to members of a consolidated group.
    (vi) Syndication transaction.
    (vii) Examples.
    (4) Placed-in-service date.
    (i) In general.
    (ii) Specified plant.
    (iii) Qualified film, television, or live theatrical production.
    (A) Qualified film or television production.
    (B) Qualified live theatrical production.
    (iv) Syndication transaction.
    (v) Technical termination of a partnership.
    (vi) Section 168(i)(7) transactions.
    (5) Acquisition of property.
    (i) In general.
    (ii) Acquisition date.
    (A) In general.
    (B) Determination of acquisition date for property acquired pursuant 
to a written binding contract.
    (iii) Definition of binding contract.
    (A) In general.
    (B) Conditions.
    (C) Options.
    (D) Letter of intent.
    (E) Supply agreements.
    (F) Components.
    (G) Acquisition of a trade or business or an entity.
    (iv) Self-constructed property.
    (A) In general.
    (B) When does manufacture, construction, or production begin.
    (C) Components of self-constructed property.
    (v) Determination of acquisition date for property not acquired 
pursuant to a written binding contract.
    (vi) Qualified film, television, or live theatrical production.
    (A) Qualified film or television production.
    (B) Qualified live theatrical production.
    (vii) Specified plant.
    (viii) Examples.
    (c) Election for components of larger self-constructed property for 
which the manufacture, construction, or production begins before 
September 28, 2017.
    (1) In general.
    (2) Eligible larger self-constructed property.
    (i) In general.
    (ii) Residential rental property or nonresidential real property.
    (iii) Beginning of manufacture, construction, or production.
    (iv) Exception.
    (3) Eligible components.
    (i) In general.
    (ii) Acquired components.
    (iii) Self-constructed components.
    (4) Special rules.
    (i) Installation costs.
    (ii) Property described in section 168(k)(2)(B).
    (5) Computation of additional first year depreciation deduction.
    (i) Election is made.
    (ii) Election is not made.
    (6) Time and manner for making election.
    (i) Time for making election.
    (ii) Manner of making election.

[[Page 779]]

    (7) Revocation of election.
    (i) In general.
    (ii) Automatic 6-month extension.
    (8) Additional procedural guidance.
    (9) Examples.
    (d) Property described in section 168(k)(2)(B) or (C).
    (1) In general.
    (2) Definition of binding contract.
    (3) Self-constructed property.
    (i) In general.
    (ii) When does manufacture, construction, or production begin.
    (A) In general.
    (B) Safe harbor.
    (iii) Components of self-constructed property.
    (A) Acquired components.
    (B) Self-constructed components.
    (iv) Determination of acquisition date for property not acquired 
pursuant to a written binding contract.
    (4) Examples.
    (e) Computation of depreciation deduction for qualified property.
    (1) Additional first year depreciation deduction.
    (i) Allowable taxable year.
    (ii) Computation.
    (iii) Property described in section 168(k)(2)(B).
    (iv) Alternative minimum tax.
    (A) In general.
    (B) Special rules.
    (2) Otherwise allowable depreciation deduction.
    (i) In general.
    (ii) Alternative minimum tax.
    (3) Examples.
    (f) Elections under section 168(k).
    (1) Election not to deduct additional first year depreciation.
    (i) In general.
    (ii) Definition of class of property.
    (iii) Time and manner for making election.
    (A) Time for making election.
    (B) Manner of making election.
    (iv) Failure to make election.
    (2) Election to apply section 168(k)(5) for specified plants.
    (i) In general.
    (ii) Time and manner for making election.
    (A) Time for making election.
    (B) Manner of making election.
    (iii) Failure to make election.
    (3) Election for qualified property placed in service during the 
2017 taxable year.
    (i) In general.
    (ii) Time and manner for making election.
    (A) Time for making election.
    (B) Manner of making election.
    (iii) Failure to make election.
    (4) Alternative minimum tax.
    (5) Revocation of election.
    (i) In general.
    (ii) Automatic 6-month extension.
    (6) Special rules for 2016 and 2017 returns.
    (7) Additional procedural guidance.
    (g) 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) Definitions.
    (iv) Examples.
    (3) Sections 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 described in section 168(k)(2)(B).
    (D) Effect of Sec.  1.168(i)-6(i)(1) election.
    (E) Alternative minimum tax.
    (iv) Replacement MACRS property or replacement computer software 
that is acquired and placed in service before disposition of 
relinquished MACRS property or relinquished computer software.
    (v) Examples.
    (6) Change in use.
    (i) Change in use of MACRS 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) Coordination with section 47.
    (i) In general.
    (ii) Example.
    (10) Coordination with section 514(a)(3).
    (11) Mid-quarter convention.
    (h) Applicability dates.
    (1) In general.
    (2) Early application of this section.
    (3) Early application of regulation project REG-104397-18.

[T.D. 9091, 68 FR 52991, Sept. 8, 2003. Redesignated and amended by T.D. 
9283, 71 FR 51738, Aug. 31, 2006; T.D. 9874, 84 FR 50128, Sept. 24, 
2019; 85 FR 71752, Nov. 10, 2020]

[[Page 780]]



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 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

[[Page 781]]

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 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),

[[Page 782]]

and is 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 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

[[Page 783]]

to H, an unrelated party, and H begins to use its proportionate share of 
the aircraft immediately upon purchase. On June 1, 2003, G 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

[[Page 784]]

purchased have not been specified. The contract will not be a binding 
contract for the property to be purchased until 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

[[Page 785]]

the taxpayer. For example, if a retail motor fuels outlet or other 
facility is to be constructed for an accrual basis 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 786]]

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 787]]

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 788]]

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 789]]

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 790]]

    (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 791]]

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 792]]

    (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 793]]

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 794]]

    (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 795]]

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 796]]

    (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 797]]

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 798]]

    (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 799]]

    (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 800]]

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 801]]

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 802]]

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 803]]

    (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 804]]

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 805]]

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 806]]

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.  1.168(k)-2  Additional first year depreciation deduction 
for property acquired and placed in service after September 27, 2017.

    (a) Scope and definitions--(1) Scope. This section provides rules 
for determining the additional first year depreciation deduction 
allowable under section 168(k) for qualified property acquired and 
placed in service after September 27, 2017, except as provided in 
paragraph (c) of this section.
    (2) Definitions. For purposes of this section--
    (i) Act is the Tax Cuts and Jobs Act, Public Law 115-97 (131 Stat. 
2054 (December 22, 2017));
    (ii) Applicable percentage is the percentage provided in section 
168(k)(6);
    (iii) Initial live staged performance is the first commercial 
exhibition of a production to an audience. However, the term initial 
live staged performance does not include limited exhibition prior to 
commercial exhibition to general audiences if the limited exhibition is 
primarily for purposes of publicity, determining the need for further 
production activity, or raising funds for the completion of production. 
For example, an initial live staged performance does not include a 
preview of the production if the preview is primarily

[[Page 807]]

to determine the need for further production activity; and
    (iv) Predecessor includes--
    (A) A transferor of an asset to a transferee in a transaction to 
which section 381(a) applies;
    (B) A transferor of the asset to a transferee in a transaction in 
which the transferee's basis in the asset is determined, in whole or in 
part, by reference to the basis of the asset in the hands of the 
transferor;
    (C) A partnership that is considered as continuing under section 
708(b)(2) and Sec.  1.708-1; or
    (D) The decedent in the case of an asset acquired by the estate.
    (b) Qualified property--(1) In general. Qualified property is 
depreciable property, as defined in Sec.  1.168(b)-1(a)(1), 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)-2(b)(2) (description of 
qualified property);
    (ii) The requirements in Sec.  1.168(k)-2(b)(3) (original use or 
used property acquisition requirements);
    (iii) The requirements in Sec.  1.168(k)-2(b)(4) (placed-in-service 
date); and
    (iv) The requirements in Sec.  1.168(k)-2(b)(5) (acquisition of 
property).
    (2) Description of qualified 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(b)-1(a)(2), that has a 
recovery period of 20 years or less. For purposes of this paragraph 
(b)(2)(i)(A) and section 168(k)(2)(A)(i)(I), the recovery period is 
determined in accordance with section 168(c) regardless of any election 
made by the taxpayer under section 168(g)(7). This paragraph 
(b)(2)(i)(A) includes the following MACRS property that is acquired by 
the taxpayer after September 27, 2017, and placed in service by the 
taxpayer after September 27, 2017, and before January 1, 2018:
    (1) Qualified leasehold improvement property as defined in section 
168(e)(6) as in effect on the day before amendment by section 
13204(a)(1) of the Act;
    (2) Qualified restaurant property, as defined in section 168(e)(7) 
as in effect on the day before amendment by section 13204(a)(1) of the 
Act, that is qualified improvement property as defined in Sec.  
1.168(b)-1(a)(5)(i)(C) and (a)(5)(ii); and
    (3) Qualified retail improvement property as defined in section 
168(e)(8) as in effect on the day before amendment by section 
13204(a)(1) of the Act;
    (B) Computer software as defined in, and depreciated under, section 
167(f)(1) and Sec.  1.167(a)-14;
    (C) Water utility property as defined in section 168(e)(5) and 
depreciated under section 168;
    (D) Qualified improvement property as defined in Sec.  1.168(b)-
1(a)(5)(i)(C) and (a)(5)(ii) and depreciated under section 168;
    (E) A qualified film or television production, as defined in section 
181(d) and Sec.  1.181-3, for which a deduction would have been 
allowable under section 181 and Sec. Sec.  1.181-1 through 1.181-6 
without regard to section 181(a)(2) and (g), Sec.  1.181-1(b)(1)(i) and 
(ii), and (b)(2)(i), or section 168(k). Only production costs of a 
qualified film or television production are allowable as a deduction 
under section 181 and Sec. Sec.  1.181-1 through 1.181-6 without regard, 
for purposes of section 168(k), to section 181(a)(2) and (g), Sec.  
1.181-1(b)(1)(i) and (ii), and (b)(2)(i). The taxpayer that claims the 
additional first year depreciation deduction under this section for the 
production costs of a qualified film or television production must be 
the owner, as defined in Sec.  1.181-1(a)(2), of the qualified film or 
television production. See Sec.  1.181-1(a)(3) for the definition of 
production costs;
    (F) A qualified live theatrical production, as defined in section 
181(e), for which a deduction would have been allowable under section 
181 and Sec. Sec.  1.181-1 through 1.181-6 without regard to section 
181(a)(2) and (g), Sec.  1.181-1(b)(1)(i) and (ii), and (b)(2)(i), or 
section 168(k). Only production costs of a qualified live theatrical 
production are allowable as a deduction under section 181 and Sec. Sec.  
1.181-1 through 1.181-6 without regard, for purposes of section 168(k), 
to section 181(a)(2) and (g), Sec.  1.181-1(b)(1)(i) and (ii), and 
(b)(2)(i). The taxpayer that claims the additional first

[[Page 808]]

year depreciation deduction under this section for the production costs 
of a qualified live theatrical production must be the owner, as defined 
in Sec.  1.181-1(a)(2), of the qualified live theatrical production. In 
applying Sec.  1.181-1(a)(2)(ii) to a person that acquires a finished or 
partially-finished qualified live theatrical production, such person is 
treated as an owner of that production, but only if the production is 
acquired prior to its initial live staged performance. Rules similar to 
the rules in Sec.  1.181-1(a)(3) for the definition of production costs 
of a qualified film or television production apply for defining 
production costs of a qualified live theatrical production; or
    (G) A specified plant, as defined in section 168(k)(5)(B), for which 
the taxpayer has properly made an election to apply section 168(k)(5) 
for the taxable year in which the specified plant is planted, or grafted 
to a plant that has already been planted, by the taxpayer in the 
ordinary course of the taxpayer's farming business, as defined in 
section 263A(e)(4) (for further guidance, see paragraph (f) of this 
section).
    (ii) Property not eligible for additional first year depreciation 
deduction. Depreciable property will not meet the requirements of this 
paragraph (b)(2) if the property is--
    (A) Described in section 168(f) (for example, automobiles for which 
the taxpayer uses the optional business standard mileage rate);
    (B) Required to be depreciated under the alternative depreciation 
system of section 168(g) pursuant to section 168(g)(1)(A), (B), (C), 
(D), (F), or (G), 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)). If section 168(h)(6) applies to the property, only the tax-
exempt entity's proportionate share of the property, as determined under 
section 168(h)(6), is treated as tax-exempt use property described in 
section 168(g)(1)(B) and in this paragraph (b)(2)(ii)(B). This paragraph 
(b)(2)(ii)(B) does not apply to property for which the adjusted basis is 
required to be determined using the alternative depreciation system of 
section 168(g) pursuant to section 250(b)(2)(B) or 951A(d)(3), as 
applicable, or to property for which the adjusted basis is required to 
be determined using the alternative depreciation system of section 
168(g) for allocating business interest expense between excepted and 
non-excepted trades or businesses under section 163(j), but only if the 
property is not required to be depreciated under the alternative 
depreciation system of section 168(g) pursuant to section 168(g)(1)(A), 
(B), (C), (D), (F), or (G), or other provisions of the Code, other than 
section 163(j), 250(b)(2)(B), or 951A(d)(3), as applicable;
    (C) Included in any class of property for which the taxpayer elects 
not to deduct the additional first year depreciation (for further 
guidance, see paragraph (f) of this section);
    (D) A specified plant that is placed in service by the taxpayer 
during the taxable year and for which the taxpayer made an election to 
apply section 168(k)(5) for a prior taxable year;
    (E) Included in any class of property for which the taxpayer elects 
to apply section 168(k)(4). This paragraph (b)(2)(ii)(E) applies to 
property placed in service by the taxpayer in any taxable year beginning 
before January 1, 2018;
    (F) Primarily used in a trade or business described in section 
163(j)(7)(A)(iv) and Sec. Sec.  1.163(j)-1(b)(15)(i) and 1.163(j)-
10(c)(3)(iii)(C)(3), and placed in service by the taxpayer in any 
taxable year beginning after December 31, 2017. For purposes of section 
168(k)(9)(A) and this paragraph (b)(2)(ii)(F), the term primarily used 
has the same meaning as that term is used in Sec.  1.167(a)-
11(b)(4)(iii)(b) and (e)(3)(iii) for classifying property. This 
paragraph (b)(2)(ii)(F) does not apply to property that is leased to a 
lessee's trade or business described in section 163(j)(7)(A)(iv) and 
Sec. Sec.  1.163(j)-1(b)(15)(i) and 1.163(j)-10(c)(3)(iii)(C)(3), by a 
lessor's trade or business that is not described in section 
163(j)(7)(A)(iv) and Sec. Sec.  1.163(j)-1(b)(15)(i) and 1.163(j)-
10(c)(3)(iii)(C)(3) for the taxable year; or

[[Page 809]]

    (G) Used in a trade or business that has had floor plan financing 
indebtedness, as defined in section 163(j)(9)(B) and Sec.  1.163(j)-
1(b)(18), if the floor plan financing interest expense, as defined in 
section 163(j)(9)(A) and Sec.  1.163(j)-1(b)(19), related to such 
indebtedness is taken into account under section 163(j)(1)(C) for the 
taxable year. Such property also must be placed in service by the 
taxpayer in any taxable year beginning after December 31, 2017. Solely 
for purposes of section 168(k)(9)(B) and this paragraph (b)(2)(ii)(G), 
floor plan financing interest expense is taken into account for the 
taxable year by a trade or business that has had floor plan financing 
indebtedness only if the business interest expense, as defined in 
section 163(j)(5) and Sec.  1.163(j)-1(b)(3), of the trade or business 
for the taxable year (which includes floor plan financing interest 
expense) exceeds the sum of the amounts calculated under section 
163(j)(1)(A) and (B) for the trade or business for the taxable year. If 
the trade or business has taken floor plan financing interest expense 
into account pursuant to this paragraph (b)(2)(ii)(G) for a taxable 
year, this paragraph (b)(2)(ii)(G) applies to any property placed in 
service by that trade or business in that taxable year. This paragraph 
(b)(2)(ii)(G) does not apply to property that is leased to a lessee's 
trade or business that has had floor plan financing indebtedness, by a 
lessor's trade or business that has not had floor plan financing 
indebtedness during the taxable year or that has had floor plan 
financing indebtedness but did not take into account floor plan 
financing interest expense for the taxable year pursuant to this 
paragraph (b)(2)(ii)(G).
    (iii) Examples. The application of this paragraph (b)(2) is 
illustrated by the following examples. Unless the facts specifically 
indicate otherwise, assume that the parties are not related within the 
meaning of section 179(d)(2)(A) or (B) and Sec.  1.179-4(c), and are not 
described in section 163(j)(3):
    (A) Example 1. On February 8, 2018, A finishes the production of a 
qualified film, as defined in Sec.  1.181-3. On June 4, 2018, B acquires 
this finished production from A. The initial release or broadcast, as 
defined in Sec.  1.181-1(a)(7), of this qualified film is on July 28, 
2018. Because B acquired the qualified film before its initial release 
or broadcast, B is treated as the owner of the qualified film for 
purposes of section 181 and Sec.  1.181-1(a)(2). Assuming all other 
requirements of this section are met and all requirements of section 181 
and Sec. Sec.  1.181-1 through 1.181-6, other than section 181(a)(2) and 
(g), and Sec.  1.181-1(b)(1)(i) and (ii), and (b)(2)(i), are met, B's 
acquisition cost of the qualified film qualifies for the additional 
first year depreciation deduction under this section.
    (B) Example 2. The facts are the same as in Example 1 of paragraph 
(b)(2)(iii)(A) of this section, except that B acquires a limited license 
or right to release the qualified film in Europe. As a result, B is not 
treated as the owner of the qualified film pursuant to Sec.  1.181-
1(a)(2). Accordingly, paragraph (b)(2)(i)(E) of this section is not 
satisfied, and B's acquisition cost of the license or right does not 
qualify for the additional first year depreciation deduction.
    (C) Example 3. C owns a film library. All of the films in this film 
library are completed and have been released or broadcasted. In 2018, D 
buys this film library from C. Because D acquired the films after their 
initial release or broadcast, D's acquisition cost of the film library 
does not qualify for a deduction under section 181. As a result, 
paragraph (b)(2)(i)(E) of this section is not satisfied, and D's 
acquisition cost of the film library does not qualify for the additional 
first year depreciation deduction.
    (D) Example 4. During 2019, E Corporation, a domestic corporation, 
acquired new equipment for use in its manufacturing trade or business in 
Mexico. To determine its qualified business asset investment for 
purposes of section 250, E Corporation must determine the adjusted basis 
of the new equipment using the alternative depreciation system of 
section 168(g) pursuant to sections 250(b)(2)(B) and 951A(d)(3). E 
Corporation also is required to depreciate the new equipment under the 
alternative depreciation system of section 168(g) pursuant to section 
168(g)(1)(A). As a result, the new equipment does not qualify for the 
additional first year

[[Page 810]]

depreciation deduction pursuant to paragraph (b)(2)(ii)(B) of this 
section.
    (E) Example 5. The facts are the same as in Example 4 of paragraph 
(b)(2)(iii)(D) of this section, except E Corporation acquired the new 
equipment for use in its manufacturing trade or business in California. 
The new equipment is not described in section 168(g)(1)(A), (B), (C), 
(D), (F), or (G). No other provision of the Internal Revenue Code, other 
than section 250(b)(2)(B) or 951A(d)(3), requires the new equipment to 
be depreciated using the alternative depreciation system of section 
168(g). To determine its qualified business asset investment for 
purposes of section 250, E Corporation must determine the adjusted basis 
of the new equipment using the alternative depreciation system of 
section 168(g) pursuant to sections 250(b)(2)(B) and 951A(d)(3). Because 
E Corporation is not required to depreciate the new equipment under the 
alternative depreciation system of section 168(g), paragraph 
(b)(2)(ii)(B) of this section does not apply to this new equipment. 
Assuming all other requirements are met, the new equipment qualifies for 
the additional first year depreciation deduction under this section.
    (F) Example 6. In 2019, a financial institution buys new equipment 
for $1 million and then leases this equipment to a lessee that primarily 
uses the equipment in a trade or business described in section 
163(j)(7)(A)(iv) and Sec. Sec.  1.163(j)-1(b)(15)(i) and 1.163(j)-
10(c)(3)(iii)(C)(3). The financial institution is not described in 
section 163(j)(7)(A)(iv) and Sec. Sec.  1.163(j)-1(b)(15)(i) and Sec.  
1.163(j)-10(c)(3)(iii)(C)(3). As a result, paragraph (b)(2)(ii)(F) of 
this section does not apply to this new equipment. Assuming all other 
requirements are met, the financial institution's purchase price of $1 
million for the new equipment qualifies for the additional first year 
depreciation deduction under this section.
    (G) Example 7. During its taxable year beginning in 2020, F, a 
corporation that is an automobile dealer, buys new computers for $50,000 
for use in its trade or business of selling automobiles. For purposes of 
section 163(j), F has the following for 2020: $700 of adjusted taxable 
income, $40 of business interest income, $400 of business interest 
expense (which includes $100 of floor plan financing interest expense). 
The sum of the amounts calculated under section 163(j)(1)(A) and (B) for 
F for 2020 is $390 ($40 + ($700 x 50 percent)). F's business interest 
expense, which includes floor plan financing interest expense, for 2020 
is $400. As a result, F's floor plan financing interest expense is taken 
into account by F for 2020 pursuant to paragraph (b)(2)(ii)(G) of this 
section. Accordingly, F's purchase price of $50,000 for the computers 
does not qualify for the additional first year depreciation deduction 
under this section.
    (H) Example 8. The facts are the same as in Example 7 in paragraph 
(b)(2)(iii)(G) of this section, except F buys new computers for $30,000 
for use in its trade or business of selling automobiles and, for 
purposes of section 163(j), F has $1,300 of adjusted taxable income. The 
sum of the amounts calculated under section 163(j)(1)(A) and (B) for F 
for 2020 is $690 ($40 + ($1,300 x 50 percent)). F's business interest 
expense, which includes floor plan financing interest expense, for 2020 
is $400. As a result, F's floor plan financing interest expense is not 
taken into account by F for 2020 pursuant to paragraph (b)(2)(ii)(G) of 
this section. Assuming all other requirements are met, F's purchase 
price of $30,000 for the computers qualifies for the additional first 
year depreciation deduction under this section.
    (I) Example 9. (1) G, a calendar-year taxpayer, owns an office 
building for use in its trade or business and G placed in service such 
building in 2000. In November 2018, G made and placed in service an 
improvement to the inside of such building at a cost of $100,000. In 
January 2019, G entered into a written contract with H for H to 
construct an improvement to the inside of the building. In March 2019, H 
completed construction of the improvement at a cost of $750,000 and G 
placed in service such improvement. Both improvements to the building 
are section 1250 property and are not described in Sec.  1.168(b)-
1(a)(5)(ii).
    (2) Both the improvement to the office building made by G in 
November 2018 and the improvement to the office building that was 
constructed by H for

[[Page 811]]

G in 2019 are improvements made by G under Sec.  1.168(b)-1(a)(5)(i)(A). 
Further, each improvement is made to the inside of the office building, 
is section 1250 property, and is not described in Sec.  1.168(b)-
1(a)(5)(ii). As a result, each improvement meets the definition of 
qualified improvement property in section 168(e)(6) and Sec.  1.168(b)-
1(a)(5)(i)(A) and (a)(5)(ii). Accordingly, each improvement is 15-year 
property under section 168(e)(3) and is described in Sec.  1.168(k)-
2(b)(2)(i)(A). Assuming all other requirements of this section are met, 
each improvement made by G qualifies for the additional first year 
depreciation deduction for G under this section.
    (3) Original use or used property acquisition requirements--(i) In 
general. Depreciable property will meet the requirements of this 
paragraph (b)(3) if the property meets the original use requirements in 
paragraph (b)(3)(ii) of this section or if the property meets the used 
property acquisition requirements in paragraph (b)(3)(iii) of this 
section.
    (ii) Original use--(A) In general. Depreciable property will meet 
the requirements of this paragraph (b)(3)(ii) if the original use of the 
property commences with the taxpayer. Except as provided in paragraphs 
(b)(3)(ii)(B) and (C) 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. Additional capital expenditures 
paid or incurred by a taxpayer to recondition or rebuild property 
acquired or owned by the taxpayer satisfy the original use requirement. 
However, the cost of reconditioned or rebuilt property does not satisfy 
the original use requirement (but may satisfy the used property 
acquisition requirements in paragraph (b)(3)(iii) of this section). The 
question of whether property is reconditioned or rebuilt property is a 
question of fact. For purposes of this paragraph (b)(3)(ii)(A), 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.
    (B) Conversion to business or income-producing use--(1) 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.
    (2) 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)(2), 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.
    (C) Fractional interests in property. If, in the ordinary course of 
its business, a taxpayer sells fractional interests in new 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

[[Page 812]]

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)(ii)(C), persons are not related if they do not have a 
relationship described in section 267(b) and Sec.  1.267(b)-1, or 
section 707(b) and Sec.  1.707-1.
    (iii) Used property acquisition requirements--(A) In general. 
Depreciable property will meet the requirements of this paragraph 
(b)(3)(iii) if the acquisition of the used property meets the following 
requirements:
    (1) Such property was not used by the taxpayer or a predecessor at 
any time prior to such acquisition;
    (2) The acquisition of such property meets the requirements of 
section 179(d)(2)(A), (B), and (C), and Sec.  1.179-4(c)(1)(ii), (iii), 
and (iv); or Sec.  1.179-4(c)(2) (property is acquired by purchase); and
    (3) The acquisition of such property meets the requirements of 
section 179(d)(3) and Sec.  1.179-4(d) (cost of property) (for further 
guidance regarding like-kind exchanges and involuntary conversions, see 
paragraph (g)(5) of this section).
    (B) Property was not used by the taxpayer at any time prior to 
acquisition--(1) In general. Solely for purposes of paragraph 
(b)(3)(iii)(A)(1) of this section, the property is treated as used by 
the taxpayer or a predecessor at any time prior to acquisition by the 
taxpayer or predecessor if the taxpayer or the predecessor had a 
depreciable interest in the property at any time prior to such 
acquisition, whether or not the taxpayer or the predecessor claimed 
depreciation deductions for the property. To determine if the taxpayer 
or a predecessor had a depreciable interest in the property at any time 
prior to the acquisition, only the five calendar years immediately prior 
to the current calendar year in which the property is placed in service 
by the taxpayer, and the portion of such current calendar year before 
the placed-in-service date of the property without taking into account 
the applicable convention, are taken into account (lookback period). If 
either the taxpayer or a predecessor, or both, have not been in 
existence for the entire lookback period, only the portion of the 
lookback period during which the taxpayer or a predecessor, or both, as 
applicable, have been in existence is taken into account to determine if 
the taxpayer or a predecessor had a depreciable interest in the property 
at any time prior to the acquisition. If a lessee has a depreciable 
interest in the improvements made to leased property and subsequently 
the lessee acquires the leased property of which the improvements are a 
part, the unadjusted depreciable basis, as defined in Sec.  1.168(b)-
1(a)(3), of the acquired property that is eligible for the additional 
first year depreciation deduction, assuming all other requirements are 
met, must not include the unadjusted depreciable basis attributable to 
the improvements.
    (2) Taxpayer has a depreciable interest in a portion of the 
property. If a taxpayer initially acquires a depreciable interest in a 
portion of the property and subsequently acquires a depreciable interest 
in an additional portion of the same property, such additional 
depreciable interest is not treated as used by the taxpayer at any time 
prior to its acquisition by the taxpayer under paragraphs 
(b)(3)(iii)(A)(1) and (b)(3)(iii)(B)(1) of this section. This paragraph 
(b)(3)(iii)(B)(2) does not apply if the taxpayer or a predecessor 
previously had a depreciable interest in the subsequently acquired 
additional portion. For purposes of this paragraph (b)(3)(iii)(B)(2), a 
portion of the property is considered to be the percentage interest in 
the property. If a taxpayer holds a depreciable interest in a portion of 
the property, sells that portion or a part of that portion, and 
subsequently acquires a depreciable interest in another portion of the 
same property, the taxpayer will be treated as previously having a 
depreciable interest in the property up to the amount of the portion for 
which the taxpayer held a depreciable interest in the property before 
the sale.
    (3) Substantial renovation of property. If a taxpayer acquires and 
places in service substantially renovated property and the taxpayer or a 
predecessor previously had a depreciable interest in the property before 
it was substantially renovated, the taxpayer's or predecessor's 
depreciable interest in

[[Page 813]]

the property before it was substantially renovated is not taken into 
account for determining whether the substantially renovated property was 
used by the taxpayer or a predecessor at any time prior to its 
acquisition by the taxpayer under paragraphs (b)(3)(iii)(A)(1) and 
(b)(3)(iii)(B)(1) of this section. For purposes of this paragraph 
(b)(3)(iii)(B)(3), property is substantially renovated if the cost of 
the used parts is not more than 20 percent of the total cost of the 
substantially renovated property, whether acquired or self-constructed.
    (4) De minimis use of property. If a taxpayer acquires and places in 
service property, the taxpayer or a predecessor did not previously have 
a depreciable interest in the property, the taxpayer disposes of the 
property to an unrelated party within 90 calendar days after the date 
the property was originally placed in service by the taxpayer, without 
taking into account the applicable convention, and the taxpayer 
reacquires and again places in service the property, then the taxpayer's 
depreciable interest in the property during that 90-day period is not 
taken into account for determining whether the property was used by the 
taxpayer or a predecessor at any time prior to its reacquisition by the 
taxpayer under paragraphs (b)(3)(iii)(A)(1) and (b)(3)(iii)(B)(1) of 
this section. If the taxpayer originally acquired the property before 
September 28, 2017, as determined under Sec.  1.168(k)-1(b)(4), and the 
taxpayer reacquires and again places in service the property during the 
same taxable year the taxpayer disposed of the property to the unrelated 
party, then this paragraph (b)(3)(iii)(B)(4) does not apply. For 
purposes of this paragraph (b)(3)(iii)(B)(4), an unrelated party is a 
person not described in section 179(d)(2)(A) or (B), and Sec.  1.179-
4(c)(1)(ii) or (iii) or (c)(2).
    (C) Special rules for a series of related transactions--(1) In 
general. Solely for purposes of paragraph (b)(3)(iii) of this section, 
each transferee in a series of related transactions tests its 
relationship under section 179(d)(2)(A) or (B) with the transferor from 
which the transferee directly acquires the depreciable property 
(immediate transferor) and with the original transferor of the 
depreciable property in the series. The transferee is treated as related 
to the immediate transferor or the original transferor if the 
relationship exists either when the transferee acquires, or immediately 
before the first transfer of, the depreciable property in the series. A 
series of related transactions may include, for example, a transfer of 
partnership assets followed by a transfer of an interest in the 
partnership that owned the assets; or a disposition of property and a 
disposition, directly or indirectly, of the transferor or transferee of 
the property. For special rules that may apply when the transferor and 
transferee of the property are members of a consolidated group, as 
defined in Sec.  1.1502-1(h), see Sec.  1.1502-68.
    (2) Special rules--(i) Property placed in service and disposed of in 
same taxable year or property not placed in service. Any party in a 
series of related transactions that is neither the original transferor 
nor the ultimate transferee is disregarded (disregarded party) for 
purposes of testing the relationships under paragraph (b)(3)(iii)(C)(1) 
of this section if the party places in service and disposes of the 
depreciable property subject to the series, other than in a transaction 
described in paragraph (g)(1)(iii) of this section, during the party's 
same taxable year, or if the party does not place in service the 
depreciable property subject to the series for use in the party's trade 
or business or production of income. In either case, the party to which 
the disregarded party disposed of the depreciable property tests its 
relationship with the party from which the disregarded party acquired 
the depreciable property and with the original transferor of the 
depreciable property in the series. If the series has consecutive 
disregarded parties, the party to which the last disregarded party 
disposed of the depreciable property tests its relationship with the 
party from which the first disregarded party acquired the depreciable 
property and with the original transferor of the depreciable property in 
the series. The rules for testing the relationships in paragraph 
(b)(3)(iii)(C)(1) of this section continue to apply for the other 
transactions in the series.

[[Page 814]]

    (ii) All section 168(i)(7) transactions. This paragraph 
(b)(3)(iii)(C) does not apply if all transactions in a series of related 
transactions are described in paragraph (g)(1)(iii) of this section 
(section 168(i)(7) transactions in which property is transferred in the 
same taxable year that the property is placed in service by the 
transferor).
    (iii) One or more section 168(i)(7) transactions. Any step in a 
series of related transactions that is neither the original step nor the 
ultimate step is disregarded (disregarded step) for purposes of testing 
the relationships under paragraph (b)(3)(iii)(C)(1) of this section if 
the step is a transaction described in paragraph (g)(1)(iii) of this 
section. In this case, the relationship is not tested between the 
transferor and transferee of that transaction. Instead, the relationship 
is tested between the transferor in the disregarded step and the party 
to which the transferee in the disregarded step disposed of the 
depreciable property, the transferee in the disregarded step and the 
party to which the transferee in the disregarded step disposed of the 
depreciable property, and the original transferor of the depreciable 
property in the series and the party to which the transferee in the 
disregarded step disposed of the depreciable property. If the series has 
consecutive disregarded steps, the relationship is tested between the 
transferor in the first disregarded step and the party to which the 
transferee in the last disregarded step disposed of the depreciable 
property, the transferee in the last disregarded step and the party to 
which the transferee in the last disregarded step disposed of the 
depreciable property, and the original transferor of the depreciable 
property in the series and the party to which the transferee in the last 
disregarded step disposed of the depreciable property. The rules for 
testing the relationships in paragraph (b)(3)(iii)(C)(1) of this section 
continue to apply for the other transactions in the series.
    (iv) Syndication transaction. This paragraph (b)(3)(iii)(C) does not 
apply to a syndication transaction described in paragraph (b)(3)(vi) of 
this section.
    (v) Certain relationships disregarded. If a party acquires 
depreciable property in a series of related transactions in which the 
party acquires stock, meeting the requirements of section 1504(a)(2), of 
a corporation in a fully taxable transaction followed by a liquidation 
of the acquired corporation under section 331, any relationship created 
as part of such series of related transactions is disregarded in 
determining whether any party is related to such acquired corporation 
for purposes of testing the relationships under paragraph 
(b)(3)(iii)(C)(1) of this section.
    (vi) Transferors that cease to exist for Federal tax purposes. Any 
transferor in a series of related transactions that ceases to exist for 
Federal tax purposes during the series is deemed, for purposes of 
testing the relationships under paragraph (b)(3)(iii)(C)(1) of this 
section, to be in existence at the time of any transfer in the series.
    (vii) Newly created party. If a transferee in a series of related 
transactions acquires depreciable property from a transferor that was 
not in existence immediately prior to the first transfer of such 
property in such series (new transferor), the transferee tests its 
relationship with the party from which the new transferor acquired such 
property and with the original transferor of the depreciable property in 
the series for purposes of paragraph (b)(3)(iii)(C)(1) of this section. 
If the series has consecutive new transferors, the party to which the 
last new transferor disposed of the depreciable property tests its 
relationship with the party from which the first new transferor acquired 
the depreciable property and with the original transferor of the 
depreciable property in the series. The rules for testing the 
relationships in paragraph (b)(3)(iii)(C)(1) of this section continue to 
apply for the other transactions in the series.
    (viii) Application of paragraph (g)(1) of this section. Paragraph 
(g)(1) of this section applies to each step in a series of related 
transactions.
    (iv) Application to partnerships--(A) Section 704(c) remedial 
allocations. Remedial allocations under section 704(c) do not satisfy 
the requirements of paragraph (b)(3) of this section. See Sec.  1.704-
3(d)(2).

[[Page 815]]

    (B) Basis determined under section 732. Any basis of distributed 
property determined under section 732 does not satisfy the requirements 
of paragraph (b)(3) of this section.
    (C) Section 734(b) adjustments. Any increase in basis of depreciable 
property under section 734(b) does not satisfy the requirements of 
paragraph (b)(3) of this section.
    (D) Section 743(b) adjustments--(1) In general. For purposes of 
determining whether the transfer of a partnership interest meets the 
requirements of paragraph (b)(3)(iii)(A) of this section, each partner 
is treated as having a depreciable interest in the partner's 
proportionate share of partnership property. Any increase in basis of 
depreciable property under section 743(b) satisfies the requirements of 
paragraph (b)(3)(iii)(A) of this section if--
    (i) At any time prior to the transfer of the partnership interest 
that gave rise to such basis increase, neither the transferee partner 
nor a predecessor of the transferee partner had any depreciable interest 
in the portion of the property deemed acquired to which the section 
743(b) adjustment is allocated under section 755 and Sec.  1.755-1; and
    (ii) The transfer of the partnership interest that gave rise to such 
basis increase satisfies the requirements of paragraphs 
(b)(3)(iii)(A)(2) and (3) of this section.
    (2) Relatedness tested at partner level. Solely for purposes of 
paragraph (b)(3)(iv)(D)(1)(ii) of this section, whether the parties are 
related or unrelated is determined by comparing the transferor and the 
transferee of the transferred partnership interest.
    (v) Application to members of a consolidated group. For rules 
applicable to the acquisition of depreciable property by a member of a 
consolidated group, see Sec.  1.1502-68.
    (vi) Syndication transaction. If new property is acquired and placed 
in service by a lessor, or if used property is acquired and placed in 
service by a lessor and the lessor or a predecessor did not previously 
have a depreciable interest in the used property, and the property 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 taxpayer that acquired the property for purposes of applying 
paragraphs (b)(3)(ii) and (iii) of this section. The purchaser of the 
property in the last sale during the three-month period is treated, for 
purposes of applying paragraph (b)(3) of this section, as--
    (A) The original user of the property in this transaction if the 
lessor acquired and placed in service new property; or
    (B) The taxpayer having the depreciable interest in the property in 
this transaction if the lessor acquired and placed in service used 
property.
    (vii) Examples. The application of this paragraph (b)(3) is 
illustrated by the following examples. Unless the facts specifically 
indicate otherwise, assume that the parties are not related within the 
meaning of section 179(d)(2)(A) or (B) and Sec.  1.179-4(c), no 
corporation is a member of a consolidated or controlled group, and the 
parties do not have predecessors:
    (A) Example 1. (1) On August 1, 2018, A buys a new machine for 
$35,000 from an unrelated party for use in A's trade or business. On 
July 1, 2020, B buys that machine from A for $20,000 for use in B's 
trade or business. On October 1, 2020, B makes a $5,000 capital 
expenditure to recondition the machine. B did not have any depreciable 
interest in the machine before B acquired it on July 1, 2020.
    (2) A's purchase price of $35,000 satisfies the original use 
requirement of paragraph (b)(3)(ii) of this section and, assuming all 
other requirements are met, qualifies for the additional first year 
depreciation deduction under this section.

[[Page 816]]

    (3) B's purchase price of $20,000 does not satisfy the original use 
requirement of paragraph (b)(3)(ii) of this section, but it does satisfy 
the used property acquisition requirements of paragraph (b)(3)(iii) of 
this section. Assuming all other requirements are met, the $20,000 
purchase price qualifies for the additional first year depreciation 
deduction under this section. Further, B's $5,000 expenditure satisfies 
the original use requirement of paragraph (b)(3)(ii) of this section 
and, assuming all other requirements are met, qualifies for the 
additional first year depreciation deduction under this section, 
regardless of whether the $5,000 is added to the basis of the machine or 
is capitalized as a separate asset.
    (B) 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 
November 1, 2017, 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 paragraph (b)(3)(ii) of this section. Assuming all other 
requirements are met, D's purchase price of the automobile qualifies for 
the additional first year depreciation deduction for D under this 
section, subject to any limitation under section 280F.
    (C) Example 3. On April 1, 2015, E acquires a horse to be used in 
E's thoroughbred racing business. On October 1, 2018, F buys the horse 
from E and will use the horse in F's horse breeding business. F did not 
have any depreciable interest in the horse before F acquired it on 
October 1, 2018. The use of the horse by E in its racing business 
prevents F from satisfying the original use requirement of paragraph 
(b)(3)(ii) of this section. However, F's acquisition of the horse 
satisfies the used property acquisition requirements of paragraph 
(b)(3)(iii) of this section. Assuming all other requirements are met, 
F's purchase price of the horse qualifies for the additional first year 
depreciation deduction for F under this section.
    (D) 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 October 1, 
2017, G sells five of the eight fractional interests in the aircraft to 
H and H begins to use its proportionate share of the aircraft 
immediately upon purchase. On February 1, 2018, G sells to I 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 additional first year 
depreciation deduction under this section and I's purchase price for its 
\3/8\ fractional interest in the aircraft qualifies for the additional 
first year depreciation deduction under this section.
    (E) Example 5. On September 1, 2017, J, an equipment dealer, buys 
new tractors that are held by J primarily for sale to customers in the 
ordinary course of its business. On October 15, 2017, J withdraws the 
tractors from inventory and begins to use the tractors primarily for 
producing rental income. The holding of the tractors by J as inventory 
does not constitute a ``use'' for purposes of the original use 
requirement and, therefore, the original use of the tractors commences 
with J on October 15, 2017, for purposes of paragraph (b)(3)(ii) of this 
section. However, the tractors are not eligible for the additional first 
year depreciation deduction under this section because J acquired the 
tractors before September 28, 2017.
    (F) Example 6. K is in the trade or business of leasing equipment to 
others. During 2016, K buys a new machine (Machine 1) and then leases 
it to L for use in L's trade or business. The lease between K and L for 
Machine 1 is a true lease for Federal income tax purposes. During 2018, 
L enters into a written binding contract with K to buy Machine 1 at its 
fair market value on May 15, 2018. L did not have any depreciable 
interest in Machine 1 before L

[[Page 817]]

acquired it on May 15, 2018. As a result, L's acquisition of Machine 1 
satisfies the used property acquisition requirements of paragraph 
(b)(3)(iii) of this section. Assuming all other requirements are met, 
L's purchase price of Machine 1 qualifies for the additional first year 
depreciation deduction for L under this section.
    (G) Example 7. The facts are the same as in Example 6 of paragraph 
(b)(3)(vii)(F) of this section, except that K and L are related parties 
within the meaning of section 179(d)(2)(A) or (B) and Sec.  1.179-4(c). 
As a result, L's acquisition of Machine 1 does not satisfy the used 
property acquisition requirements of paragraph (b)(3)(iii) of this 
section. Thus, Machine 1 is not eligible for the additional first year 
depreciation deduction for L.
    (H) Example 8. The facts are the same as in Example 6 of paragraph 
(b)(3)(vii)(F) of this section, except L incurred capital expenditures 
of $5,000 to improve Machine 1 on September 5, 2017, and has a 
depreciable interest in such improvements. L's purchase price of $5,000 
for the improvements to Machine 1 satisfies the original use 
requirement of Sec.  1.168(k)-1(b)(3)(i) and, assuming all other 
requirements are met, qualifies for the 50-percent additional first year 
depreciation deduction. Because L had a depreciable interest only in the 
improvements to Machine 1, L's acquisition of Machine 1, excluding L's 
improvements to such machine, satisfies the used property acquisition 
requirements of paragraph (b)(3)(iii) of this section. Assuming all 
other requirements are met, L's unadjusted depreciable basis of Machine 
1, excluding the amount of such unadjusted depreciable basis 
attributable to L's improvements to Machine 1, qualifies for the 
additional first year depreciation deduction for L under this section.
    (I) Example 9. During 2016, M and N purchased used equipment for use 
in their trades or businesses and each own a 50 percent interest in such 
equipment. Prior to this acquisition, M and N did not have any 
depreciable interest in the equipment. Assume this ownership arrangement 
is not a partnership. During 2018, N enters into a written binding 
contract with M to buy M's interest in the equipment. Pursuant to 
paragraph (b)(3)(iii)(B)(2) of this section, N is not treated as using 
M's interest in the equipment prior to N's acquisition of M's interest. 
As a result, N's acquisition of M's interest in the equipment satisfies 
the used property acquisition requirements of paragraph (b)(3)(iii) of 
this section. Assuming all other requirements are met, N's purchase 
price of M's interest in the equipment qualifies for the additional 
first year depreciation deduction for N under this section.
    (J) Example 10. The facts are the same as in Example 9 of paragraph 
(b)(3)(vii)(I) of this section, except N had a 100-percent depreciable 
interest in the equipment during 2011 through 2015, and M purchased from 
N a 50-percent interest in the equipment during 2016. Pursuant to 
paragraph (b)(3)(iii)(B)(1) of this section, the lookback period is 2013 
through 2017 to determine if N had a depreciable interest in M's 50-
percent interest in the equipment N acquired from M in 2018. Because N 
had a 100-percent depreciable interest in the equipment during 2013 
through 2015, N had a depreciable interest in M's 50-percent interest in 
the equipment during the lookback period. As a result, N's acquisition 
of M's interest in the equipment during 2018 does not satisfy the used 
property acquisition requirements of paragraphs (b)(3)(iii)(A)(1) and 
(b)(3)(iii)(B)(1) of this section. Paragraph (b)(3)(iii)(B)(2) of this 
section does not apply because N initially acquired a 100-percent 
depreciable interest in the equipment. Accordingly, N's purchase price 
of M's interest in the equipment during 2018 does not qualify for the 
additional first year depreciation deduction for N.
    (K) Example 11. The facts are the same as in Example 9 of paragraph 
(b)(3)(vii)(I) of this section, except N had a 100-percent depreciable 
interest in the equipment only during 2011, and M purchased from N a 50-
percent interest in the equipment during 2012. Pursuant to paragraph 
(b)(3)(iii)(B)(1) of this section, the lookback period is 2013 through 
2017 to determine if N had a depreciable interest in M's 50-percent 
interest in the equipment N acquired from M in 2018. Because N had a 
depreciable interest in only its 50-percent interest in the equipment 
during this

[[Page 818]]

lookback period, N's acquisition of M's interest in the equipment during 
2018 satisfies the used property acquisition requirements of paragraphs 
(b)(3)(iii)(A)(1) and (b)(3)(iii)(B)(1) of this section. Assuming all 
other requirements are met, N's purchase price of M's interest in the 
equipment during 2018 qualifies for the additional first year 
depreciation deduction for N under this section.
    (L) Example 12. The facts are the same as in Example 9 of paragraph 
(b)(3)(vii)(I) of this section, except during 2018, M also enters into a 
written binding contract with N to buy N's interest in the equipment. 
Pursuant to paragraph (b)(3)(iii)(B)(2) of this section, both M and N 
are treated as previously having a depreciable interest in a 50-percent 
portion of the equipment. Accordingly, the acquisition by M of N's 50-
percent interest and the acquisition by N of M's 50-percent interest in 
the equipment during 2018 do not qualify for the additional first year 
depreciation deduction.
    (M) Example 13. O and P form an equal partnership, OP, in 2018. O 
contributes cash to OP, and P contributes equipment to OP. OP's basis in 
the equipment contributed by P is determined under section 723. Because 
OP's basis in such equipment is determined in whole or in part by 
reference to P's adjusted basis in such equipment, OP's acquisition of 
such equipment does not satisfy section 179(d)(2)(C) and Sec.  1.179-
4(c)(1)(iv) and, thus, does not satisfy the used property acquisition 
requirements of paragraph (b)(3)(iii) of this section. Accordingly, OP's 
acquisition of such equipment is not eligible for the additional first 
year depreciation deduction.
    (N) Example 14. Q, R, and S form an equal partnership, QRS, in 2019. 
Each partner contributes $100, which QRS uses to purchase a retail motor 
fuels outlet for $300. Assume this retail motor fuels outlet is QRS' 
only property and is qualified property under section 168(k)(2)(A)(i). 
QRS makes an election not to deduct the additional first year 
depreciation for all qualified property placed in service during 2019. 
QRS has a section 754 election in effect. QRS claimed depreciation of 
$15 for the retail motor fuels outlet for 2019. During 2020, when the 
retail motor fuels outlet's fair market value is $600, Q sells all of 
its partnership interest to T in a fully taxable transaction for $200. T 
never previously had a depreciable interest in the retail motor fuels 
outlet. T takes an outside basis of $200 in the partnership interest 
previously owned by Q. T's share of the partnership's previously taxed 
capital is $95. Accordingly, T's section 743(b) adjustment is $105 and 
is allocated entirely to the retail motor fuels outlet under section 
755. Assuming all other requirements are met, T's section 743(b) 
adjustment qualifies for the additional first year depreciation 
deduction under this section.
    (O) Example 15. The facts are the same as in Example 14 of paragraph 
(b)(3)(vii)(N) of this section, except that Q sells his partnership 
interest to U, a related person within the meaning of section 
179(d)(2)(A) or (B) and Sec.  1.179-4(c). U's section 743(b) adjustment 
does not qualify for the additional first year depreciation deduction.
    (P) Example 16. The facts are the same as in Example 14 of paragraph 
(b)(3)(vii)(N) of this section, except that Q dies and his partnership 
interest is transferred to V. V takes a basis in Q's partnership 
interest under section 1014. As a result, section 179(d)(2)(C)(ii) and 
Sec.  1.179-4(c)(1)(iv) are not satisfied, and V's section 743(b) 
adjustment does not qualify for the additional first year depreciation 
deduction.
    (Q) Example 17. The facts are the same as in Example 14 of paragraph 
(b)(3)(vii)(N) of this section, except that QRS purchased the retail 
motor fuels outlet from T prior to T purchasing Q's partnership interest 
in QRS. T had a depreciable interest in such retail motor fuels outlet. 
Because T had a depreciable interest in the retail motor fuels outlet 
before T acquired its interest in QRS, T's section 743(b) adjustment 
does not qualify for the additional first year depreciation deduction.
    (R) Example 18. (1) W, a freight transportation company, acquires 
and places in service a used aircraft during 2019 (Airplane 1). Prior 
to this acquisition, W never had a depreciable interest in this 
aircraft. During September 2020, W enters into a written binding 
contract

[[Page 819]]

with a third party to renovate Airplane 1. The third party begins to 
renovate Airplane 1 in October 2020 and delivers the renovated aircraft 
(Airplane 2) to W in February 2021. To renovate Airplane 1, the third 
party used mostly new parts but also used parts from Airplane 1. The 
cost of the used parts is not more than 20 percent of the total cost of 
the renovated airplane, Airplane 2. W uses Airplane 2 in its trade or 
business.
    (2) Although Airplane 2 contains used parts, the cost of the used 
parts is not more than 20 percent of the total cost of Airplane 2. As a 
result, Airplane 2 is not treated as reconditioned or rebuilt property, 
and W is considered the original user of Airplane 2, pursuant to 
paragraph (b)(3)(ii)(A) of this section. Accordingly, assuming all other 
requirements are met, the amount paid or incurred by W for Airplane 2 
qualifies for the additional first year depreciation deduction for W 
under this section.
    (S) Example 19. (1) X, a freight transportation company, acquires 
and places in service a new aircraft in 2019 (Airplane 1). During 2022, 
X sells Airplane 1 to AB and AB uses Airplane 1 in its trade or 
business. Prior to this acquisition, AB never had a depreciable interest 
in Airplane 1. During January 2023, AB enters into a written binding 
contract with a third party to renovate Airplane 1. The third party 
begins to renovate Airplane 1 in February 2023 and delivers the 
renovated aircraft (Airplane 2) to AB in June 2023. To renovate 
Airplane 1, the third party used mostly new parts but also used parts 
from Airplane 1. The cost of the used parts is not more than 20 percent 
of the total cost of the renovated airplane, Airplane 2. AB uses 
Airplane 2 in its trade or business. During 2025, AB sells Airplane 2 
to X and X uses Airplane 2 in its trade or business.
    (2) With respect to X's purchase of Airplane 1 in 2019, X is the 
original user of this airplane pursuant to paragraph (b)(3)(ii)(A) of 
this section. Accordingly, assuming all other requirements are met, X's 
purchase price for Airplane 1 qualifies for the additional first year 
depreciation deduction for X under this section.
    (3) Because AB never had a depreciable interest in Airplane 1 prior 
to its acquisition in 2022, the requirements of paragraphs 
(b)(3)(iii)(A)(1) and (b)(3)(ii)(B)(1) of this section are satisfied. 
Accordingly, assuming all other requirements are met, AB's purchase 
price for Airplane 1 qualifies for the additional first year 
depreciation deduction for AB under this section.
    (4) Although Airplane 2 contains used parts, the cost of the used 
parts is not more than 20 percent of the total cost of Airplane 2. As a 
result, Airplane 2 is not treated as reconditioned or rebuilt property, 
and AB is considered the original user of Airplane 2, pursuant to 
paragraph (b)(3)(ii)(A) of this section. Accordingly, assuming all other 
requirements are met, the amount paid or incurred by AB for Airplane 2 
qualifies for the additional first year depreciation deduction for AB 
under this section.
    (5) With respect to X's purchase of Airplane 2 in 2025, Airplane 2 
is substantially renovated property pursuant to paragraph 
(b)(3)(iii)(B)(3) of this section. Also, pursuant to paragraph 
(b)(3)(iii)(B)(3) of this section, X's depreciable interest in Airplane 
1 is not taken into account for determining if X previously had a 
depreciable interest in Airplane 2 prior to its acquisition during 
2025. As a result, Airplane 2 is not treated as used by X at any time 
before its acquisition of Airplane 2 in 2025 pursuant to paragraph 
(b)(3)(iii)(B)(3) of this section. Accordingly, assuming all other 
requirements are met, X's purchase price of Airplane 2 qualifies for 
the additional first year depreciation deduction for X under this 
section.
    (T) Example 20. In November 2017, AA Corporation purchases a used 
drill press costing $10,000 and is granted a trade-in allowance of 
$2,000 on its old drill press. The used drill press is qualified 
property under section 168(k)(2)(A)(i). The old drill press had a basis 
of $1,200. Under sections 1012 and 1031(d), the basis of the used drill 
press is $9,200 ($1,200 basis of old drill press plus cash expended of 
$8,000). Only $8,000 of the basis of the used drill press satisfies the 
requirements of section

[[Page 820]]

179(d)(3) and Sec.  1.179-4(d) and, thus, satisfies the used property 
acquisition requirement of paragraph (b)(3)(iii) of this section. The 
remaining $1,200 of the basis of the used drill press does not satisfy 
the requirements of section 179(d)(3) and Sec.  1.179-4(d) because it is 
determined by reference to the old drill press. Accordingly, assuming 
all other requirements are met, only $8,000 of the basis of the used 
drill press is eligible for the additional first year depreciation 
deduction under this section.
    (U) Example 21. (1) M Corporation acquires and places in service a 
used airplane on March 26, 2018. Prior to this acquisition, M 
Corporation never had a depreciable interest in this airplane. On March 
26, 2018, M Corporation also leases the used airplane to N Corporation, 
an airline company. On May 27, 2018, M Corporation sells to O 
Corporation the used airplane subject to the lease with N Corporation. M 
Corporation and O Corporation are related parties within the meaning of 
section 179(d)(2)(A) or (B) and Sec.  1.179-4(c). As of May 27, 2018, N 
Corporation is still the lessee of the used airplane. Prior to this 
acquisition, O Corporation never had a depreciable interest in the used 
airplane. O Corporation is a calendar-year taxpayer.
    (2) The sale transaction of May 27, 2018, satisfies the requirements 
of a syndication transaction described in paragraph (b)(3)(vi) of this 
section. As a result, O Corporation is considered the taxpayer that 
acquired the used airplane for purposes of applying the used property 
acquisition requirements in paragraph (b)(3)(iii) of this section. In 
applying these rules, the fact that M Corporation and O Corporation are 
related parties is not taken into account because O Corporation, not M 
Corporation, is treated as acquiring the used airplane. Also, O 
Corporation, not M Corporation, is treated as having the depreciable 
interest in the used airplane. Further, pursuant to paragraph (b)(4)(iv) 
of this section, the used airplane is treated as originally placed in 
service by O Corporation on May 27, 2018. Because O Corporation never 
had a depreciable interest in the used airplane and assuming all other 
requirements are met, O Corporation's purchase price of the used 
airplane qualifies for the additional first year depreciation deduction 
for O Corporation under this section.
    (V) Example 22. (1) The facts are the same as in Example 21 of 
paragraph (b)(3)(vii)(U)(1) of this section. Additionally, on September 
5, 2018, O Corporation sells to P Corporation the used airplane subject 
to the lease with N Corporation. Prior to this acquisition, P 
Corporation never had a depreciable interest in the used airplane.
    (2) Because O Corporation, a calendar-year taxpayer, placed in 
service and disposed of the used airplane during 2018, the used airplane 
is not eligible for the additional first year depreciation deduction for 
O Corporation pursuant to paragraph (g)(1)(i) of this section.
    (3) Because P Corporation never had a depreciable interest in the 
used airplane and assuming all other requirements are met, P 
Corporation's purchase price of the used airplane qualifies for the 
additional first year depreciation deduction for P Corporation under 
this section.
    (W) Example 23. (1) The facts are the same as in Example 21 of 
paragraph (b)(3)(vii)(U)(1) of this section, except M Corporation and O 
Corporation are not related parties within the meaning of section 
179(d)(2)(A) or (B) and Sec.  1.179-4(c). Additionally, on March 26, 
2020, O Corporation sells to M Corporation the used airplane subject to 
the lease with N Corporation.
    (2) The sale transaction of May 27, 2018, satisfies the requirements 
of a syndication transaction described in paragraph (b)(3)(vi) of this 
section. As a result, O Corporation is considered the taxpayer that 
acquired the used airplane for purposes of applying the used property 
acquisition requirements in paragraph (b)(3)(iii) of this section. Also, 
O Corporation, not M Corporation, is treated as having the depreciable 
interest in the used airplane. Further, pursuant to paragraph (b)(4)(iv) 
of this section, the used airplane is treated as originally placed in 
service by O Corporation on May 27, 2018. Because O Corporation never 
had a depreciable interest in the used airplane before its acquisition 
in 2018 and assuming all other requirements are met, O Corporation's 
purchase price of

[[Page 821]]

the used airplane qualifies for the additional first year depreciation 
deduction for O Corporation under this section.
    (3) Prior to its acquisition of the used airplane on March 26, 2020, 
M Corporation never had a depreciable interest in the used airplane 
pursuant to paragraph (b)(3)(vi) of this section. Assuming all other 
requirements are met, M Corporation's purchase price of the used 
airplane on March 26, 2020, qualifies for the additional first year 
depreciation deduction for M Corporation under this section.
    (X) Example 24. (1) J, K, and L are corporations that are unrelated 
parties within the meaning of section 179(d)(2)(A) or (B) and Sec.  
1.179-4(c). None of J, K, or L is a member of a consolidated group. J 
has a depreciable interest in Equipment 5. During 2018, J sells 
Equipment 5 to K. During 2020, J merges into L in a transaction 
described in section 368(a)(1)(A). In 2021, L acquires Equipment 5 from 
K.
    (2) Because J is the predecessor of L, and because J previously had 
a depreciable interest in Equipment 5, L's acquisition of Equipment 5 
does not satisfy paragraphs (b)(3)(iii)(A)(1) and (b)(3)(iii)(B)(1) of 
this section. Thus, L's acquisition of Equipment 5 does not satisfy the 
used property acquisition requirements of paragraph (b)(3)(iii) of this 
section. Accordingly, L's acquisition of Equipment 5 is not eligible 
for the additional first year depreciation deduction.
    (Y) Example 25. (1) JL is a fiscal year taxpayer with a taxable year 
ending June 30. On April 22, 2020, JL acquires and places in service a 
new machine for use in its trade or business. On May 1, 2022, JL sells 
this machine to JM, an unrelated party, for use in JM's trade or 
business. JM is a fiscal year taxpayer with a taxable year ending March 
31. On February 1, 2023, JL buys the machine from JM and places the 
machine in service. JL uses the machine in its trade or business for the 
remainder of its taxable year ending June 30, 2023.
    (2) JL's acquisition of the machine on April 22, 2020, satisfies the 
original use requirement in paragraph (b)(3)(ii) of this section. 
Assuming all other requirements are met, JL's purchase price of the 
machine qualifies for the additional first year depreciation deduction 
for JL for the taxable year ending June 30, 2020, under this section.
    (3) JM placed in service the machine on May 1, 2022, and disposed of 
it on February 1, 2023. As a result, JM placed in service and disposed 
of the machine during the same taxable year (JM's taxable year beginning 
April 1, 2022, and ending March 31, 2023). Accordingly, JM's acquisition 
of the machine on May 1, 2022, does not qualify for the additional first 
year depreciation deduction pursuant to paragraph (g)(1)(i) of this 
section.
    (4) Pursuant to paragraph (b)(3)(iii)(B)(1) of this section, the 
lookback period is calendar years 2018 through 2022 and January 1, 2023, 
through January 31, 2023, to determine if JL had a depreciable interest 
in the machine when JL reacquired it on February 1, 2023. As a result, 
JL's depreciable interest in the machine during the period April 22, 
2020, to April 30, 2022, is taken into account for determining whether 
the machine was used by JL or a predecessor at any time prior to its 
reacquisition by JL on February 1, 2023. Accordingly, the reacquisition 
of the machine by JL on February 1, 2023, does not qualify for the 
additional first year depreciation deduction.
    (Z) Example 26. (1) EF has owned and had a depreciable interest in 
Property since 2012. On January 1, 2016, EF contributes assets (not 
including Property) to existing Partnership T in a transaction described 
in section 721, in exchange for a partnership interest in Partnership T, 
and Partnership T placed in service these assets for use in its trade or 
business. On July 1, 2016, EF sells Property to EG, a party unrelated to 
either EF or Partnership T. On April 1, 2018, Partnership T buys 
Property from EG and places it in service for use in its trade or 
business.
    (2) EF is not Partnership T's predecessor with respect to Property 
within the meaning of paragraph (a)(2)(iv)(B) of this section. Pursuant 
to paragraph (b)(3)(iii)(B)(1) of this section, the lookback period is 
2013-2017, plus January through March 2018, to determine if Partnership 
T had a depreciable interest in Property that Partnership T acquired

[[Page 822]]

on April 1, 2018. EF need not be examined in the lookback period to see 
if EF had a depreciable interest in Property, because EF is not 
Partnership T's predecessor. Because Partnership T did not have a 
depreciable interest in Property in the lookback period prior to its 
acquisition of Property on April 1, 2018, Partnership T's acquisition of 
Property on April 1, 2018, satisfies the used property acquisition 
requirement of paragraph (b)(3)(iii)(B)(1) of this section. Assuming all 
other requirements of this section are satisfied, Partnership T's 
purchase price of Property qualifies for the additional first year 
depreciation deduction under this section.
    (AA) Example 27. (1) The facts are the same as in Example 26 of 
paragraph (b)(3)(vii)(Z)(1) of this section, except that on January 1, 
2016, EF's contribution of assets to Partnership T includes Property. On 
July 1, 2016, Partnership T sells Property to EG.
    (2) Partnership T's acquisition of Property on January 1, 2016, does 
not satisfy the original use requirement of Sec.  1.168(k)-1(b)(3) and 
is not eligible for the additional first year depreciation deduction 
under section 168(k) as in effect prior to the enactment of the Act.
    (3) With respect to Partnership T's acquisition of Property on April 
1, 2018, EF is Partnership T's predecessor with respect to Property 
within the meaning of paragraph (a)(2)(iv)(B) of this section. Pursuant 
to paragraph (b)(3)(iii)(B)(1) of this section, the lookback period is 
2013-2017, plus January through March 2018, to determine if EF or 
Partnership T had a depreciable interest in Property that Partnership T 
acquired on April 1, 2018. Because EF had a depreciable interest in 
Property from 2013 to 2015 and Partnership T had a depreciable interest 
in Property from January through June 2016, Partnership T's acquisition 
of Property on April 1, 2018, does not satisfy the used property 
acquisition requirement of paragraph (b)(3)(iii)(B)(1) of this section 
and is not eligible for the additional first year depreciation 
deduction.
    (BB) Example 28. (1) X Corporation has owned and had a depreciable 
interest in Property since 2012. On January 1, 2015, X Corporation sold 
Property to Q, an unrelated party. Y Corporation is formed July 1, 2015. 
On January 1, 2016, Y Corporation merges into X Corporation in a 
transaction described in section 368(a)(1)(A). On April 1, 2018, X 
Corporation buys Property from Q and places it in service for use in its 
trade or business.
    (2) Pursuant to paragraph (a)(2)(iv)(A) of this section, Y 
Corporation is X Corporation's predecessor. Pursuant to paragraph 
(b)(3)(iii)(B)(1) of this section, the lookback period is 2013-2017, 
plus January through March 2018, to determine if Y Corporation or X 
Corporation had a depreciable interest in Property that X Corporation 
acquired on April 1, 2018. Y Corporation did not have a depreciable 
interest in Property at any time during the lookback period. Because X 
Corporation had a depreciable interest in Property from 2013 through 
2014, X Corporation's acquisition of Property on April 1, 2018, does not 
satisfy the used property acquisition requirement of paragraph 
(b)(3)(iii)(B)(1) of this section and is not eligible for the additional 
first year depreciation deduction.
    (CC) Example 29. (1) Y Corporation has owned and had a depreciable 
interest in Property since 2012. On January 1, 2015, Y Corporation sells 
Property to Q, an unrelated party. X Corporation is formed on July 1, 
2015. On January 1, 2016, Y Corporation merges into X Corporation in a 
transaction described in section 368(a)(1)(A). On April 1, 2018, X 
Corporation buys Property from Q and places it in service for use in its 
trade or business.
    (2) Pursuant to paragraph (a)(2)(iv)(A) of this section, Y 
Corporation is X Corporation's predecessor. Pursuant to paragraph 
(b)(3)(iii)(B)(1) of this section, the lookback period is 2013-2017, 
plus January through March 2018, to determine if X Corporation or Y 
Corporation had a depreciable interest in Property that X Corporation 
acquired on April 1, 2018. Because Y Corporation had a depreciable 
interest in Property from 2013 through 2014, X Corporation's acquisition 
of Property on April 1, 2018, does not satisfy the used property 
acquisition requirement of paragraph (b)(3)(iii)(B)(1) of this section 
and is not eligible for the additional first year depreciation 
deduction.

[[Page 823]]

    (DD) Example 30. (1) On September 5, 2017, Y, a calendar-year 
taxpayer, acquires and places in service a new machine (Machine 1), and 
begins using Machine 1 in its manufacturing trade or business. On 
November 1, 2017, Y sells Machine 1 to Z, then Z leases Machine 1 back 
to Y for 4 years, and Y continues to use Machine 1 in its manufacturing 
trade or business. The lease agreement contains a purchase option 
provision allowing Y to buy Machine 1 at the end of the lease term. On 
November 1, 2021, Y exercises the purchase option in the lease agreement 
and buys Machine 1 from Z. The lease between Y and Z for Machine 1 is 
a true lease for Federal tax purposes.
    (2) Because Y, a calendar-year taxpayer, placed in service and 
disposed of Machine 1 during 2017, Machine 1 is not eligible for the 
additional first year depreciation deduction for Y pursuant to Sec.  
1.168(k)-1(f)(1)(i).
    (3) The use of Machine 1 by Y prevents Z from satisfying the 
original use requirement of paragraph (b)(3)(ii) of this section. 
However, Z's acquisition of Machine 1 satisfies the used property 
acquisition requirements of paragraph (b)(3)(iii) of this section. 
Assuming all other requirements are met, Z's purchase price of Machine 
1 qualifies for the additional first year depreciation deduction for Z 
under this section.
    (4) During 2017, Y sold Machine 1 within 90 calendar days of 
placing Machine 1 in service originally on September 5, 2017. Pursuant 
to paragraph (b)(3)(iii)(B)(4) of this section, Y's depreciable interest 
in Machine 1 during that 90-day period is not taken into account for 
determining whether Machine 1 was used by Y or a predecessor at any 
time prior to its reacquisition by Y on November 1, 2021. Accordingly, 
assuming all other requirements are met, Y's purchase price of Machine 
1 on November 1, 2021, qualifies for the additional first year 
depreciation deduction for Y under this section.
    (EE) Example 31. (1) On October 15, 2019, FA, a calendar-year 
taxpayer, buys and places in service a new machine for use in its trade 
or business. On January 10, 2020, FA sells this machine to FB for use in 
FB's trade or business. FB is a calendar-year taxpayer and is not 
related to FA. On March 30, 2020, FA buys the machine from FB and places 
the machine in service. FA uses the machine in its trade or business for 
the remainder of 2020.
    (2) FA's acquisition of the machine on October 15, 2019, satisfies 
the original use requirement in paragraph (b)(3)(ii) of this section. 
Assuming all other requirements are met, FA's purchase price of the 
machine qualifies for the additional first year depreciation deduction 
for FA for the 2019 taxable year under this section.
    (3) Because FB placed in service the machine on January 10, 2020, 
and disposed of it on March 30, 2020, FB's acquisition of the machine on 
January 10, 2020, does not qualify for the additional first year 
depreciation deduction pursuant to Sec.  1.168(k)-2(g)(1)(i).
    (4) FA sold the machine to FB in 2020 and within 90 calendar days of 
placing the machine in service originally on October 15, 2019. Pursuant 
to paragraph (b)(3)(iii)(B)(4) of this section, FA's depreciable 
interest in the machine during that 90-day period is not taken into 
account for determining whether the machine was used by FA or a 
predecessor at any time prior to its reacquisition by FA on March 30, 
2020. Accordingly, assuming all other requirements are met, FA's 
purchase price of the machine on March 30, 2020, qualifies for the 
additional first year depreciation deduction for FA for the 2020 taxable 
year under this section.
    (FF) Example 32. (1) The facts are the same as in Example 31 of 
paragraph (b)(3)(vii)(EE)(1) of this section, except that on November 1, 
2020, FB buys the machine from FA and places the machine in service. FB 
uses the machine in its trade or business for the remainder of 2020.
    (2) Because FA placed in service the machine on March 30, 2020, and 
disposed of it on November 1, 2020, FA's reacquisition of the machine on 
March 30, 2020, does not qualify for the additional first year 
depreciation deduction pursuant to paragraph (g)(1)(i) of this section.
    (3) During 2020, FB sold the machine to FA within 90 calendar days 
of placing the machine in service originally on January 10, 2020. After 
FB reacquired the machine on November 1,

[[Page 824]]

2020, FB did not dispose of the property during the remainder of 2020. 
Pursuant to paragraph (b)(3)(iii)(B)(4) of this section, FB's 
depreciable interest in the machine during that 90-day period is not 
taken into account for determining whether the machine was used by FB or 
a predecessor at any time prior to its reacquisition by FB on November 
1, 2020. Accordingly, assuming all other requirements are met, FB's 
purchase price of the machine on November 1, 2020, qualifies for the 
additional first year depreciation deduction for FB under this section.
    (GG) Example 33. (1) The facts are the same as in Example 32 of 
paragraph (b)(3)(vii)(FF)(1) of this section, except FB sells the 
machine to FC, an unrelated party, on December 31, 2020.
    (2) Because FB placed in service the machine on November 1, 2020, 
and disposed of it on December 31, 2020, FB's reacquisition of the 
machine on November 1, 2020, does not qualify for the additional first 
year depreciation deduction pursuant to paragraph (g)(1)(i) of this 
section.
    (3) FC's acquisition of the machine on December 31, 2020, satisfies 
the used property acquisition requirement of paragraph (b)(3)(iii)(A)(2) 
of this section. Accordingly, assuming all other requirements of this 
section are satisfied, FC's purchase price of the machine qualifies for 
the additional first year depreciation deduction under this section.
    (HH) Example 34. (1) In August 2017, FD, a calendar-year taxpayer, 
entered into a written binding contract with X for X to manufacture a 
machine for FD for use in its trade or business. Before September 28, 
2017, FD incurred more than 10 percent of the total cost of the machine. 
On February 8, 2020, X delivered the machine to FD and FD placed in 
service the machine. The machine is property described in section 
168(k)(2)(B) as in effect on the day before the date of the enactment of 
the Act. FD's entire unadjusted depreciable basis of the machine is 
attributable to the machine's manufacture before January 1, 2020. FD 
uses the safe harbor test in Sec.  1.168(k)-1(b)(4)(iii)(B)(2) to 
determine when manufacturing of the machine began. On March 26, 2020, FD 
sells the machine to FE for use in FE's trade or business. FE is a 
calendar-year taxpayer and is not related to FD. On November 7, 2020, FD 
buys the machine from FE and places in service the machine. FD uses the 
machine in its trade or business for the remainder of 2020.
    (2) Because FD incurred more than 10 percent of the cost of the 
machine before September 28, 2017, and FD uses the safe harbor test in 
Sec.  1.168(k)-1(b)(4)(iii)(B)(2) to determine when the manufacturing of 
the machine began, FD acquired the machine before September 28, 2017. If 
FD had not disposed of the machine on March 26, 2020, the cost of the 
machine would have qualified for the 30-percent additional first year 
depreciation deduction pursuant to section 168(k)(8), assuming all 
requirements are met under section 168(k)(2) as in effect on the day 
before the date of the enactment of the Act. However, because FD placed 
in service the machine on February 8, 2020, and disposed of it on March 
26, 2020, FD's acquisition of the machine on February 8, 2020, does not 
qualify for the additional first year depreciation deduction pursuant to 
Sec.  1.168(k)-1(f)(1)(i).
    (3) Because FE placed in service the machine on March 26, 2020, and 
disposed of it on November 7, 2020, FE's acquisition of the machine on 
March 26, 2020, does not qualify for the additional first year 
depreciation deduction pursuant to paragraph (g)(1)(i) of this section.
    (4) During 2020, FD sold the machine to FE within 90 calendar days 
of placing the machine in service originally on February 8, 2020. After 
FD reacquired the machine on November 7, 2020, FD did not dispose of the 
machine during the remainder of 2020. FD originally acquired this 
machine before September 28, 2017. As a result, paragraph 
(b)(3)(iii)(B)(4) of this section does not apply. Pursuant to paragraph 
(b)(3)(iii)(B)(1) of this section, the lookback period is 2015 through 
2019 and January 1, 2020, through November 6, 2020, to determine if FD 
had a depreciable interest in the machine when FD reacquired it on 
November 7, 2020. As a result, FD's depreciable interest in the machine 
during the period February 8, 2020, to March 26, 2020, is taken into 
account for determining whether the machine was used by FD or a 
predecessor

[[Page 825]]

at any time prior to its reacquisition by FD on November 7, 2020. 
Accordingly, the reacquisition of the machine by FD on November 7, 2020, 
does not qualify for the additional first year depreciation deduction.
    (II) Example 35. (1) In a series of related transactions, a father 
sells a machine to an unrelated individual on December 15, 2019, who 
sells the machine to the father's daughter on January 2, 2020, for use 
in the daughter's trade or business. Pursuant to paragraph 
(b)(3)(iii)(C)(1) of this section, a transferee tests its relationship 
with the transferor from which the transferee directly acquires the 
depreciable property, and with the original transferor of the 
depreciable property in the series. The relationship is tested when the 
transferee acquires, and immediately before the first transfer of, the 
depreciable property in the series. As a result, the following 
relationships are tested under section 179(d)(2)(A): The unrelated 
individual tests its relationship to the father as of December 15, 2019; 
and the daughter tests her relationship to the unrelated individual as 
of January 2, 2020, and December 15, 2019, and to the father as of 
January 2, 2020, and December 15, 2019.
    (2) Because the individual is not related to the father within the 
meaning of section 179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii) as of 
December 15, 2019, the individual's acquisition of the machine satisfies 
the used property acquisition requirement of paragraph (b)(3)(iii)(A)(2) 
of this section. Accordingly, assuming the unrelated individual placed 
the machine in service for use in its trade or business in 2019 and all 
other requirements of this section are satisfied, the unrelated 
individual's purchase price of the machine qualifies for the additional 
first year depreciation deduction under this section.
    (3) The individual and the daughter are not related parties within 
the meaning of section 179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii) as of 
January 2, 2020, or December 15, 2019. However, the father and his 
daughter are related parties within the meaning of section 179(d)(2)(A) 
and Sec.  1.179-4(c)(1)(ii) as of January 2, 2020, or December 15, 2019. 
Accordingly, the daughter's acquisition of the machine does not satisfy 
the used property acquisition requirements of paragraph (b)(3)(iii) of 
this section and is not eligible for the additional first year 
depreciation deduction.
    (JJ) Example 36. (1) The facts are the same as in Example 35 of 
paragraph (b)(3)(vii)(II)(1) of this section, except that instead of 
selling to an unrelated individual, the father sells the machine to his 
son on December 15, 2019, who sells the machine to his sister (the 
father's daughter) on January 2, 2020. Pursuant to paragraph 
(b)(3)(iii)(C)(1) of this section, a transferee tests its relationship 
with the transferor from which the transferee directly acquires the 
depreciable property, and with the original transferor of the 
depreciable property in the series. The relationship is tested when the 
transferee acquires, and immediately before the first transfer of, the 
depreciable property in the series. As a result, the following 
relationships are tested under section 179(d)(2)(A): The son tests his 
relationship to the father as of December 15, 2019; and the daughter 
tests her relationship to her brother as of January 2, 2020, and 
December 15, 2019, and to the father as of January 2, 2020, and December 
15, 2019.
    (2) Because the father and his son are related parties within the 
meaning of section 179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii) as of 
December 15, 2019, the son's acquisition of the machine does not satisfy 
the used property acquisition requirements of paragraph (b)(3)(iii) of 
this section. Accordingly, the son's acquisition of the machine is not 
eligible for the additional first year depreciation deduction.
    (3) The son and his sister are not related parties within the 
meaning of section 179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii) as of 
January 2, 2020, or December 15, 2019. However, the father and his 
daughter are related parties within the meaning of section 179(d)(2)(A) 
and Sec.  1.179-4(c)(1)(ii) as of January 2, 2020, or December 15, 2019. 
Accordingly, the daughter's acquisition of the machine does not satisfy 
the used property acquisition requirements of paragraph (b)(3)(iii) of 
this section and is not eligible for the additional first year 
depreciation deduction.

[[Page 826]]

    (KK) Example 37. (1) In June 2018, BA, an individual, bought and 
placed in service a new machine from an unrelated party for use in its 
trade or business. In a series of related transactions, BA sells the 
machine to BB and BB places it in service on October 1, 2019, BB sells 
the machine to BC and BC places it in service on December 1, 2019, and 
BC sells the machine to BD and BD places it in service on January 2, 
2020. BA and BB are related parties within the meaning of section 
179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii). BB and BC are related parties 
within the meaning of section 179(d)(2)(B) and Sec.  1.179-4(c)(1)(iii). 
BC and BD are not related parties within the meaning of section 
179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii), or section 179(d)(2)(B) and 
Sec.  1.179-4(c)(1)(iii). BA is not related to BC or to BD within the 
meaning of section 179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii). All parties 
are calendar-year taxpayers.
    (2) BA's purchase of the machine in June 2018 satisfies the original 
use requirement of paragraph (b)(3)(ii) of this section and, assuming 
all other requirements of this section are met, BA's purchase price of 
the machine qualifies for the additional first year depreciation 
deduction under this section.
    (3) Pursuant to paragraph (b)(3)(iii)(C)(1) of this section, a 
transferee tests its relationship with the transferor from which the 
transferee directly acquires the depreciable property, and with the 
original transferor of the depreciable property in the series. The 
relationship is tested when the transferee acquires, and immediately 
before the first transfer of, the depreciable property in the series. 
However, because BB placed in service and disposed of the machine in the 
same taxable year, BB is disregarded pursuant to paragraph 
(b)(3)(iii)(C)(2)(i) of this section. As a result, the following 
relationships are tested under section 179(d)(2)(A) and (B): BC tests 
its relationship to BA as of December 1, 2019, and October 1, 2019; and 
BD tests its relationship to BC as of January 2, 2020, and October 1, 
2019, and to BA as of January 2, 2020, and October 1, 2020.
    (4) Because BA is not related to BC within the meaning of section 
179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii) as of December 1, 2019, or 
October 1, 2019, BC's acquisition of the machine satisfies the used 
property acquisition requirement of paragraph (b)(3)(iii)(A)(2) of this 
section. Accordingly, assuming all other requirements of this section 
are satisfied, BC's purchase price of the machine qualifies for the 
additional first year depreciation deduction under this section.
    (5) Because BC is not related to BD and BA is not related to BD 
within the meaning of section 179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii), 
or section 179(d)(2)(B) and Sec.  1.179-4(c)(1)(iii) as of January 2, 
2020, or October 1, 2019, BD's acquisition of the machine satisfies the 
used property acquisition requirement of paragraph (b)(3)(iii)(A)(2) of 
this section. Accordingly, assuming all other requirements of this 
section are satisfied, BD's purchase price of the machine qualifies for 
the additional first year depreciation deduction under this section.
    (LL) Example 38. (1) In June 2018, CA, an individual, bought and 
placed in service a new machine from an unrelated party for use in his 
trade or business. In a series of related transactions, CA sells the 
machine to CB and CB places it in service on September 1, 2019, CB 
transfers the machine to CC in a transaction described in paragraph 
(g)(1)(iii) of this section and CC places it in service on November 1, 
2019, and CC sells the machine to CD and CD places it in service on 
January 2, 2020. CA and CB are not related parties within the meaning of 
section 179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii). CB and CC are related 
parties within the meaning of section 179(d)(2)(B) and Sec.  1.179-
4(c)(1)(iii). CB and CD are related parties within the meaning of 
section 179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii), or section 
179(d)(2)(B) and Sec.  1.179-4(c)(1)(iii). CC and CD are not related 
parties within the meaning of section 179(d)(2)(A) and Sec.  1.179-
4(c)(1)(ii), or section 179(d)(2)(B) and Sec.  1.179-4(c)(1)(iii). CA is 
not related to CC or to CD within the meaning of section 179(d)(2)(A) 
and Sec.  1.179-4(c)(1)(ii). All parties are calendar-year taxpayers.
    (2) CA's purchase of the machine in June 2018 satisfies the original 
use requirement of paragraph (b)(3)(ii) of this

[[Page 827]]

section and, assuming all other requirements of this section are met, 
CA's purchase price of the machine qualifies for the additional first 
year depreciation deduction under this section.
    (3) Pursuant to paragraph (b)(3)(iii)(C)(1) of this section, a 
transferee tests its relationship with the transferor from which the 
transferee directly acquires the depreciable property, and with the 
original transferor of the depreciable property in the series. The 
relationship is tested when the transferee acquires, and immediately 
before the first transfer of, the depreciable property in the series. 
However, because CB placed in service and transferred the machine in the 
same taxable year in a transaction described in paragraph (g)(1)(iii) of 
this section, the section 168(i)(7) transaction between CB and CC is 
disregarded pursuant to paragraph (b)(3)(iii)(C)(2)(iii) of this 
section. As a result, the following relationships are tested under 
section 179(d)(2)(A) and (B): CB tests its relationship to CA as of 
September 1, 2019; and CD tests its relationship to CB, CC, and CA as of 
January 2, 2020, and September 1, 2019.
    (4) Because CA is not related to CB within the meaning of section 
179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii) as of September 1, 2019, CB's 
acquisition of the machine satisfies the used property acquisition 
requirement of paragraph (b)(3)(iii)(A)(2) of this section. Accordingly, 
assuming all other requirements of this section are satisfied, CB's 
purchase price of the machine qualifies for the additional first year 
depreciation deduction under this section. Pursuant to paragraph 
(g)(1)(iii) of this section, CB is allocated 2/12 of its 100-percent 
additional first year depreciation deduction for the machine, and CC is 
allocated the remaining portion of CB's 100-percent additional first 
year depreciation deduction for the machine.
    (5) CC is not related to CD and CA is not related to CD within the 
meaning of section 179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii), or section 
179(d)(2)(B) and Sec.  1.179-4(c)(1)(iii) as of January 2, 2020, or 
September 1, 2019. However, CB and CD are related parties within the 
meaning of section 179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii), or section 
179(d)(2)(B) and Sec.  1.179-4(c)(1)(iii) as of January 2, 2020, or 
September 1, 2019. Accordingly, CD's acquisition of the machine does not 
satisfy the used property acquisition requirements of paragraph 
(b)(3)(iii) of this section and is not eligible for the additional first 
year depreciation deduction.
    (MM) Example 39. (1) In a series of related transactions, on January 
2, 2018, DA, a corporation, bought and placed in service a new machine 
from an unrelated party for use in its trade or business. As part of the 
same series, DB purchases 100 percent of the stock of DA on January 2, 
2019, and such stock acquisition meets the requirements of section 
1504(a)(2). DB and DA were not related prior to the acquisition within 
the meaning of section 179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii) or 
section 179(d)(2)(B) and Sec.  1.179-4(c)(1)(iii). Immediately after 
acquiring the DA stock, and DB liquidates DA under section 331. In the 
liquidating distribution, DB receives the machine that was acquired by 
DA on January 2, 2018. As part of the same series, on March 1, 2020, DB 
sells the machine to DC and DC places it in service. Throughout the 
series, DC is not related to DB or DA within the meaning of section 
179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii) or section 179(d)(2)(B) and 
Sec.  1.179-4(c)(1)(iii).
    (2) DA's purchase of the machine on January 2, 2018, satisfies the 
original use requirement of paragraph (b)(3)(ii) of this section and, 
assuming all other requirements of this section are met, DA's purchase 
price of the machine qualifies for the additional first year 
depreciation deduction under this section.
    (3) Pursuant to paragraph (b)(3)(iii)(C)(1) of this section, a 
transferee tests its relationship with the transferor from which the 
transferee directly acquires the depreciable property, and with the 
original transferor of the depreciable property in the series. The 
relationship is tested when the transferee acquires, and immediately 
before the first transfer of, the depreciable property in the series. 
Although DA is no longer in existence as of the date DC acquires the 
machine, pursuant to paragraph (b)(3)(iii)(C)(2)(vi) of this section, DA 
is deemed to be in existence at the time

[[Page 828]]

of each transfer for purposes of testing relationships under paragraph 
(b)(3)(iii)(C)(1). As a result, the following relationships are tested 
under section 179(d)(2)(A) and (B): DB tests its relationship to DA as 
of January 2, 2019, and January 2, 2018; and DC tests its relationship 
to DB and DA as of March 1, 2020, and January 2, 2018.
    (4) Because DB acquired the machine in a series of related 
transactions in which DB acquired stock, meeting the requirements of 
section 1504(a)(2), of DA followed by a liquidation of DA under section 
331, the relationship of DB and DA created thereof is disregarded for 
purposes of testing the relationship pursuant to paragraph 
(b)(3)(iii)(C)(2)(v) of this section. Therefore, DA is not related to DB 
within the meaning of section 179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii) 
or section 179(d)(2)(B) and Sec.  1.179-4(c)(1)(iii) as of January 2, 
2019, or January 2, 2018, and DB's acquisition of the machine satisfies 
the used property acquisition requirement of paragraph (b)(3)(iii)(A)(2) 
of this section. Accordingly, assuming all other requirements of this 
section are satisfied, DB's depreciable basis of the machine as a result 
of the liquidation of DA qualifies for the additional first year 
depreciation deduction under this section.
    (5) Because DC is not related to DB or DA within the meaning of 
section 179(d)(2)(A) and Sec.  1.179-4(c)(1)(ii) or section 179(d)(2)(B) 
and Sec.  1.179-4(c)(1)(iii) as of March 1, 2020, or January 2, 2018, DC 
's acquisition of the machine satisfies the used property acquisition 
requirements of paragraph (b)(3)(iii)(A)(2) of this section. 
Accordingly, assuming all other requirements of this section are 
satisfied, DC 's purchase price of the machine qualifies for the 
additional first year depreciation deduction.
    (NN) Example 40. (1) Pursuant to a series of related transactions, 
on January 2, 2018, EA bought and placed in service a new machine from 
an unrelated party for use in its trade or business. As part of the same 
series, EA sells the machine to EB and EB places it in service on 
January 2, 2019. As part of the same series, EB sells the machine to EC 
and EC places it in service on January 2, 2020. Throughout the series, 
EA is not related to EB or EC within the meaning of section 179(d)(2)(B) 
and Sec.  1.179-4(c)(1)(iii). EB and EC were related parties within the 
meaning of section 179(d)(2)(B) and Sec.  1.179-4(c)(1)(iii) until July 
1, 2019, at which time, they ceased to be related.
    (2) EA's purchase of the machine on January 2, 2018, satisfies the 
original use requirement of paragraph (b)(3)(ii) of this section and, 
assuming all other requirements of this section are met, EA's purchase 
price of the machines qualifies for the additional first year 
depreciation deduction under this section.
    (3) Pursuant to paragraph (b)(3)(iii)(C)(1) of this section, a 
transferee tests its relationship with the transferor from which the 
transferee directly acquires the depreciable property, and with the 
original transferor of the depreciable property in the series. The 
relationship is tested when the transferee acquires, and immediately 
before the first transfer of, the depreciable property in the series. As 
a result, the following relationships are tested under section 
179(d)(2)(A) and (B): EB tests its relationship to EA as of January 2, 
2019, and January 2, 2018; and EC tests its relationship to EA and EB as 
of January 2, 2020, and January 2, 2018.
    (4) Because EA is not related to EB within the meaning of section 
179(d)(2)(B) and Sec.  1.179-4(c)(1)(iii) as of January 2, 2019, or 
January 2, 2018, EB's acquisition of the machine satisfies the used 
property acquisition requirement of paragraph (b)(3)(iii)(A)(2) of this 
section. Accordingly, assuming all other requirements of this section 
are satisfied, EB's purchase price of the machine qualifies for the 
additional first year depreciation deduction under this section.
    (5) EC and EA are not related parties within the meaning of section 
179(d)(2)(B) and Sec.  1.179-4(c)(1)(iii) as of January 2, 2020, or 
January 2, 2018. Within the meaning of section 179(d)(2)(B) and Sec.  
1.179-4(c)(1)(iii), EC is not related to EB as of January 2, 2020; 
however, EC is related to EB as of January 2, 2018. Accordingly, EC 's 
acquisition of the machine does not satisfy

[[Page 829]]

the used property acquisition requirement of paragraph (b)(3)(iii) of 
this section and is not eligible for the additional first year 
depreciation deduction.
    (OO) Example 41. (1) The facts are the same as in Example 40 of 
paragraph (b)(3)(vii)(NN)(1) of this section, except that instead of 
selling to EC, EB sells the machine to EE, and EE places in service on 
January 2, 2020, and EE sells the machine to EC and EC places in service 
on January 2, 2021. EE was not in existence until July 2019 and is not 
related to EA or EB.
    (2) EA's purchase of the machine on January 2, 2018, satisfies the 
original use requirement of paragraph (b)(3)(ii) of this section and, 
assuming all other requirements of this section are met, EA's purchase 
price of the machine qualifies for the additional first year 
depreciation deduction under this section.
    (3) Pursuant to paragraph (b)(3)(iii)(C)(1) of this section, a 
transferee tests its relationship with the transferor from which the 
transferee directly acquires the depreciable property, and with the 
original transferor of the depreciable property in the series. The 
relationship is tested when the transferee acquires, and immediately 
before the first transfer of, the depreciable property in the series. 
However, because EE was not in existence immediately prior to the first 
transfer of the depreciable property in the series, EC tests its 
relationship with EB and EA pursuant to paragraph (b)(3)(iii)(C)(2)(vii) 
of this section. As a result, the following relationships are tested 
under section 179(d)(2)(A) and (B): EB tests its relationship to EA as 
of January 2, 2019, and January 2, 2018; EE tests its relationship to EA 
and EB as of January 2, 2020, and January 2, 2018; and EC tests its 
relationship to EA and EB as of January 2, 2021, and January 2, 2018.
    (4) Because EA is not related to EB within the meaning of section 
179(d)(2)(B) and Sec.  1.179-4(c)(1)(iii) as of January 2, 2019, or 
January 2, 2018, EB's acquisition of the machine satisfies the used 
property acquisition requirement of paragraph (b)(3)(iii)(A)(2) of this 
section. Accordingly, assuming all other requirements of this section 
are satisfied, EB's purchase price of the machine qualifies for the 
additional first year depreciation deduction under this section.
    (5) Because EE is not related to EA or EB within the meaning of 
section 179(d)(2)(B) and Sec.  1.179-4(c)(1)(iii) as of January 2, 2020, 
or January 2, 2018, EE's acquisition of the machine satisfies the used 
property acquisition requirement of paragraph (b)(3)(iii)(A)(2) of this 
section. Accordingly, assuming all other requirements of this section 
are satisfied, EE 's purchase price of the machine qualifies for the 
additional first year depreciation deduction under this section.
    (6) Within the meaning of section 179(d)(2)(B) and Sec.  1.179-
4(c)(1)(iii), EC is not related to EA as of January 2, 2021, or January 
2, 2018; however, EC is related to EB as of January 2, 2018. 
Accordingly, EC 's acquisition of the machine does not satisfy the used 
property acquisition requirement of paragraph (b)(3)(iii) of this 
section and is not eligible for the additional first year depreciation 
deduction.
    (4) Placed-in-service date--(i) In general. Depreciable property 
will meet the requirements of this paragraph (b)(4) if the property is 
placed in service by the taxpayer for use in its trade or business or 
for production of income after September 27, 2017; and, except as 
provided in paragraphs (b)(2)(i)(A) and (D) of this section, before 
January 1, 2027, or, in the case of property described in section 
168(k)(2)(B) or (C), before January 1, 2028.
    (ii) Specified plant. If the taxpayer has properly made an election 
to apply section 168(k)(5) for a specified plant, the requirements of 
this paragraph (b)(4) are satisfied only if the specified plant is 
planted before January 1, 2027, or is grafted before January 1, 2027, to 
a plant that has already been planted, by the taxpayer in the ordinary 
course of the taxpayer's farming business, as defined in section 
263A(e)(4).
    (iii) Qualified film, television, or live theatrical production--(A) 
Qualified film or television production. For purposes of this paragraph 
(b)(4), a qualified film or television production is treated as placed 
in service at the time of initial release or broadcast as defined under 
Sec.  1.181-1(a)(7). The taxpayer that places

[[Page 830]]

in service a qualified film or television production must be the owner, 
as defined in Sec.  1.181-1(a)(2), of the qualified film or television 
production.
    (B) Qualified live theatrical production. For purposes of this 
paragraph (b)(4), a qualified live theatrical production is treated as 
placed in service at the time of the initial live staged performance. 
The taxpayer that places in service a qualified live theatrical 
production must be the owner, as defined in paragraph (b)(2)(i)(F) of 
this section and in Sec.  1.181-1(a)(2), of the qualified live 
theatrical production.
    (iv) Syndication transaction. If new property is acquired and placed 
in service by a lessor, or if used property is acquired and placed in 
service by a lessor and the lessor and any predecessor did not 
previously have a depreciable interest in the used property, and the 
property 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 for purposes of sections 167 and 168, and Sec. Sec.  1.46-
3(d) and 1.167(a)-11(e)(1).
    (v) Technical termination of a partnership. For purposes of this 
paragraph (b)(4), in the case of a technical termination of a 
partnership under section 708(b)(1)(B) occurring in a taxable year 
beginning before January 1, 2018, qualified property placed in service 
by the terminated partnership during the taxable year of termination is 
treated as originally placed in service by the new partnership on the 
date the qualified property is contributed by the terminated partnership 
to the new partnership.
    (vi) Section 168(i)(7) transactions. For purposes of this paragraph 
(b)(4), if qualified property is transferred in a transaction described 
in section 168(i)(7) in the same taxable year that the qualified 
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. In the case of 
multiple transfers of qualified 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.
    (5) Acquisition of property--(i) In general. This paragraph (b)(5) 
provides rules for the acquisition requirements in section 13201(h) of 
the Act. These rules apply to all property, including self-constructed 
property or property described in section 168(k)(2)(B) or (C).
    (ii) Acquisition date--(A) In general. Except as provided in 
paragraph (b)(5)(vi) of this section, depreciable property will meet the 
requirements of this paragraph (b)(5) if the property is acquired by the 
taxpayer after September 27, 2017, or is acquired by the taxpayer 
pursuant to a written binding contract entered into by the taxpayer 
after September 27, 2017. Property that is manufactured, constructed, or 
produced for the taxpayer by another person under a written binding 
contract 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 not acquired pursuant to a 
written binding contract but is considered to be self-constructed 
property under this paragraph (b)(5). For determination of acquisition 
date, see paragraph (b)(5)(ii)(B) of this section for property acquired 
pursuant to a written binding contract, paragraph (b)(5)(iv) of this 
section for self-constructed property, and paragraph (b)(5)(v) of this 
section for property not acquired pursuant to a written binding 
contract.
    (B) Determination of acquisition date for property acquired pursuant 
to a written binding contract. Except as provided in paragraphs 
(b)(5)(vi) and (vii) of this

[[Page 831]]

section, the acquisition date of property that the taxpayer acquired 
pursuant to a written binding contract is the later of--
    (1) The date on which the contract was entered into;
    (2) The date on which the contract is enforceable under State law;
    (3) If the contract has one or more cancellation periods, the date 
on which all cancellation periods end. For purposes of this paragraph 
(b)(5)(ii)(B)(3), a cancellation period is the number of days stated in 
the contract for any party to cancel the contract without penalty; or
    (4) If the contract has one or more contingency clauses, the date on 
which all conditions subject to such clauses are satisfied. For purposes 
of this paragraph (b)(5)(ii)(B)(4), a contingency clause is one that 
provides for a condition (or conditions) or action (or actions) that is 
within the control of any party or a predecessor.
    (iii) Definition of binding contract--(A) In general. Except as 
provided in paragraph (b)(5)(iii)(G) of this section, 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, 
any 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. If a contract has multiple 
provisions that limit damages, only the provision with the highest 
damages is taken into account in determining whether the contract limits 
damages. Also, 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 did not 
contain a 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. Except as provided in paragraph (b)(5)(iii)(G) of 
this section, 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 if 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) Letter of intent. A letter of intent for an acquisition is not a 
binding contract.
    (E) 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 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.
    (F) 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)(5), 
the component does not qualify for the additional first year 
depreciation deduction under this section.
    (G) Acquisition of a trade or business or an entity. A contract to 
acquire all or substantially all of the assets of a

[[Page 832]]

trade or business or to acquire an entity (for example, a corporation, a 
partnership, or a limited liability company) is binding if it is 
enforceable under State law against the parties to the contract. The 
presence of a condition outside the control of the parties, including, 
for example, regulatory agency approval, will not prevent the contract 
from being a binding contract. Further, the fact that insubstantial 
terms remain to be negotiated by the parties to the contract, or that 
customary conditions remain to be satisfied, does not prevent the 
contract from being a binding contract. This paragraph (b)(5)(iii)(G) 
also applies to a contract for the sale of the stock of a corporation 
that is treated as an asset sale as a result of an election under 
section 338 or under section 336(e) made for a disposition described in 
Sec.  1.336-2(b)(1).
    (iv) 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)(5)(ii) of this section are treated as 
met for the property if the taxpayer begins manufacturing, constructing, 
or producing the property after September 27, 2017. Property that is 
manufactured, constructed, or produced for the taxpayer by another 
person under a written binding contract, as defined in paragraph 
(b)(5)(iii) 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)(5)(iii) of this section, before September 28, 2017, with 
another person to manufacture, construct, or produce property and the 
manufacture, construction, or production of this property begins after 
September 27, 2017, the acquisition rules in paragraph (b)(5)(ii) of 
this section are met.
    (B) When does manufacture, construction, or production begin--(1) In 
general. For purposes of paragraph (b)(5)(iv)(A) 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 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 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)(5)(iv)(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)(5)(iv)(B)(2). Physical work of a significant nature will be 
considered to begin at the time 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 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

[[Page 833]]

paragraph (b)(5)(iv)(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)(5)(iv)(B)(2) by filing a 
Federal 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)(5)(iv)(B)(2).
    (C) Components of self-constructed property--(1) Acquired 
components. If a binding contract, as defined in paragraph (b)(5)(iii) 
of this section, to acquire a component does not satisfy the 
requirements of paragraph (b)(5)(ii) of this section, the component does 
not qualify for the additional first year depreciation deduction under 
this section. A binding contract described in the preceding sentence 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)(5)(iv)(A) of this section. 
Accordingly, the unadjusted depreciable basis of the larger self-
constructed property that is eligible for the additional first year 
depreciation deduction under this section, 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)(5)(ii) of this section. If the manufacture, construction, or 
production of the larger self-constructed property begins before 
September 28, 2017, the larger self-constructed property and any 
acquired components related to the larger self-constructed property do 
not qualify for the additional first year depreciation deduction under 
this section, except as provided in paragraph (c) of this section. If a 
binding contract to acquire the component is entered into after 
September 27, 2017, but the manufacture, construction, or production of 
the larger self-constructed property does not begin before January 1, 
2027, the component qualifies for the additional first year depreciation 
deduction under this section, 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 this 
paragraph (b)(5)(iv), the component does not qualify for the additional 
first year depreciation deduction under this section. However, if the 
manufacture, construction, or production of a component does not satisfy 
the requirements of this paragraph (b)(5)(iv), but the manufacture, 
construction, or production of the larger self-constructed property 
satisfies the requirements of this paragraph (b)(5)(iv), the larger 
self-constructed property qualifies for the additional first year 
depreciation deduction under this section, assuming all other 
requirements are met, even though the component does not qualify for the 
additional first year depreciation deduction under this section. 
Accordingly, the unadjusted depreciable basis of the larger self-
constructed property that is eligible for the additional first year 
depreciation deduction under this section, assuming all other 
requirements are met, must not include the unadjusted depreciable basis 
of any component that does not qualify for the additional first year 
depreciation deduction under this section. If the manufacture, 
construction, or production of the larger self-constructed property 
began before September 28, 2017, the larger self-constructed property 
and any self-constructed components related to the larger self-
constructed property do not qualify for the additional first year 
depreciation deduction under this section, except as provided in 
paragraph (c) of this section. If the manufacture, construction, or 
production of a component begins after September 27, 2017, but the 
manufacture, construction, or production of the larger self-constructed 
property does not begin before January 1, 2027, the component qualifies 
for the additional first year depreciation deduction under this section, 
assuming all other requirements are met, but the larger self-constructed 
property does not.
    (v) Determination of acquisition date for property not acquired 
pursuant to a written binding contract. Except as provided in paragraphs 
(b)(5)(iv), (vi), and (vii) of this section, the acquisition

[[Page 834]]

date of property that the taxpayer acquires pursuant to a contract that 
does not meet the definition of a written binding contract in paragraph 
(b)(5)(iii) of this section, is the date on which the taxpayer paid, in 
the case of a cash basis taxpayer, or incurred, in the case of an 
accrual 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 and designing, securing financing, exploring, or 
researching. The preceding sentence also applies to property that is 
manufactured, constructed, or produced for the taxpayer by another 
person under a written contract that does not meet the definition of a 
binding contract in paragraph (b)(5)(iii) of this section, and 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. This paragraph (b)(5)(v) does not apply to an 
acquisition described in paragraph (b)(5)(iii)(G) of this section.
    (vi) Qualified film, television, or live theatrical production--(A) 
Qualified film or television production. For purposes of section 
13201(h)(1)(A) of the Act, a qualified film or television production is 
treated as acquired on the date principal photography commences.
    (B) Qualified live theatrical production. For purposes of section 
13201(h)(1)(A) of the Act, a qualified live theatrical production is 
treated as acquired on the date when all of the necessary elements for 
producing the live theatrical production are secured. These elements may 
include a script, financing, actors, set, scenic and costume designs, 
advertising agents, music, and lighting.
    (vii) Specified plant. If the taxpayer has properly made an election 
to apply section 168(k)(5) for a specified plant, the requirements of 
this paragraph (b)(5) are satisfied if the specified plant is planted 
after September 27, 2017, or is grafted after September 27, 2017, to a 
plant that has already been planted, by the taxpayer in the ordinary 
course of the taxpayer's farming business, as defined in section 
263A(e)(4).
    (viii) Examples. The application of this paragraph (b)(5) is 
illustrated by the following examples. Unless the facts specifically 
indicate otherwise, assume that the parties are not related within the 
meaning of section 179(d)(2)(A) or (B) and Sec.  1.179-4(c), paragraph 
(c) of this section does not apply, and the parties do not have 
predecessors:
    (A) Example 1. On September 1, 2017, BB, a corporation, entered into 
a written agreement with CC, 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)(5)(iii)(E) 
of this section.
    (B) Example 2. The facts are the same as in Example 1 of paragraph 
(b)(5)(viii)(A) of this section. On December 1, 2017, BB placed a 
purchase order with CC 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 BB with CC on 
December 1, 2017, is a binding contract pursuant to paragraph 
(b)(5)(iii)(E) of this section. Accordingly, assuming all other 
requirements are met, the cost of the 20 lamps qualifies for the 100-
percent additional first year depreciation deduction.
    (C) Example 3. The facts are the same as in Example 1 of paragraph 
(b)(5)(viii)(A) of this section, except that the written agreement 
between BB and CC 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)(5)(iii)(E) of this section. However, 
because the agreement was entered into before September 28, 2017, no 
lamp acquired by BB under this contract qualifies for the 100-percent 
additional first year depreciation deduction.
    (D) Example 4. On September 1, 2017, DD began constructing a retail 
motor fuels outlet for its own use. On November 1, 2018, DD ceases 
construction of the retail motor fuels outlet prior to

[[Page 835]]

its completion. Between September 1, 2017, and November 1, 2018, DD 
incurred $3,000,000 of expenditures for the construction of the retail 
motor fuels outlet. On May 1, 2019, DD resumed construction of the 
retail motor fuels outlet and completed its construction on August 31, 
2019. Between May 1, 2019, and August 31, 2019, DD incurred another 
$1,600,000 of expenditures to complete the construction of the retail 
motor fuels outlet and, on September 1, 2019, DD placed the retail motor 
fuels outlet in service. None of DD's total expenditures of $4,600,000 
qualify for the 100-percent additional first year depreciation deduction 
because, pursuant to paragraph (b)(5)(iv)(A) of this section, DD began 
constructing the retail motor fuels outlet before September 28, 2017.
    (E) Example 5. The facts are the same as in Example 4 of paragraph 
(b)(5)(viii)(D) of this section except that DD began constructing the 
retail motor fuels outlet for its own use on October 1, 2017, and DD 
incurred the $3,000,000 between October 1, 2017, and November 1, 2018. 
DD's total expenditures of $4,600,000 qualify for the 100-percent 
additional first year depreciation deduction because, pursuant to 
paragraph (b)(5)(iv)(A) of this section, DD began constructing the 
retail motor fuels outlet after September 27, 2017, and DD placed the 
retail motor fuels outlet in service on September 1, 2019. Accordingly, 
assuming all other requirements are met, the additional first year 
depreciation deduction for the retail motor fuels outlet will be 
$4,600,000, computed as $4,600,000 multiplied by 100 percent.
    (F) Example 6. On August 15, 2017, EE, an accrual basis taxpayer, 
entered into a written binding contract with FF to manufacture an 
aircraft described in section 168(k)(2)(C) for use in EE's trade or 
business. FF begins to manufacture the aircraft on October 1, 2017. The 
completed aircraft is delivered to EE on February 15, 2018, at which 
time EE incurred the total cost of the aircraft. EE places the aircraft 
in service on March 1, 2018. Pursuant to paragraphs (b)(5)(ii)(A) and 
(b)(5)(iv)(A) of this section, the aircraft is considered to be 
manufactured by EE. Because EE began manufacturing the aircraft after 
September 27, 2017, the aircraft qualifies for the 100-percent 
additional first year depreciation deduction, assuming all other 
requirements are met.
    (G) Example 7. On June 1, 2017, HH entered into a written binding 
contract with GG to acquire a new component part of property that is 
being constructed by HH for its own use in its trade or business. HH 
commenced construction of the property in November 2017, and placed the 
property in service in November 2018. Because HH entered into a written 
binding contract to acquire a component part prior to September 28, 
2017, pursuant to paragraphs (b)(5)(ii) and (b)(5)(iv)(C)(1) of this 
section, the component part does not qualify for the 100-percent 
additional first year depreciation deduction. However, pursuant to 
paragraphs (b)(5)(iv)(A) and (b)(5)(iv)(C)(1) of this section, the 
property constructed by HH will qualify for the 100-percent additional 
first year depreciation deduction, because construction of the property 
began after September 27, 2017, assuming all other requirements are met. 
Accordingly, the unadjusted depreciable basis of the property that is 
eligible for the 100-percent additional first year depreciation 
deduction must not include the unadjusted depreciable basis of the 
component part.
    (H) Example 8. The facts are the same as in Example 7 of paragraph 
(b)(5)(viii)(G) of this section except that HH entered into the written 
binding contract with GG to acquire the new component part on September 
30, 2017, and HH commenced construction of the property on August 1, 
2017. Pursuant to paragraphs (b)(5)(iv)(A) and (C) of this section, 
neither the property constructed by HH nor the component part will 
qualify for the 100-percent additional first year depreciation 
deduction, because HH began construction of the property prior to 
September 28, 2017.
    (I) Example 9. On September 1, 2017, II acquired and placed in 
service equipment. On January 15, 2018, II sells the equipment to JJ and 
leases the property back from JJ in a sale-leaseback transaction. 
Pursuant to paragraph (b)(5)(ii) of this section, II's cost of the 
equipment does not qualify for the 100-

[[Page 836]]

percent additional first year depreciation deduction because II acquired 
the equipment prior to September 28, 2017. However, JJ acquired used 
equipment from an unrelated party after September 27, 2017, and, 
assuming all other requirements are met, JJ's cost of the used equipment 
qualifies for the 100-percent additional first year depreciation 
deduction for JJ.
    (J) Example 10. On July 1, 2017, KK began constructing property for 
its own use in its trade or business. KK placed this property in service 
on September 15, 2017. On January 15, 2018, KK sells the property to LL 
and leases the property back from LL in a sale-leaseback transaction. 
Pursuant to paragraph (b)(5)(iv) of this section, KK's cost of the 
property does not qualify for the 100-percent additional first year 
depreciation deduction because KK began construction of the property 
prior to September 28, 2017. However, LL acquired used property from an 
unrelated party after September 27, 2017, and, assuming all other 
requirements are met, LL's cost of the used property qualifies for the 
100-percent additional first year depreciation deduction for LL.
    (K) Example 11. MM, a calendar year taxpayer, is engaged in a trade 
or business described in section 163(j)(7)(A)(iv). In December 2018, MM 
began constructing a new electric generation power plant for its own 
use. MM placed in service this new power plant, including all component 
parts, in 2020. Even though MM began constructing the power plant after 
September 27, 2017, none of MM's total expenditures of the power plant 
qualify for the additional first year depreciation deduction under this 
section because, pursuant to paragraph (b)(2)(ii)(F) of this section, 
the power plant is property that is primarily used in a trade or 
business described in section 163(j)(7)(A)(iv) and the power plant was 
placed in service in MM's taxable year beginning after 2017.
    (c) Election for components of larger self-constructed property for 
which the manufacture, construction, or production begins before 
September 28, 2017--(1) In general. A taxpayer may elect to treat any 
acquired or self-constructed component, as described in paragraph (c)(3) 
of this section, of the larger self-constructed property, as described 
in paragraph (c)(2) of this section, as being eligible for the 
additional first year depreciation deduction under this section, 
assuming all requirements of section 168(k) and this section are met. 
The taxpayer may make this election for one or more such components.
    (2) Eligible larger self-constructed property--(i) In general. 
Solely for purposes of this paragraph (c), a larger self-constructed 
property is property that is manufactured, constructed, or produced by 
the taxpayer for its own use in its trade or business or production of 
income. Solely for purposes of this paragraph (c), property that is 
manufactured, constructed, or produced for the taxpayer by another 
person under a written binding contract, as defined in paragraph 
(b)(5)(iii) of this section, or under a written contract that does not 
meet the definition of a binding contract in paragraph (b)(5)(iii) 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 production of income is considered to be 
manufactured, constructed, or produced by the taxpayer. Except as 
provided in paragraph (c)(2)(iv) of this section, such larger self-
constructed property must be property--
    (A) That is described in paragraph (b)(2)(i)(A), (B), (C), or (D) of 
this section. Solely for purposes of the preceding sentence, the 
requirement that property has to be acquired after September 27, 2017, 
is disregarded;
    (B) That meets the requirements under paragraph (b) of this section, 
determined without regard to the acquisition date requirement in 
paragraph (b)(5) of this section; and
    (C) For which the taxpayer begins the manufacture, construction, or 
production before September 28, 2017.
    (ii) Residential rental property or nonresidential real property. If 
the taxpayer constructs, manufactures, or produces residential rental 
property or nonresidential real property, as defined in section 
168(e)(2), or an improvement to such property, for use in its trade or 
business or production of income, all

[[Page 837]]

property that is constructed, manufactured, or produced as part of such 
residential rental property, nonresidential real property, or 
improvement, as applicable, and that is described in paragraph 
(c)(2)(i)(A) of this section is the larger self-constructed property for 
purposes of applying the rules in this paragraph (c).
    (iii) Beginning of manufacturing, construction, or production. 
Solely for purposes of paragraph (c)(2)(i)(C) of this section, the 
determination of when manufacture, construction, or production of the 
larger self-constructed property begins is made in accordance with the 
rules in paragraph (b)(5)(iv)(B) of this section if the larger self-
constructed property is manufactured, constructed, or produced by the 
taxpayer for its own use in its trade or business or production of 
income, or is manufactured, constructed, or produced for the taxpayer by 
another person under a written binding contract, as defined in paragraph 
(b)(5)(iii) 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 production of income. If the larger 
self-constructed property is manufactured, constructed, or produced for 
the taxpayer by another person under a written contract that does not 
meet the definition of a binding contract in paragraph (b)(5)(iii) 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 production of income, the determination of when 
manufacture, construction, or production of the larger self-constructed 
property begins is made in accordance with the rules in paragraph 
(b)(5)(v) of this section. If the taxpayer enters into a written binding 
contract, as defined in paragraph (b)(5)(iii) of this section, before 
September 28, 2017, with another person to manufacture, construct, or 
produce the larger self-constructed property and the manufacture, 
construction, or production of this property begins after September 27, 
2017, as determined under paragraph (b)(5)(iv)(B) of this section, this 
paragraph (c) does not apply. If the taxpayer enters into a written 
contract that does not meet the definition of a binding contract in 
paragraph (b)(5)(iii) of this section before September 28, 2017, with 
another person to manufacture, construct, or produce the larger self-
constructed property and the manufacture, construction, or production of 
this property begins after September 27, 2017, as determined under 
paragraph (b)(5)(v) of this section, this paragraph (c) does not apply.
    (iv) Exception. This paragraph (c) does not apply to any larger 
self-constructed property that is included in a class of property for 
which the taxpayer made an election under section 168(k)(7) (formerly 
section 168(k)(2)(D)(iii)) not to deduct the additional first year 
depreciation deduction.
    (3) Eligible components--(i) In general. Solely for purposes of this 
paragraph (c), a component of the larger self-constructed property, as 
described in paragraph (c)(2) of this section, must be qualified 
property under section 168(k)(2) and paragraph (b) of this section. 
Solely for purposes of the preceding sentence, a component will satisfy 
the acquisition date requirement in paragraph (b)(5) of this section if 
it satisfies the requirements in paragraph (c)(3)(ii) or (iii) of this 
section, as applicable.
    (ii) Acquired components. If a component of the larger self-
constructed property is acquired pursuant to a written binding contract, 
as defined in paragraph (b)(5)(iii) of this section, the component must 
be acquired by the taxpayer after September 27, 2017, as determined 
under the rules in paragraph (b)(5)(ii)(B) of this section. If a 
component of the larger self-constructed property is acquired pursuant 
to a written contract that does not meet the definition of a binding 
contract in paragraph (b)(5)(iii) of this section, the component must be 
acquired by the taxpayer after September 27, 2017, as determined under 
the rules in paragraph (b)(5)(v) of this section.
    (iii) Self-constructed components. The manufacture, construction, or 
production of a component of a larger self-constructed property must 
begin after September 27, 2017. The determination of when manufacture, 
construction, or

[[Page 838]]

production of the component begins is made in accordance with the rules 
in--
    (A) Paragraph (b)(5)(iv)(B) of this section if the component is 
manufactured, constructed, or produced by the taxpayer for its own use 
in its trade or business or for its production of income, or is 
manufactured, constructed, or produced for the taxpayer by another 
person under a written binding contract, as defined in paragraph 
(b)(5)(iii) of this section, that is entered into prior to the 
manufacture, construction, or production of the component for use by the 
taxpayer in its trade or business or for its production of income; or
    (B) Paragraph (b)(5)(v) of this section if the component is 
manufactured, constructed, or produced for the taxpayer by another 
person under a written contract that does not meet the definition of a 
binding contract in paragraph (b)(5)(iii) of this section, that is 
entered into prior to the manufacture, construction, or production of 
the component for use by the taxpayer in its trade or business or for 
its production of income.
    (4) Special rules--(i) Installation costs. If the taxpayer pays, in 
the case of a cash basis taxpayer, or incurs, in the case of an accrual 
basis taxpayer, costs, including labor costs, to install a component of 
the larger self-constructed property, as described in paragraph (c)(2) 
of this section, such costs are eligible for the additional first year 
depreciation under this section, assuming all requirements are met, only 
if the component being installed meets the requirements in paragraph 
(c)(3) of this section.
    (ii) Property described in section 168(k)(2)(B). The rules in 
paragraph (e)(1)(iii) of this section apply for determining the 
unadjusted depreciable basis, as defined in Sec.  1.168(b)-1(a)(3), of 
larger self-constructed property described in paragraph (c)(2) of this 
section and in section 168(k)(2)(B).
    (5) Computation of additional first year depreciation deduction--(i) 
Election is made. Before determining the allowable additional first year 
depreciation deduction for the larger self-constructed property, as 
described in paragraph (c)(2) of this section, for which the taxpayer 
makes the election specified in this paragraph (c) for one or more 
components of such property, the taxpayer must determine the portion of 
the unadjusted depreciable basis, as defined in Sec.  1.168(b)-1(a)(3), 
of the larger self-constructed property, including all components, 
attributable to the component that meets the requirements of paragraphs 
(c)(3) and (c)(4)(i) of this section (component basis). The additional 
first year depreciation deduction for the component basis is determined 
by multiplying such component basis by the applicable percentage for the 
placed-in-service year of the larger self-constructed property. The 
additional first year depreciation deduction, if any, for the remaining 
unadjusted depreciable basis of the larger self-constructed property, as 
described in paragraph (c)(2) of this section, is determined under 
section 168(k), as in effect on the day before the date of the enactment 
of the Act, and section 168(k)(8). For purposes of this paragraph (c), 
the remaining unadjusted depreciable basis of the larger self-
constructed property is equal to the unadjusted depreciable basis, as 
defined in Sec.  1.168(b)-1(a)(3), of the larger self-constructed 
property, including all components, reduced by the sum of the component 
basis of the components for which the taxpayer makes the election 
specified in this paragraph (c).
    (ii) Election is not made. If the taxpayer does not make the 
election specified in this paragraph (c), the additional first year 
depreciation deduction, if any, for the larger self-constructed 
property, including all components, is determined under section 168(k), 
as in effect on the day before the date of the enactment of the Act, and 
section 168(k)(8).
    (6) Time and manner for making election--(i) Time for making 
election. The election specified in this paragraph (c) must be made by 
the due date, including extensions, of the Federal tax return for the 
taxable year in which the taxpayer placed in service the larger self-
constructed property.
    (ii) Manner of making election. The election specified in this 
paragraph (c) must be made by attaching a statement to such return 
indicating that the taxpayer is making the election

[[Page 839]]

provided in this paragraph (c) and whether the taxpayer is making the 
election for all or some of the components described in paragraph (c)(3) 
of this section. The election is made separately by each person owning 
qualified property (for example, for each member of a consolidated group 
by the agent for the group (within the meaning of Sec.  1.1502-77(a) and 
(c)), by the partnership (including a lower-tier partnership), or by the 
S corporation).
    (7) Revocation of election--(i) In general. Except as provided in 
paragraph (c)(7)(ii) of this section, the election specified in this 
paragraph (c), once made, may be revoked only by filing a request for a 
private letter ruling and obtaining the Commissioner of Internal 
Revenue's written consent to revoke the election. The Commissioner may 
grant a request to revoke the 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 this paragraph (c) may not be revoked through a 
request under section 446(e) to change the taxpayer's method of 
accounting.
    (ii) Automatic 6-month extension. If a taxpayer made the election 
specified in this paragraph (c), 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 larger self-constructed property 
is granted to revoke that election, provided the taxpayer timely filed 
the taxpayer's Federal tax return for that placed-in-service year and, 
within this 6-month extension period, the taxpayer, and all taxpayers 
whose tax liability would be affected by the election, file an amended 
Federal tax return for the placed-in-service year in a manner that is 
consistent with the revocation of the election.
    (8) Additional procedural guidance. The IRS may publish procedural 
guidance in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter) that provides alternative 
procedures for complying with paragraph (c)(6) or (c)(7)(i) of this 
section.
    (9) Examples. The application of this paragraph (c) is illustrated 
by the following examples. Unless the facts specifically indicate 
otherwise, assume that the larger self-constructed property is described 
in paragraph (c)(2) of this section, the components that are acquired or 
self-constructed after September 27, 2017, are described in paragraph 
(c)(3) of this section, the taxpayer is an accrual basis taxpayer, and 
none of the costs paid or incurred after September 27, 2017, are for the 
installation of components that do not meet the requirements of 
paragraph (c)(3) of this section.
    (i) Example 1. (A) BC, a calendar year taxpayer, is engaged in a 
trade or business described in section 163(j)(7)(A)(iv) and Sec. Sec.  
1.163(j)-1(b)(15)(i) and 1.163(j)-10(c)(3)(iii)(C)(3). In December 2015, 
BC decided to construct an electric generation power plant for its own 
use. This plant is property described in section 168(k)(2)(B) as in 
effect on the day before the date of the enactment of the Act. However, 
the turbine for the plant had to be manufactured by another person for 
BC. In January 2016, BC entered into a written binding contract with CD 
to acquire the turbine. BC received the completed turbine in August 2017 
at which time BC incurred the cost of the turbine. The cost of the 
turbine is 11 percent of the total cost of the electric generation power 
plant to be constructed by BC. BC began constructing the electric 
generation power plant in October 2017 and placed in service this new 
power plant, including all component parts, in 2020.
    (B) The larger self-constructed property is the electric generation 
power plant to be constructed by BC. For determining if the construction 
of this power plant begins before September 28, 2017, paragraph 
(b)(5)(iv)(B) of this section provides that manufacture, construction, 
or production of property begins when physical work of a significant 
nature begins. BC uses the safe harbor test in paragraph 
(b)(5)(iv)(B)(2) of this section to determine when physical work of a 
significant nature begins for the electric generation power plant. 
Because the turbine that was manufactured by CD for BC is more than 10 
percent of the total cost of the electric generation power plant, 
physical work of a significant nature for this plant began before 
September 28, 2017.

[[Page 840]]

    (C) The power plant is described in section 168(k)(9)(A) and 
paragraph (b)(2)(ii)(F) of this section and, therefore, is not larger 
self-constructed property eligible for the election pursuant to 
paragraph (c)(2)(i)(B) of this section. Accordingly, none of BC's 
expenditures for components of the power plant that are acquired or 
self-constructed after September 27, 2017, are eligible for the election 
specified in this paragraph (c). Assuming all requirements are met under 
section 168(k)(2) as in effect on the day before the date of the 
enactment of the Act, the unadjusted depreciable basis of the power 
plant, including all components, attributable to its construction before 
January 1, 2020, is eligible for the 30-percent additional first year 
depreciation deduction pursuant to section 168(k)(8).
    (ii) Example 2. (A) In August 2017, BD, a calendar-year taxpayer, 
entered into a written binding contract with CE for CE to manufacture a 
locomotive for BD for use in its trade or business. Before September 28, 
2017, BD acquired or self-constructed components of the locomotive. 
These components cost $500,000, which is more than 10 percent of the 
total cost of the locomotive, and BD incurred such costs before 
September 28, 2017. After September 27, 2017, BD acquired or self-
constructed components of the locomotive and these components cost 
$4,000,000. In February 2019, CE delivered the locomotive to BD and BD 
placed in service the locomotive. The total cost of the locomotive is 
$4,500,000. The locomotive is property described in section 168(k)(2)(B) 
as in effect on the day before the date of the enactment of the Act. On 
its timely filed Federal income tax return for 2019, BD made the 
election specified in this paragraph (c).
    (B) The larger self-constructed property is the locomotive being 
manufactured by CE for BD. For determining if the manufacturing of this 
locomotive begins before September 28, 2017, paragraph (b)(5)(iv)(B) of 
this section provides that manufacture, construction, or production of 
property begins when physical work of a significant nature begins. BD 
uses the safe harbor test in paragraph (b)(5)(iv)(B)(2) of this section 
to determine when physical work of a significant nature begins for the 
locomotive. Because BD had incurred more than 10 percent of the total 
cost of the locomotive before September 28, 2017, physical work of a 
significant nature for this locomotive began before September 28, 2017.
    (C) Because BD made the election specified in this paragraph (c), 
the cost of $4,000,000 for the locomotive's components acquired or self-
constructed after September 27, 2017, qualifies for the 100-percent 
additional first year depreciation deduction under this section, 
assuming all other requirements are met. The remaining cost of the 
locomotive is $500,000 and such amount qualifies for the 40-percent 
additional first year depreciation deduction pursuant to section 
168(k)(8), assuming all other requirements in section 168(k) as in 
effect on the day before the date of the enactment of the Act are met.
    (iii) Example 3. (A) In February 2016, BF, a calendar-year taxpayer, 
entered into a written binding contract with CG for CG to manufacture a 
vessel for BF for use in its trade or business. Before September 28, 
2017, BF acquired or self-constructed components for the vessel. These 
components cost $30,000,000, which is more than 10 percent of the total 
cost of the vessel, and BF incurred such costs before September 28, 
2017. After September 27, 2017, BF acquired or self-constructed 
components for the vessel and these components cost $15,000,000. In 
February 2021, CG delivered the vessel to BF and BF placed in service 
the vessel. The vessel is property described in section 168(k)(2)(B) as 
in effect on the day before the date of the enactment of the Act. The 
total cost of the vessel is $45,000,000. On its timely filed Federal 
income tax return for 2021, BF made the election specified in this 
paragraph (c).
    (B) The larger self-constructed property is the vessel being 
manufactured by CG for BF. For determining if the manufacturing of this 
vessel begins before September 28, 2017, paragraph (b)(5)(iv)(B) of this 
section provides that manufacture, construction, or production of 
property begins when physical work of a significant nature begins. BF 
uses the safe harbor test in paragraph (b)(5)(iv)(B)(2) of this section

[[Page 841]]

to determine when physical work of a significant nature begins for the 
vessel. Because BF had incurred more than 10 percent of the total cost 
of the vessel before September 28, 2017, physical work of a significant 
nature for this vessel began before September 28, 2017.
    (C) Because BF made the election specified in this paragraph (c), 
the cost of $15,000,000 for the vessel's components acquired or self-
constructed after September 27, 2017, qualifies for the 100-percent 
additional first year depreciation deduction under this section, 
assuming all other requirements are met. Pursuant to section 168(k)(8) 
and because BF placed in service the vessel after 2020, none of the 
remaining cost of the vessel is eligible for any additional first year 
depreciation deduction under section 168(k) and this section nor under 
section 168(k) as in effect on the day before the date of the enactment 
of the Act.
    (iv) Example 4. (A) In March 2017, BG, a calendar year taxpayer, 
entered into a written contract with CH for CH to construct a building 
for BG to use in its retail business. This written contract does not 
meet the definition of a binding contract in paragraph (b)(5)(iii) of 
this section. In September 2019, the construction of the building was 
completed and placed in service by BG. The total cost is $10,000,000. Of 
this amount, $3,000,000 is the total cost for all section 1245 
properties constructed as part of the building, and $7,000,000 is for 
the building. Under section 168(e), section 1245 properties in the total 
amount of $2,400,000 are 5-year property and in the total amount of 
$600,000 are 7-year property. The building is nonresidential real 
property under section 168(e). Before September 28, 2017, BG acquired or 
self-constructed certain components and the total cost of these 
components is $500,000 for the section 1245 properties and $3,000,000 
for the building. BG incurred these costs before September 28, 2017. 
After September 27, 2017, BG acquired or self-constructed the remaining 
components of the section 1245 properties and these components cost 
$2,500,000. BG incurred these costs of $2,500,000 after September 27, 
2017. On its timely filed Federal income tax return for 2019, BG made 
the election specified in this paragraph (c).
    (B) All section 1245 properties are constructed as part of the 
construction of the building and are described in paragraph (b)(2)(i)(A) 
of this section. The building is not described in paragraph 
(b)(2)(i)(A), (B), (C), or (D) of this section. As a result, under 
paragraph (c)(2)(ii) of this section, the larger self-constructed 
property is all section 1245 properties with a total cost of $3,000,000. 
For determining if the construction of these section 1245 properties 
begins before September 28, 2017, paragraph (b)(5)(v) of this section 
provides that manufacture, construction, or production of property 
begins when the taxpayer incurs more than 10 percent of the total cost 
of the property. Because BG incurred more than 10 percent of the total 
cost of the section 1245 properties before September 28, 2017, 
construction of the section 1245 properties began before September 28, 
2017.
    (C) Because BG made the election specified in this paragraph (c), 
the cost of $2,500,000 for the section 1245 components acquired or self-
constructed by BG after September 27, 2017, qualifies for the 100-
percent additional first year depreciation deduction under this section, 
assuming all other requirements are met. The remaining cost of the 
section 1245 components is $500,000 and such amount qualifies for the 
30-percent additional first year depreciation deduction pursuant to 
section 168(k)(8), assuming all other requirements in section 168(k), as 
in effect on the day before the date of the enactment of the Act, are 
met. Because the building is not qualified property under section 
168(k), as in effect on the day before the date of the enactment of the 
Act, none of the cost of $7,000,000 for the building is eligible for any 
additional first year depreciation deduction under section 168(k) and 
this section or under section 168(k), as in effect on the day before the 
date of the enactment of the Act.
    (d) Property described in section 168(k)(2)(B) or (C)--(1) In 
general. Property described in section 168(k)(2)(B) or (C) will meet the 
acquisition requirements of section 168(k)(2)(B)(i)(III) or (k)(2)(C)(i) 
if the property is acquired by the taxpayer before January 1, 2027, or 
acquired by the taxpayer pursuant

[[Page 842]]

to a written binding contract that is entered into before January 1, 
2027. Property described in section 168(k)(2)(B) or (C), including its 
components, also must meet the acquisition requirement in section 
13201(h)(1)(A) of the Act (for further guidance, see paragraph (b)(5) of 
this section).
    (2) Definition of binding contract. For purposes of this paragraph 
(d), the rules in paragraph (b)(5)(iii) of this section for a binding 
contract apply.
    (3) Self-constructed property--(i) 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 (d)(1) of this section are treated as met 
for the property if the taxpayer begins manufacturing, constructing, or 
producing the property before January 1, 2027. Property that is 
manufactured, constructed, or produced for the taxpayer by another 
person under a written binding contract, as defined in paragraph 
(b)(5)(iii) 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)(5)(iii) of this section, before January 1, 2027, with 
another person to manufacture, construct, or produce property described 
in section 168(k)(2)(B) or (C) and the manufacture, construction, or 
production of this property begins after December 31, 2026, the 
acquisition rule in paragraph (d)(1) of this section is met.
    (ii) When does manufacture, construction, or production begin--(A) 
In general. For purposes of this paragraph (d)(3), 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 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 
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.
    (B) Safe harbor. For purposes of paragraph (d)(3)(ii)(A) of this 
section, a taxpayer may choose to determine when physical work of a 
significant nature begins in accordance with this paragraph 
(d)(3)(ii)(B). Physical work of a significant nature will be considered 
to begin at the time 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 is to be constructed for an accrual basis 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 (d)(3)(ii)(B) 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 (d)(3)(ii)(B) 
by filing a Federal 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 (d)(3)(ii)(B).

[[Page 843]]

    (iii) Components of self-constructed property--(A) Acquired 
components. If a binding contract, as defined in paragraph (b)(5)(iii) 
of this section, to acquire a component does not satisfy the 
requirements of paragraph (d)(1) of this section, the component does not 
qualify for the additional first year depreciation deduction under this 
section. A binding contract described in the preceding sentence 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 (d)(3)(i) of this section. 
Accordingly, the unadjusted depreciable basis of the larger self-
constructed property that is eligible for the additional first year 
depreciation deduction under this section, assuming all other 
requirements are met, must not include the unadjusted depreciable basis 
of any component that does not satisfy the requirements of paragraph 
(d)(1) of this section. If a binding contract to acquire the component 
is entered into before January 1, 2027, but the manufacture, 
construction, or production of the larger self-constructed property does 
not begin before January 1, 2027, the component qualifies for the 
additional first year depreciation deduction under this section, 
assuming all other requirements are met, but the larger self-constructed 
property does not.
    (B) Self-constructed components. If the manufacture, construction, 
or production of a component by the taxpayer does not satisfy the 
requirements of paragraph (d)(3)(i) of this section, the component does 
not qualify for the additional first year depreciation deduction under 
this section. However, if the manufacture, construction, or production 
of a component does not satisfy the requirements of paragraph (d)(3)(i) 
of this section, but the manufacture, construction, or production of the 
larger self-constructed property satisfies the requirements of paragraph 
(d)(3)(i) of this section, the larger self-constructed property 
qualifies for the additional first year depreciation deduction under 
this section, assuming all other requirements are met, even though the 
component does not qualify for the additional first year depreciation 
deduction under this section. Accordingly, the unadjusted depreciable 
basis of the larger self-constructed property that is eligible for the 
additional first year depreciation deduction under this section, 
assuming all other requirements are met, must not include the unadjusted 
depreciable basis of any component that does not qualify for the 
additional first year depreciation deduction under this section. If the 
manufacture, construction, or production of a component begins before 
January 1, 2027, but the manufacture, construction, or production of the 
larger self-constructed property does not begin before January 1, 2027, 
the component qualifies for the additional first year depreciation 
deduction under this section, assuming all other requirements are met, 
but the larger self-constructed property does not.
    (iv) Determination of acquisition date for property not acquired 
pursuant to a written binding contract. For purposes of the acquisition 
rules in paragraph (d)(1) of this section, the following property is 
acquired by the taxpayer before January 1, 2027, if the taxpayer paid, 
in the case of a cash basis taxpayer, or incurred, in the case of an 
accrual basis taxpayer, more than 10 percent of the total cost of the 
property before January 1, 2027, excluding the cost of any land and 
preliminary activities such as planning and designing, securing 
financing, exploring, or researching:
    (A) Property that the taxpayer acquires pursuant to a contract that 
does not meet the definition of a written binding contract in paragraph 
(b)(5)(iii) of this section; or
    (B) Property that is manufactured, constructed, or produced for the 
taxpayer by another person under a written contract that does not meet 
the definition of a binding contract in paragraph (b)(5)(iii) of this 
section, and 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 production of income.
    (4) Examples. The application of this paragraph (d) is illustrated 
by the following examples:
    (A) Example 1. (1) On June 1, 2016, NN decided to construct property 
described in section 168(k)(2)(B) for its own use.

[[Page 844]]

However, one of the component parts of the property had to be 
manufactured by another person for NN. On August 15, 2016, NN entered 
into a written binding contract with OO to acquire this component part 
of the property for $100,000. OO began manufacturing the component part 
on November 1, 2016, and delivered the completed component part to NN on 
September 1, 2017, at which time NN incurred $100,000 for the cost of 
the component. The cost of this component part is 9 percent of the total 
cost of the property to be constructed by NN. NN did not incur any other 
cost of the property to be constructed before NN began construction. NN 
began constructing the property described in section 168(k)(2)(B) on 
October 15, 2017, and placed in service this property, including all 
component parts, on November 1, 2020. NN uses the safe harbor test in 
paragraph (d)(3)(ii)(B) of this section to determine when physical work 
of a significant nature begins for the property described in section 
168(k)(2)(B).
    (2) Because the component part of $100,000 that was manufactured by 
OO for NN is not more than 10 percent of the total cost of the property 
described in section 168(k)(2)(B), physical work of a significant nature 
for the property described in section 168(k)(2)(B) did not begin before 
September 28, 2017.
    (3) Pursuant to paragraphs (b)(5)(iv)(C)(2) and (d)(1) of this 
section, the self-constructed component part of $100,000 manufactured by 
OO for NN is not eligible for the 100-percent additional first year 
depreciation deduction because the manufacturing of such component part 
began before September 28, 2017. However, pursuant to paragraph 
(d)(3)(i) of this section, the cost of the property described in section 
168(k)(2)(B), excluding the cost of the component part of $100,000 
manufactured by OO for NN, is eligible for the 100-percent additional 
first year depreciation deduction, assuming all other requirements are 
met, because construction of the property began after September 27, 
2017, and before January 1, 2027, and the property described in section 
168(k)(2)(B) was placed in service by NN during 2020.
    (B) Example 2. (1) On June 1, 2026, PP 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 PP. On August 15, 2026, PP entered into a written binding contract 
with XP to acquire this component part of the property for $100,000. XP 
began manufacturing the component part on September 1, 2026, and 
delivered the completed component part to PP on February 1, 2027, at 
which time PP incurred $100,000 for the cost of the component. The cost 
of this component part is 9 percent of the total cost of the property to 
be constructed by PP. PP did not incur any other cost of the property to 
be constructed before PP began construction. PP began constructing the 
property described in section 168(k)(2)(B) on January 15, 2027, and 
placed this property, including all component parts, in service on 
November 1, 2027.
    (2) Pursuant to paragraph (d)(3)(iii)(B) of this section, the self-
constructed component part of $100,000 manufactured by XP for PP is 
eligible for the additional first year depreciation deduction under this 
section, assuming all other requirements are met, because the 
manufacturing of the component part began before January 1, 2027, and 
the property described in section 168(k)(2)(B), the larger self-
constructed property, was placed in service by PP before January 1, 
2028. However, pursuant to paragraph (d)(3)(i) 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 XP for 
PP, is not eligible for the additional first year depreciation deduction 
under this section because construction of the property began after 
December 31, 2026.
    (C) Example 3. On December 1, 2026, QQ entered into a written 
binding contract, as defined in paragraph (b)(5)(iii) of this section, 
with RR to manufacture an aircraft described in section 168(k)(2)(C) for 
use in QQ's trade or business. RR begins to manufacture the aircraft on 
February 1, 2027. QQ places the aircraft in service on August 1, 2027. 
Pursuant to paragraph (d)(3)(i) of this section, the aircraft meets the 
requirements of paragraph (d)(1) of this

[[Page 845]]

section because the aircraft was acquired by QQ pursuant to a written 
binding contract entered into before January 1, 2027. Further, the 
aircraft was placed in service by QQ before January 1, 2028. Thus, 
assuming all other requirements are met, QQ's cost of the aircraft is 
eligible for the additional first year depreciation deduction under this 
section.
    (e) Computation of depreciation deduction for qualified property--
(1) Additional first year depreciation deduction--(i) Allowable taxable 
year. The additional first year depreciation deduction is allowable--
    (A) Except as provided in paragraph (e)(1)(i)(B) or (g) of this 
section, in the taxable year in which the qualified property is placed 
in service by the taxpayer for use in its trade or business or for the 
production of income; or
    (B) In the taxable year in which the specified plant is planted, or 
grafted to a plant that has already been planted, by the taxpayer in the 
ordinary course of the taxpayer's farming business, as defined in 
section 263A(e)(4), if the taxpayer properly made the election to apply 
section 168(k)(5) (for further guidance, see paragraph (f) of this 
section).
    (ii) Computation. Except as provided in paragraph (g)(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(b)-1(a)(3), of the 
qualified property by the applicable percentage. Except as provided in 
paragraph (g)(1) of this section, the additional first year depreciation 
deduction is not affected by a taxable year of less than 12 months. See 
paragraph (g)(1) of this section for qualified property placed in 
service or planted or grafted, as applicable, and disposed of during the 
same taxable year. See paragraph (g)(5) of this section for qualified 
property acquired in a like-kind exchange or as a result of an 
involuntary conversion.
    (iii) Property described in section 168(k)(2)(B). For purposes of 
paragraph (e)(1)(ii) of this section, the unadjusted depreciable basis, 
as defined in Sec.  1.168(b)-1(a)(3), of qualified 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 before January 1, 2027. The amounts of unadjusted depreciable 
basis attributable to the property's manufacture, construction, or 
production before January 1, 2027, are referred to as ``progress 
expenditures.'' Rules similar to the rules in section 4.02(1)(b) of 
Notice 2007-36 (2007-17 I.R.B. 1000) (see Sec.  601.601(d)(2)(ii)(b) of 
this chapter) apply for determining progress expenditures, regardless of 
whether the property is manufactured, constructed, or produced for the 
taxpayer by another person under a written binding contract, as defined 
in paragraph (b)(5)(iii) of this section, or under a written contract 
that does not meet the definition of a binding contract in paragraph 
(b)(5)(iii) of this section. The IRS may publish procedural guidance in 
the Internal Revenue Bulletin (see Sec.  601.601(d)(2)(ii)(b) of this 
chapter) that provides alternative procedures for complying with this 
paragraph (e)(1)(iii).
    (iv) Alternative minimum tax--(A) In general. The additional first 
year depreciation deduction is allowable for alternative minimum tax 
purposes--
    (1) Except as provided in paragraph (e)(1)(iv)(A)(2) of this 
section, in the taxable year in which the qualified property is placed 
in service by the taxpayer; or
    (2) In the taxable year in which a specified plant is planted by the 
taxpayer, or grafted by the taxpayer to a plant that was previously 
planted, if the taxpayer properly made the election to apply section 
168(k)(5) (for further guidance, see paragraph (f) of this section).
    (B) Special rules. In general, the 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 (g)(5)(iii)(E) of this section for 
qualified 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 for the placed-in-

[[Page 846]]

service year and any subsequent taxable year, the taxpayer must 
determine the remaining adjusted depreciable basis of the qualified 
property. This remaining adjusted depreciable basis is equal to the 
unadjusted depreciable basis, as defined in Sec.  1.168(b)-1(a)(3), of 
the qualified property reduced by the amount of the additional first 
year depreciation allowed or allowable, whichever is greater. The 
remaining adjusted depreciable basis of the qualified property is then 
depreciated using the applicable depreciation provisions under the 
Internal Revenue Code for the qualified property. The remaining adjusted 
depreciable basis of the qualified 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 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 is based on the remaining 
adjusted depreciable basis for alternative minimum tax purposes. The 
remaining adjusted depreciable basis of the qualified 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 
for regular tax purposes.
    (3) Examples. This paragraph (e) is illustrated by the following 
examples:
    (i) Example 1. On March 1, 2023, SS, a calendar-year taxpayer, 
purchased and placed in service qualified property that costs $1 million 
and is 5-year property under section 168(e). SS depreciates its 5-year 
property placed in service in 2023 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 2023, SS is allowed an 80-percent additional first year 
depreciation deduction of $800,000 (the unadjusted depreciable basis of 
$1 million multiplied by 0.80). Next, SS must reduce the unadjusted 
depreciable basis of $1 million by the additional first year 
depreciation deduction of $800,000 to determine the remaining adjusted 
depreciable basis of $200,000. Then, SS' depreciation deduction 
allowable in 2023 for the remaining adjusted depreciable basis of 
$200,000 is $40,000 (the remaining adjusted depreciable basis of 
$200,000 multiplied by the annual depreciation rate of 0.20 for recovery 
year 1).
    (ii) Example 2. On June 1, 2023, TT, a calendar-year taxpayer, 
purchased and placed in service qualified property that costs 
$1,500,000. The property qualifies for the expensing election under 
section 179 and is 5-year property under section 168(e). TT did not 
purchase any other section 179 property in 2023. TT makes the election 
under section 179 for the property and depreciates its 5-year property 
placed in service in 2023 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. Assume the maximum section 179 deduction for 2023 is 
$1,000,000. For 2023, TT is first allowed a $1,000,000 deduction under 
section 179. Next, TT must reduce the cost of $1,500,000 by the section 
179 deduction of $1,000,000 to determine the unadjusted depreciable 
basis of $500,000. Then, for 2023, TT is allowed an 80-percent 
additional first year depreciation deduction of $400,000 (the unadjusted 
depreciable basis of $500,000 multiplied by 0.80). Next, TT must reduce 
the unadjusted depreciable basis of $500,000 by the additional first 
year depreciation deduction of $400,000 to determine the remaining 
adjusted depreciable basis of $100,000. Then, TT's depreciation 
deduction allowable in 2023 for the remaining adjusted depreciable basis 
of $100,000 is $20,000 (the remaining adjusted depreciable basis of 
$100,000 multiplied by the annual depreciation rate of 0.20 for recovery 
year 1).
    (f) Elections under section 168(k)--(1) Election not to deduct 
additional first year depreciation--(i) In general. A taxpayer may make 
an election not to deduct the additional first year depreciation for any 
class of property that is

[[Page 847]]

qualified property placed in service during the taxable year. If this 
election is made, the election applies to all qualified property that is 
in the same class of property and placed in service in the same taxable 
year, and no additional first year depreciation deduction is allowable 
for the property placed in service during the taxable year in the class 
of property, except as provided in Sec.  1.743-1(j)(4)(i)(B)(1).
    (ii) Definition of class of property. For purposes of this paragraph 
(f)(1), the term class of property means:
    (A) Except for the property described in paragraphs (f)(1)(ii)(B) 
and (D), and (f)(2) of this section, each class of property described in 
section 168(e) (for example, 5-year property);
    (B) Water utility property as defined in section 168(e)(5) and 
depreciated under section 168;
    (C) Computer software as defined in, and depreciated under, section 
167(f)(1) and Sec.  1.167(a)-14(b);
    (D) Qualified improvement property as defined in Sec.  1.168(b)-
1(a)(5)(i)(C) and (a)(5)(ii) (acquired by the taxpayer after September 
27, 2017, and placed in service by the taxpayer after September 27, 
2017, and before January 1, 2018), and depreciated under section 168;
    (E) Each separate production, as defined in Sec.  1.181-3(b), of a 
qualified film or television production;
    (F) Each separate production, as defined in section 181(e)(2), of a 
qualified live theatrical production; or
    (G) Each partner's basis adjustment in partnership assets under 
section 743(b) for each class of property described in paragraphs 
(f)(1)(ii)(A) through (F), and (f)(2) of this section (for further 
guidance, see Sec.  1.743-1(j)(4)(i)(B)(1)).
    (iii) Time and manner for making election--(A) Time for making 
election. Except as provided in paragraph (f)(6) of this section, any 
election specified in paragraph (f)(1)(i) 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 is placed in service by the 
taxpayer.
    (B) Manner of making election. Except as provided in paragraph 
(f)(6) of this section, any election specified in paragraph (f)(1)(i) 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 (for example, 
for each member of a consolidated group by the common parent of the 
group, by the partnership (including a lower-tier partnership; also 
including basis adjustments in the partnership assets under section 
743(b)), 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.
    (iv) Failure to make election. If a taxpayer does not make the 
election specified in paragraph (f)(1)(i) of this section within the 
time and in the manner prescribed in paragraph (f)(1)(iii) of this 
section, the amount of depreciation allowable for that property under 
section 167 or 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 (f)(1)(i) 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).
    (2) Election to apply section 168(k)(5) for specified plants--(i) In 
general. A taxpayer may make an election to apply section 168(k)(5) to 
one or more specified plants that are planted, or grafted to a plant 
that has already been planted, by the taxpayer in the ordinary course of 
the taxpayer's farming business, as defined in section 263A(e)(4). If 
this election is made for a specified plant, such plant is not treated 
as qualified property under section 168(k) and this section in its 
placed-in-service year.
    (ii) Time and manner for making election--(A) Time for making 
election. Except as provided in paragraph (f)(6) of this section, any 
election specified in paragraph (f)(2)(i) of this section must be made 
by the due date, including extensions, of the Federal tax return for the 
taxable year in which the taxpayer

[[Page 848]]

planted or grafted the specified plant to which the election applies.
    (B) Manner of making election. Except as provided in paragraph 
(f)(6) of this section, any election specified in paragraph (f)(2)(i) 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 specified plants (for example, for 
each member of a consolidated group by the common parent of the group, 
by the partnership (including a lower-tier 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.
    (iii) Failure to make election. If a taxpayer does not make the 
election specified in paragraph (f)(2)(i) of this section for a 
specified plant within the time and in the manner prescribed in 
paragraph (f)(2)(ii) of this section, the specified plant is treated as 
qualified property under section 168(k), assuming all requirements are 
met, in the taxable year in which such plant is placed in service by the 
taxpayer. Thus, any election specified in paragraph (f)(2)(i) 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).
    (3) Election for qualified property placed in service during the 
2017 taxable year--(i) In general. A taxpayer may make an election to 
deduct 50 percent, instead of 100 percent, additional first year 
depreciation for all qualified property acquired after September 27, 
2017, by the taxpayer and placed in service by the taxpayer during its 
taxable year that includes September 28, 2017. If a taxpayer makes an 
election to apply section 168(k)(5) for its taxable year that includes 
September 28, 2017, the taxpayer also may make an election to deduct 50 
percent, instead of 100 percent, additional first year depreciation for 
all specified plants that are planted, or grafted to a plant that has 
already been planted, after September 27, 2017, by the taxpayer in the 
ordinary course of the taxpayer's farming business during such taxable 
year.
    (ii) Time and manner for making election--(A) Time for making 
election. Except as provided in paragraph (f)(6) of this section, any 
election specified in paragraph (f)(3)(i) of this section must be made 
by the due date, including extensions, of the Federal tax return for the 
taxpayer's taxable year that includes September 28, 2017.
    (B) Manner of making election. Except as provided in paragraph 
(f)(6) of this section, any election specified in paragraph (f)(3)(i) of 
this section must be made in the manner prescribed on the 2017 Form 
4562, ``Depreciation and Amortization,'' and its instructions. The 
election is made separately by each person owning qualified property 
(for example, for each member of a consolidated group by the common 
parent of the group, by the partnership (including a lower-tier 
partnership), or by the S corporation).
    (iii) Failure to make election. If a taxpayer does not make the 
election specified in paragraph (f)(3)(i) of this section within the 
time and in the manner prescribed in paragraph (f)(3)(ii) of this 
section, the amount of depreciation allowable for qualified property 
under section 167 or 168, as applicable, acquired and placed in service, 
or planted or grafted, as applicable, by the taxpayer after September 
27, 2017, must be determined for the taxable year that includes 
September 28, 2017, and for all subsequent taxable years by taking into 
account the 100-percent additional first year depreciation deduction, 
unless the taxpayer makes the election specified in paragraph (f)(1)(i) 
of this section within the time and in the manner prescribed in 
paragraph (f)(1)(iii) of this section for the class of property in which 
the qualified property is included. Thus, any election specified in 
paragraph (f)(3)(i) 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).
    (4) Alternative minimum tax. If a taxpayer makes an election 
specified in paragraph (f)(1) of this section for a class of property or 
in paragraph (f)(2)

[[Page 849]]

of this section for a specified plant, the depreciation adjustments 
under section 56 and the regulations in this part under section 56 do 
not apply to the property or specified plant, as applicable, to which 
that election applies for purposes of computing the taxpayer's 
alternative minimum taxable income. If a taxpayer makes an election 
specified in paragraph (f)(3) of this section for all qualified 
property, see paragraphs (e)(1)(iv) and (e)(2)(ii) of this section.
    (5) Revocation of election-(i) In general. Except as provided in 
paragraphs (f)(5)(ii) and (f)(6) of this section, an election specified 
in this paragraph (f), once made, may be revoked only by filing a 
request for a private letter ruling and obtaining the Commissioner of 
Internal Revenue's written consent to revoke the election. The 
Commissioner may grant a request to revoke the 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. An election specified in this paragraph (f) may not 
be revoked through a request under section 446(e) to change the 
taxpayer's method of accounting.
    (ii) Automatic 6-month extension. If a taxpayer made an election 
specified in this paragraph (f), 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 or the taxable year in which the 
specified plant is planted or grafted, as applicable, is granted to 
revoke that election, provided the taxpayer timely filed the taxpayer's 
Federal tax return for the placed-in-service year or the taxable year in 
which the specified plant is planted or grafted, as applicable, and, 
within this 6-month extension period, the taxpayer, and all taxpayers 
whose tax liability would be affected by the election, file an amended 
Federal tax return for the placed-in-service year or the taxable year in 
which the specified plant is planted or grafted, as applicable, in a 
manner that is consistent with the revocation of the election.
    (6) Special rules for 2016 and 2017 returns. For an election 
specified in this paragraph (f) for qualified property placed in 
service, or for a specified plant that is planted, or grafted to a plant 
that has already been planted, by the taxpayer during its taxable year 
that included September 28, 2017, the taxpayer should refer to Rev. 
Proc. 2019-33 (2019-34 I.R.B. 662) (see Sec.  601.601(d)(2)(ii)(b) of 
this chapter) for the time and manner of making the election on the 2016 
or 2017 Federal tax return.
    (7) Additional procedural guidance. The IRS may publish procedural 
guidance in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter) that provides alternative 
procedures for complying with paragraph (f)(1)(iii), (f)(1)(iv), 
(f)(2)(ii), (f)(2)(iii), (f)(3)(ii), (f)(3)(iii), or (f)(5)(i) of this 
section.
    (g) Special rules--(1) Property placed in service and disposed of in 
the same taxable year--(i) In general. Except as provided in paragraphs 
(g)(1)(ii) and (iii) of this section and by the application of paragraph 
(b)(3)(iii)(B)(4) of this section, the additional first year 
depreciation deduction is not allowed for qualified property placed in 
service or planted or grafted, as applicable, and disposed of during the 
same taxable year. If a partnership interest is acquired and disposed of 
during the same taxable year, the additional first year depreciation 
deduction is not allowed for any section 743(b) adjustment arising from 
the initial acquisition. Also, if qualified 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, except as otherwise provided by the 
application of paragraph (b)(3)(iii)(B) of this section.
    (ii) Technical termination of a partnership. In the case of a 
technical termination of a partnership under section 708(b)(1)(B) in a 
taxable year beginning before January 1, 2018, the additional first year 
depreciation deduction is allowable for any qualified property placed in 
service or planted or grafted, as applicable, by the terminated 
partnership during the taxable year of termination and contributed by 
the terminated partnership to the new partnership. The allowable 
additional first

[[Page 850]]

year depreciation deduction for the qualified 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 was contributed by the terminated partnership to the 
new partnership. However, if qualified property is both placed in 
service or planted or grafted, as applicable, 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 is 
transferred in a transaction described in section 168(i)(7) in the same 
taxable year that the qualified property is placed in service or planted 
or grafted, as applicable, by the transferor, the additional first year 
depreciation deduction is allowable for the qualified property. If a 
partnership interest is purchased and transferred in a transaction 
described in section 168(i)(7) in the same taxable year, the additional 
first year depreciation deduction is allowable for any section 743(b) 
adjustment that arises from the initial acquisition with respect to 
qualified property held by the partnership, provided the requirements of 
paragraph (b)(3)(iv)(D) of this section and all other requirements of 
section 168(k) and this section are satisfied. The allowable additional 
first year depreciation deduction for the qualified property for the 
transferor's taxable year in which the property is placed in service or 
planted or grafted, as applicable, is allocated between the transferor 
and the transferee on a monthly basis. The allowable additional first 
year depreciation deduction for a section 743(b) adjustment with respect 
to qualified property held by the partnership is allocated between the 
transferor and the transferee on a monthly basis notwithstanding that 
under Sec.  1.743-1(f) a transferee's section 743(b) adjustment is 
determined without regard to a transferors section 743(b) adjustment. 
These allocations 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, solely for purposes of this 
section, if the qualified property is transferred in a section 721(a) 
transaction to a partnership that has as a partner a person, other than 
the transferor, who previously had a depreciable interest in the 
qualified property, in the same taxable year that the qualified property 
is acquired or planted or grafted, as applicable, by the transferor, the 
qualified property is deemed to be placed in service or planted or 
grafted, as applicable, by the transferor during that taxable year, and 
the allowable additional first year depreciation deduction is allocated 
entirely to the transferor and not to the partnership. Additionally, if 
qualified property is both placed in service or planted or grafted, as 
applicable, 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.
    (iv) Examples. The application of this paragraph (g)(1) is 
illustrated by the following examples:
    (A) Example 1. UU and VV are equal partners in Partnership JL, a 
general partnership. Partnership JL is a calendar-year taxpayer. On 
October 1, 2017, Partnership JL purchased and placed in service 
qualified property at a cost of $30,000. On November 1, 2017, UU sells 
its entire 50 percent interest to WW in a transfer that terminates the 
partnership under section 708(b)(1)(B). As a result, terminated 
Partnership JL is deemed to have contributed the qualified property to 
new Partnership JL. Pursuant to paragraph (g)(1)(ii) of this section, 
new Partnership JL, not terminated Partnership JL,

[[Page 851]]

is eligible to claim the 100-percent additional first year depreciation 
deduction allowable for the qualified property for the taxable year 
2017, assuming all other requirements are met.
    (B) Example 2. On January 5, 2018, XX purchased and placed in 
service qualified property for a total amount of $9,000. On August 20, 
2018, XX transferred this qualified property to Partnership BC in a 
transaction described in section 721(a). No other partner of Partnership 
BC has ever had a depreciable interest in the qualified property. XX and 
Partnership BC are calendar-year taxpayers. Because the transaction 
between XX and Partnership BC is a transaction described in section 
168(i)(7), pursuant to paragraph (g)(1)(iii) of this section, the 100-
percent additional first year depreciation deduction allowable for the 
qualified property is allocated between XX 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 100-percent additional first year depreciation 
deduction allowable of $9,000 for the qualified property for 2018 is 
allocated between XX and Partnership BC based on the number of months 
that XX and Partnership BC held the qualified property in service during 
2018. Thus, because the qualified property was held in service by XX for 
7 of 12 months, which includes the month in which XX placed the 
qualified property in service but does not include the month in which 
the qualified property was transferred, XX is allocated $5,250 (\7/12\ x 
$9,000 additional first year depreciation deduction). Partnership BC is 
allocated $3,750, the remaining \5/12\ of the $9,000 additional first 
year depreciation deduction allowable for the qualified property.
    (2) Redetermination of basis. If the unadjusted depreciable basis, 
as defined in Sec.  1.168(b)-1(a)(3), of qualified property is 
redetermined (for example, due to contingent purchase price or discharge 
of indebtedness) before January 1, 2027, or in the case of property 
described in section 168(k)(2)(B) or (C), is redetermined before January 
1, 2028, the additional first year depreciation deduction allowable for 
the qualified property is redetermined as follows:
    (i) Increase in basis. For the taxable year in which an increase in 
basis of qualified 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 the 
applicable percentage for the taxable year in which the underlying 
property was placed in service by the taxpayer. For purposes of this 
paragraph (g)(2)(i), the additional first year depreciation deduction 
applies to the increase in basis only if the underlying property is 
qualified property. To determine the amount otherwise allowable as a 
depreciation deduction for the increase in basis of qualified property, 
the amount of the increase in basis of the qualified 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, except for computer software described in 
paragraph (b)(2)(i)(B) of this section, a qualified film or television 
production described in paragraph (b)(2)(i)(E) of this section, or a 
qualified live theatrical production described in paragraph (b)(2)(i)(F) 
of this section, is depreciated over the recovery period of the 
qualified property 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 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 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 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

[[Page 852]]

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 the 
applicable percentage for the taxable year in which the underlying 
property was placed in service by the taxpayer. For purposes of this 
paragraph (g)(2)(ii), the additional first year depreciation deduction 
applies to the decrease in basis only if the underlying property is 
qualified 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 before the decrease in basis, or if the taxpayer 
claimed more than the additional first year depreciation deduction 
allowable for the qualified 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 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, the amount of the decrease 
in basis of the qualified 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 (g)(2)(ii), and the remaining decrease in basis 
of--
    (A) Qualified property, except for computer software described in 
paragraph (b)(2)(i)(B) of this section, a qualified film or television 
production described in paragraph (b)(2)(i)(E) of this section, or a 
qualified live theatrical production described in paragraph (b)(2)(i)(F) 
of this section, reduces the amount otherwise allowable as a 
depreciation deduction over the recovery period of the qualified 
property 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 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 (g)(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
    (B) Computer software, as defined in paragraph (b)(2)(i)(B) of this 
section, that is qualified 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 
(g)(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) Definitions. 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 for purposes of this paragraph (g)(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.

[[Page 853]]

    (iv) Examples. The application of this paragraph (g)(2) is 
illustrated by the following examples:
    (A) Example 1. (1) On May 15, 2023, YY, 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, YY agrees 
to pay the seller 25 percent of the gross profits from the operation of 
the property in 2023. On May 15, 2024, YY paid to the seller an 
additional $10,000. YY depreciates the 5-year property placed in service 
in 2023 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.
    (2) For 2023, YY is allowed an 80-percent additional first year 
depreciation deduction of $160,000 (the unadjusted depreciable basis of 
$200,000 multiplied by 0.80). In addition, YY's depreciation deduction 
for 2023 for the remaining adjusted depreciable basis of $40,000 (the 
unadjusted depreciable basis of $200,000 reduced by the additional first 
year depreciation deduction of $160,000) is $8,000 (the remaining 
adjusted depreciable basis of $40,000 multiplied by the annual 
depreciation rate of 0.20 for recovery year 1).
    (3) For 2024, YY's depreciation deduction for the remaining adjusted 
depreciable basis of $40,000 is $12,800 (the remaining adjusted 
depreciable basis of $40,000 multiplied by the annual depreciation rate 
of 0.32 for recovery year 2). In addition, pursuant to paragraph 
(g)(2)(i) of this section, YY is allowed an additional first year 
depreciation deduction for 2024 for the $10,000 increase in basis of the 
qualified property. Consequently, YY is allowed an additional first year 
depreciation deduction of $8,000 (the increase in basis of $10,000 
multiplied by 0.80, the applicable percentage for 2023). Also, YY is 
allowed a depreciation deduction for 2024 attributable to the remaining 
increase in basis of $2,000 (the increase in basis of $10,000 reduced by 
the additional first year depreciation deduction of $8,000). The 
depreciation deduction allowable for 2024 attributable to the remaining 
increase in basis of $2,000 is $889 (the remaining increase in basis of 
$2,000 multiplied by 0.4444, which is equal to 1/remaining recovery 
period of 4.5 years at January 1, 2024, multiplied by 2). Accordingly, 
for 2024, YY's total depreciation deduction allowable for the qualified 
property is $21,689 ($12,800 plus $8,000 plus $889).
    (B) Example 2. (1) On May 15, 2023, ZZ, 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, ZZ borrowed 
$250,000 from Bank1. On May 15, 2024, Bank1 forgives $50,000 of the 
indebtedness. ZZ 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. ZZ depreciates the 5-year 
property placed in service in 2023 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.
    (2) For 2023, ZZ is allowed an 80-percent additional first year 
depreciation deduction of $320,000 (the unadjusted depreciable basis of 
$400,000 multiplied by 0.80). In addition, ZZ's depreciation deduction 
allowable for 2023 for the remaining adjusted depreciable basis of 
$80,000 (the unadjusted depreciable basis of $400,000 reduced by the 
additional first year depreciation deduction of $320,000) is $16,000 
(the remaining adjusted depreciable basis of $80,000 multiplied by the 
annual depreciation rate of 0.20 for recovery year 1).
    (3) For 2024, ZZ's deduction for the remaining adjusted depreciable 
basis of $80,000 is $25,600 (the remaining adjusted depreciable basis of 
$80,000 multiplied by the annual depreciation rate 0.32 for recovery 
year 2). Although Bank1 forgave the indebtedness in 2024, the basis of 
the property is reduced on January 1, 2025, pursuant to sections 
108(b)(5) 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.
    (4) For 2025, ZZ's deduction for the remaining adjusted depreciable 
basis of $80,000 is $15,360 (the remaining adjusted depreciable basis of 
$80,000 multiplied by the annual depreciation rate 0.192 for recovery 
year 3). However,

[[Page 854]]

pursuant to paragraph (g)(2)(ii) of this section, ZZ must reduce the 
amount otherwise allowable as a depreciation deduction for 2025 by the 
excess depreciation previously claimed for the $50,000 decrease in basis 
of the qualified property. Consequently, ZZ must reduce the amount of 
depreciation otherwise allowable for 2025 by the excess additional first 
year depreciation of $40,000 (the decrease in basis of $50,000 
multiplied by 0.80, the applicable percentage for 2023). Also, ZZ must 
reduce the amount of depreciation otherwise allowable for 2025 by the 
excess depreciation attributable to the remaining decrease in basis of 
$10,000 (the decrease in basis of $50,000 reduced by the excess 
additional first year depreciation of $40,000). The reduction in the 
amount of depreciation otherwise allowable for 2025 for the remaining 
decrease in basis of $10,000 is $5,714 (the remaining decrease in basis 
of $10,000 multiplied by 0.5714, which is equal to (1/remaining recovery 
period of 3.5 years at January 1, 2025, multiplied by 2). Accordingly, 
assuming the qualified property is the only depreciable property owned 
by ZZ, for 2025, ZZ has a negative depreciation deduction for the 
qualified property of $30,354 ($15,360 minus $40,000 minus $5,714).
    (3) Sections 1245 and 1250 depreciation recapture. For purposes of 
section 1245 and Sec. Sec.  1.1245-1 through -6, the additional first 
year depreciation deduction is an amount allowed or allowable for 
depreciation. Further, for purposes of section 1250(b) and Sec.  1.1250-
2, 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 even if the taxpayer makes the election to 
amortize the certified pollution control facility under section 169 and 
Sec. Sec.  1.169-1 through -4 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 (g)(5) apply to replacement MACRS property or 
replacement computer software that is qualified property at the time of 
replacement provided the time of replacement is after September 27, 
2017, and before January 1, 2027; or, in the case of replacement MACRS 
property or replacement computer software that is qualified property 
described in section 168(k)(2)(B) or (C), the time of replacement is 
after September 27, 2017, and before January 1, 2028.
    (ii) Definitions. For purposes of this paragraph (g)(5), the 
following definitions apply:
    (A) Replacement MACRS property has the same meaning as that term is 
defined in Sec.  1.168(i)-6(b)(1).
    (B) Relinquished MACRS property has the same meaning as that term is 
defined in Sec.  1.168(i)-6(b)(2).
    (C) Replacement 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 for other computer software in a like-kind 
exchange or in an involuntary conversion.
    (D) Relinquished computer software is computer software that is 
transferred by the taxpayer in a like-kind exchange or in an involuntary 
conversion.
    (E) Time of disposition has the same meaning as that term is defined 
in Sec.  1.168(i)-6(b)(3) for relinquished MACRS property. For 
relinquished computer software, time of disposition is when the 
disposition of the relinquished computer software takes place under the 
convention determined under Sec.  1.167(a)-14(b).
    (F) Except as provided in paragraph (g)(5)(iv) of this section, the 
time of replacement has the same meaning as that term is defined in 
Sec.  1.168(i)-6(b)(4) for replacement MACRS property. For replacement 
computer software, the time of replacement is, except as provided in 
paragraph (g)(5)(iv) of this section, the later of--
    (1) When the replacement computer software is placed in service 
under the convention determined under Sec.  1.167(a)-14(b); or
    (2) The time of disposition of the relinquished property.
    (G) Exchanged basis has the same meaning as that term is defined in 
Sec.  1.168(i)-6(b)(7) for MACRS property, as

[[Page 855]]

defined in Sec.  1.168(b)-1(a)(2). For computer software, the exchanged 
basis is determined after the amortization deductions for the year of 
disposition are determined under Sec.  1.167(a)-14(b) and is the lesser 
of--
    (1) The basis in the replacement computer software, as determined 
under section 1031(d) and Sec.  1.1031(d)-1, 1.1031(d)-2, 1.1031(j)-1, 
or 1.1031(k)-1; or section 1033(b) and Sec.  1.1033(b)-1; or
    (2) The adjusted depreciable basis of the relinquished computer 
software.
    (H) Excess basis has the same meaning as that term is defined in 
Sec.  1.168(i)-6(b)(8) for replacement MACRS property. For replacement 
computer software, the excess basis is any excess of the basis in the 
replacement computer software, as determined under section 1031(d) and 
Sec.  1.1031(d)-1, 1.1031(d)-2, 1.1031(j)-1, or 1.1031(k)-1; or section 
1033(b) and Sec.  1.1033(b)-1, over the exchanged basis as determined 
under paragraph (g)(5)(ii)(G) of this section.
    (I) Remaining exchanged basis is the exchanged basis as determined 
under paragraph (g)(5)(ii)(G) of this section reduced by--
    (1) 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
    (2) 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 periods prior to the disposition of the relinquished 
property.
    (J) Remaining excess basis is the excess basis as determined under 
paragraph (g)(5)(ii)(H) of this section reduced by--
    (1) 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;
    (2) Any portion of the basis the taxpayer properly elects to treat 
as an expense under section 179 or 179C; and
    (3) Any adjustments to basis provided by other provisions of the 
Code and the regulations under the Code.
    (K) Year of disposition has the same meaning as that term is defined 
in Sec.  1.168(i)-6(b)(5).
    (L) Year of replacement has the same meaning as that term is defined 
in Sec.  1.168(i)-6(b)(6).
    (M) Like-kind exchange has the same meaning as that term is defined 
in Sec.  1.168(i)-6(b)(11).
    (N) Involuntary conversion has the same meaning as that term is 
defined in Sec.  1.168(i)-6(b)(12).
    (iii) Computation--(A) In general. If the replacement MACRS property 
or the replacement computer software, as applicable, meets the original 
use requirement in paragraph (b)(3)(ii) of this section and all other 
requirements of section 168(k) and this section, the remaining exchanged 
basis for the year of replacement and the remaining excess basis, if 
any, for the year of replacement for the replacement MACRS property or 
the replacement computer software, as applicable, are eligible for the 
additional first year depreciation deduction under this section. If the 
replacement MACRS property or the replacement computer software, as 
applicable, meets the used property acquisition requirements in 
paragraph (b)(3)(iii) of this section and all other requirements of 
section 168(k) and this section, only the remaining excess basis for the 
year of replacement for the replacement MACRS property or the 
replacement computer software, as applicable, is eligible for the 
additional first year depreciation deduction under this section. See 
paragraph (b)(3)(iii)(A)(3) of this section. The additional first year 
depreciation deduction applies to the remaining exchanged basis and any 
remaining excess basis, as applicable, of the replacement MACRS property 
or the replacement computer software, as applicable, if the time of 
replacement is after September 27, 2017, and before January 1, 2027; or, 
in the case of replacement MACRS property or replacement computer 
software, as applicable, described in section 168(k)(2)(B) or (C), the 
time of replacement is after September 27, 2017, and before January 1, 
2028. The additional first year depreciation deduction is computed 
separately for the remaining exchanged basis and any remaining excess 
basis, as applicable.
    (B) Year of disposition and year of replacement. The additional 
first year depreciation deduction is allowable for

[[Page 856]]

the replacement MACRS property or replacement computer software in the 
year of replacement. However, the additional first year depreciation 
deduction is not allowable for the relinquished MACRS property or the 
relinquished computer software, as applicable, if the relinquished MACRS 
property or the relinquished computer software, as applicable, is placed 
in service and disposed of in a like-kind exchange or in an involuntary 
conversion in the same taxable year.
    (C) Property described in section 168(k)(2)(B). For purposes of 
paragraph (g)(5)(iii)(A) of this section, the total of the remaining 
exchanged basis and the remaining excess basis, if any, of the 
replacement MACRS property that is qualified property described in 
section 168(k)(2)(B) and meets the original use requirement in paragraph 
(b)(3)(ii) of this section is limited to the total of the property's 
remaining exchanged basis and remaining excess basis, if any, 
attributable to the property's manufacture, construction, or production 
after September 27, 2017, and before January 1, 2027. For purposes of 
paragraph (g)(5)(iii)(A) of this section, the remaining excess basis, if 
any, of the replacement MACRS property that is qualified property 
described in section 168(k)(2)(B) and meets the used property 
acquisition requirements in paragraph (b)(3)(iii) of this section is 
limited to the property's remaining excess basis, if any, attributable 
to the property's manufacture, construction, or production after 
September 27, 2017, and before January 1, 2027.
    (D) Effect of Sec.  1.168(i)-6(i)(1) election. If a taxpayer 
properly makes the election under Sec.  1.168(i)-6(i)(1) not to apply 
Sec.  1.168(i)-6 for any MACRS property, as defined in Sec.  1.168(b)-
1(a)(2), involved in a like-kind exchange or involuntary conversion, 
then:
    (1) If the replacement MACRS property meets the original use 
requirement in paragraph (b)(3)(ii) of this section and all other 
requirements of section 168(k) and this section, the total of 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), if any, in the replacement 
MACRS property is eligible for the additional first year depreciation 
deduction under this section; or
    (2) If the replacement MACRS property meets the used property 
acquisition requirements in paragraph (b)(3)(iii) of this section and 
all other requirements of section 168(k) and this section, only the 
excess basis, as defined in Sec.  1.168(i)-6(b)(8), if any, in the 
replacement MACRS property is eligible for the additional first year 
depreciation deduction under this section.
    (E) Alternative minimum tax. The additional first year depreciation 
deduction is allowed for alternative minimum tax purposes for the year 
of replacement of replacement MACRS property or replacement computer 
software, as applicable, that is qualified property. If the replacement 
MACRS property or the replacement computer software, as applicable, 
meets the original use requirement in paragraph (b)(3)(ii) of this 
section and all other requirements of section 168(k) and this section, 
the additional first year depreciation deduction for alternative minimum 
tax purposes is based on the remaining exchanged basis and the remaining 
excess basis, if any, of the replacement MACRS property or the 
replacement computer software, as applicable, for alternative minimum 
tax purposes. If the replacement MACRS property or the replacement 
computer software, as applicable, meets the used property acquisition 
requirements in paragraph (b)(3)(iii) of this section and all other 
requirements of section 168(k) and this section, the additional first 
year depreciation deduction for alternative minimum tax purposes is 
based on the remaining excess basis, if any, of the replacement MACRS 
property or the replacement computer software, as applicable, for 
alternative minimum tax purposes.
    (iv) Replacement MACRS property or replacement computer software 
that is acquired and placed in service before disposition of 
relinquished MACRS property or relinquished computer software. If, in an 
involuntary conversion, a taxpayer acquires and places in service the 
replacement MACRS property or the replacement computer software, as 
applicable, before the time of disposition of the involuntarily 
converted MACRS property or the involuntarily converted computer 
software, as applicable; and the time of disposition of the

[[Page 857]]

involuntarily converted MACRS property or the involuntarily converted 
computer software, as applicable, is after December 31, 2026, or, in the 
case of property described in service 168(k)(2)(B) or (C), after 
December 31, 2027, then--
    (A) The time of replacement for purposes of this paragraph (g)(5) is 
when the replacement MACRS property or replacement computer software, as 
applicable, 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, as 
applicable, existed before January 1, 2027, or, in the case of property 
described in section 168(k)(2)(B) or (C), existed before January 1, 
2028; and
    (B) The taxpayer depreciates the replacement MACRS property or 
replacement computer software, as applicable, in accordance with 
paragraph (e) 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 replacement MACRS 
property and begins to depreciate the depreciable exchanged basis, as 
defined in Sec.  1.168(i)-6(b)(9), of the replacement 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 replacement MACRS property 
continues to be depreciated by the taxpayer in accordance with the first 
sentence of this paragraph (g)(5)(iv)(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 replacement MACRS 
property over the additional first year depreciation deduction that 
would have been allowable to the taxpayer on the remaining exchanged 
basis of the replacement MACRS property at the time of replacement, as 
defined in paragraph (g)(5)(iv)(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 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 involuntarily converted MACRS property. Similar rules 
apply to replacement computer software.
    (v) Examples. The application of this paragraph (g)(5) is 
illustrated by the following examples:
    (A) Example 1. (1) In April 2016, CSK, 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)(2), as in 
effect on the day before amendment by the Act, and is 5-year property 
under section 168(e). CSK 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. CSK elected to use the optional depreciation tables to 
compute the depreciation allowance for Canopy V1. In November 2017, 
Canopy V1 was destroyed in a fire and was no longer usable in CSK's 
business. In December 2017, in an involuntary conversion, CSK acquired 
and placed in service Canopy W1 with all of the $160,000 of insurance 
proceeds CSK received due to the loss of Canopy V1. Canopy W1 is 
qualified property under section 168(k)(2) and this section, and is 5-
year property under section 168(e). Canopy W1 also meets the original 
use requirement in paragraph (b)(3)(ii) of this section. CSK did not 
make the election under Sec.  1.168(i)-6(i)(1).
    (2) For 2016, CSK is allowed a 50-percent additional first year 
depreciation deduction of $100,000 for Canopy V1 (the unadjusted 
depreciable basis of $200,000 multiplied by 0.50), and a regular MACRS 
depreciation deduction of $20,000 for Canopy V1 (the remaining adjusted 
depreciable basis of $100,000 multiplied by the annual depreciation rate 
of 0.20 for recovery year 1).
    (3) For 2017, CSK is allowed a regular MACRS depreciation deduction 
of $16,000 for Canopy V1 (the remaining adjusted depreciable basis of 
$100,000

[[Page 858]]

multiplied by the annual depreciation rate of 0.32 for recovery year 2 x 
\1/2\ year).
    (4) Pursuant to paragraph (g)(5)(iii)(A) of this section, the 
additional first year depreciation deduction allowable for Canopy W1 for 
2017 equals $64,000 (100 percent of Canopy W1's remaining exchanged 
basis at the time of replacement of $64,000 (Canopy V1's remaining 
adjusted depreciable basis of $100,000 minus 2016 regular MACRS 
depreciation deduction of $20,000 minus 2017 regular MACRS depreciation 
deduction of $16,000)).
    (B) Example 2. (1) The facts are the same as in Example 1 of 
paragraph (g)(5)(v)(A)(1) of this section, except CSK elected not to 
deduct the additional first year depreciation for 5-year property placed 
in service in 2016. CSK deducted the additional first year depreciation 
for 5-year property placed in service in 2017.
    (2) For 2016, CSK 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 0.20 for recovery year 1).
    (3) For 2017, CSK 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 0.32 for recovery year 2 x 
\1/2\ year).
    (4) Pursuant to paragraph (g)(5)(iii)(A) of this section, the 
additional first year depreciation deduction allowable for Canopy W1 for 
2017 equals $128,000 (100 percent of Canopy W1's remaining exchanged 
basis at the time of replacement of $128,000 (Canopy V1's unadjusted 
depreciable basis of $200,000 minus 2016 regular MACRS depreciation 
deduction of $40,000 minus 2017 regular MACRS depreciation deduction of 
$32,000)).
    (C) Example 3. The facts are the same as in Example 1 of paragraph 
(g)(5)(v)(A)(1) of this section, except Canopy W1 meets the used 
property acquisition requirements in paragraph (b)(3)(iii) of this 
section. Because the remaining excess basis of Canopy W1 is zero, CSK is 
not allowed any additional first year depreciation for Canopy W1 
pursuant to paragraph (g)(5)(iii)(A) of this section.
    (D) Example 4. (1) In December 2016, AB, a calendar-year 
corporation, acquired for $10,000 and placed in service Computer X2. 
Computer X2 is qualified property under section 168(k)(2), as in effect 
on the day before amendment by the Act, and is 5-year property under 
section 168(e). AB 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. AB elected to use the optional depreciation tables to 
compute the depreciation allowance for Computer X2. In November 2017, AB 
acquired Computer Y2 by exchanging Computer X2 and $1,000 cash in a 
like-kind exchange. Computer Y2 is qualified property under section 
168(k)(2) and this section, and is 5-year property under section 168(e). 
Computer Y2 also meets the original use requirement in paragraph 
(b)(3)(ii) of this section. AB did not make the election under Sec.  
1.168(i)-6(i)(1).
    (2) For 2016, AB is allowed a 50-percent additional first year 
depreciation deduction of $5,000 for Computer X2 (unadjusted basis of 
$10,000 multiplied by 0.50), and a regular MACRS depreciation deduction 
of $1,000 for Computer X2 (the remaining adjusted depreciable basis of 
$5,000 multiplied by the annual depreciation rate of 0.20 for recovery 
year 1).
    (3) For 2017, AB is allowed a regular MACRS depreciation deduction 
of $800 for Computer X2 (the remaining adjusted depreciable basis of 
$5,000 multiplied by the annual depreciation rate of 0.32 for recovery 
year 2 x \1/2\ year).
    (4) Pursuant to paragraph (g)(5)(iii)(A) of this section, the 100-
percent additional first year depreciation deduction for Computer Y2 for 
2017 is allowable for the remaining exchanged basis at the time of 
replacement of $3,200 (Computer X2's unadjusted depreciable basis of 
$10,000 minus additional first year depreciation deduction allowable of 
$5,000 minus the 2016 regular MACRS depreciation deduction of $1,000 
minus the 2017 regular MACRS depreciation deduction of $800) and for the 
remaining excess basis at the time of replacement of $1,000 (cash paid 
for Computer Y2). Thus, the 100-percent

[[Page 859]]

additional first year depreciation deduction allowable for Computer Y2 
totals $4,200 for 2017.
    (E) Example 5. (1) In July 2017, BC, a calendar-year corporation, 
acquired for $20,000 and placed in service Equipment X3. Equipment X3 is 
qualified property under section 168(k)(2), as in effect on the day 
before amendment by the Act, and is 5-year property under section 
168(e). BC 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. BC elected to use the optional depreciation tables to 
compute the depreciation allowance for Equipment X3. In December 2017, 
BC acquired Equipment Y3 by exchanging Equipment X3 and $5,000 cash in a 
like-kind exchange. Equipment Y3 is qualified property under section 
168(k)(2) and this section, and is 5-year property under section 168(e). 
Equipment Y3 also meets the used property acquisition requirements in 
paragraph (b)(3)(iii) of this section. BC did not make the election 
under Sec.  1.168(i)-6(i)(1).
    (2) Pursuant to Sec.  1.168(k)-1(f)(5)(iii)(B), no additional first 
year depreciation deduction is allowable for Equipment X3 and, pursuant 
to Sec.  1.168(d)-1(b)(3)(ii), no regular depreciation deduction is 
allowable for Equipment X3, for 2017.
    (3) Pursuant to paragraph (g)(5)(iii)(A) of this section, no 
additional first year depreciation deduction is allowable for Equipment 
Y3's remaining exchanged basis at the time of replacement of $20,000 
(Equipment X3's unadjusted depreciable basis of $20,000). However, 
pursuant to paragraph (g)(5)(iii)(A) of this section, the 100-percent 
additional first year depreciation deduction is allowable for Equipment 
Y3's remaining excess basis at the time of replacement of $5,000 (cash 
paid for Equipment Y3). Thus, the 100-percent additional first year 
depreciation deduction allowable for Equipment Y3 is $5,000 for 2017.
    (F) Example 6. (1) The facts are the same as in Example 5 of 
paragraph (g)(5)(v)(E)(1) of this section, except BC properly makes the 
election under Sec.  1.168(i)-6(i)(1) not to apply Sec.  1.168(i)-6 to 
Equipment X3 and Equipment Y3.
    (2) Pursuant to Sec.  1.168(k)-1(f)(5)(iii)(B), no additional first 
year depreciation deduction is allowable for Equipment X3 and, pursuant 
to Sec.  1.168(d)-1(b)(3)(ii), no regular depreciation deduction is 
allowable for Equipment X3, for 2017.
    (3) Pursuant to Sec.  1.168(i)-6(i)(1), BC is treated as placing 
Equipment Y3 in service in December 2017 with a basis of $25,000 (the 
total of the exchanged basis of $20,000 and the excess basis of $5,000). 
However, pursuant to paragraph (g)(5)(iii)(D)(2) of this section, the 
100-percent additional first year depreciation deduction is allowable 
only for Equipment Y3's excess basis at the time of replacement of 
$5,000 (cash paid for Equipment Y3). Thus, the 100-percent additional 
first year depreciation deduction allowable for Equipment Y3 is $5,000 
for 2017.
    (6) Change in use--(i) Change in use of MACRS property. The 
determination of whether the use of MACRS property, as defined in Sec.  
1.168(b)-1(a)(2), changes is made in accordance with section 168(i)(5) 
and Sec.  1.168(i)-4.
    (ii) Conversion to personal use. If qualified 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. See Sec.  1.168(i)-4(b)(1) for determining the 
depreciable basis of the property at the time of conversion to business 
or income-producing use.

[[Page 860]]

    (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 27, 2017, and converted by the taxpayer 
from personal use to business or income-producing use by January 1, 
2027. 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. See Sec.  1.168(i)-4(b)(1) for determining the depreciable basis of 
the property at the time of conversion to business or income-producing 
use.
    (iv) Depreciable property changes use subsequent to the placed-in-
service year. (A) If the use of qualified property changes in the hands 
of the same taxpayer subsequent to the taxable year the qualified 
property is placed in service and, as a result of the change in use, the 
property is no longer qualified property, the additional first year 
depreciation deduction allowable for the qualified property is not 
redetermined.
    (B) If depreciable property is not qualified 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 in the taxable year of the change in use.
    (v) Examples. The application of this paragraph (g)(6) is 
illustrated by the following examples:
    (A) Example 1. (1) On January 1, 2019, FFF, a calendar year 
corporation, purchased and placed in service several new computers at a 
total cost of $100,000. FFF used these computers within the United 
States for 3 months in 2019 and then moved and used the computers 
outside the United States for the remainder of 2019. On January 1, 2020, 
FFF permanently returns the computers to the United States for use in 
its business.
    (2) For 2019, the computers are considered as used predominantly 
outside the United States in 2019 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)(B) of this section, the computers are not qualified property 
in 2019, the placed-in-service year. Thus, pursuant to paragraph 
(g)(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 2020.
    (B) Example 2. (1) On February 8, 2023, GGG, 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). GGG depreciates its 5-year property placed in service in 2023 
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, 2024, due to 
changes in GGG's business circumstances, GGG permanently moves the 
equipment to its plant in Mexico.
    (2) For 2023, GGG is allowed an 80-percent additional first year 
depreciation deduction of $800,000 (the adjusted depreciable basis of 
$1,000,000 multiplied by 0.80). In addition, GGG's depreciation 
deduction allowable in 2023 for the remaining adjusted depreciable basis 
of $200,000 (the unadjusted depreciable basis of $1,000,000 reduced by 
the additional first year depreciation deduction of $800,000) is $40,000 
(the remaining adjusted depreciable basis of $200,000 multiplied by the 
annual depreciation rate of 0.20 for recovery year 1).
    (3) For 2024, 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 $160,000 for 
the equipment is required to be depreciated under the alternative

[[Page 861]]

depreciation system of section 168(g) beginning in 2024. However, the 
additional first year depreciation deduction of $800,000 allowed for the 
equipment in 2023 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 $8,000 for qualified property acquired and placed in service by a 
taxpayer after September 27, 2017.
    (9) 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, 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 (f)(1)(i) 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 Sec.  1.168(b)-1(a)(3) 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 (e)(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 (g)(9)(i)(B), the remaining rehabilitated 
basis is equal to the unadjusted depreciable basis, as defined in Sec.  
1.168(b)-1(a)(3) but before the reduction in basis for the amount of the 
rehabilitation credit, of the qualified rehabilitation expenditures that 
are qualified property reduced by the additional first year depreciation 
allowed or allowable, whichever is greater.
    (ii) Example. The application of this paragraph (g)(9) is 
illustrated by the following example:
    (A) Between February 8, 2023, and June 4, 2023, JM, 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 qualified property and qualify for the 
20-percent rehabilitation credit under section 47(a)(1). JM's basis in 
the qualified rehabilitated building is zero before incurring the 
qualified rehabilitation expenditures and JM placed the qualified 
rehabilitated building in service in July 2023. JM depreciates its 
nonresidential real property placed in service in 2023 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. JM elected to use the optional depreciation tables to 
compute the depreciation allowance for its depreciable property placed 
in service in 2023. Further, for 2023, JM did not make any election 
under paragraph (f) of this section.
    (B) Because JM did not make any election under paragraph (f) of this 
section, JM is allowed an 80-percent additional first year depreciation 
deduction of $160,000 for the qualified rehabilitation expenditures for 
2023 (the unadjusted depreciable basis of $200,000 (before reduction in 
basis for the rehabilitation credit) multiplied by 0.80). JM also is 
allowed to claim a rehabilitation credit of $8,000 for the remaining 
rehabilitated basis of $40,000 (the unadjusted depreciable basis (before 
reduction in basis for the rehabilitation credit) of $200,000 less the 
additional first year depreciation deduction of $160,000, multiplied by 
0.20 to calculate the rehabilitation credit). For 2023, the ratable 
share of the rehabilitation

[[Page 862]]

credit of $8,000 is $1,600. Further, JM's depreciation deduction for 
2023 for the remaining adjusted depreciable basis of $32,000 (the 
unadjusted depreciable basis (before reduction in basis for the 
rehabilitation credit) of $200,000 less the additional first year 
depreciation deduction of $160,000 less the rehabilitation credit of 
$8,000) is $376.64 (the remaining adjusted depreciable basis of $32,000 
multiplied by the depreciation rate of 0.01177 for recovery year 1, 
placed in service in month 7).
    (10) Coordination with section 514(a)(3). The additional first year 
depreciation deduction is not allowable for purposes of section 
514(a)(3).
    (11) Mid-quarter convention. In determining whether the mid-quarter 
convention applies for a taxable year under section 168(d)(3) and Sec.  
1.168(d)-1, the depreciable basis, as defined in Sec.  1.168(d)-1(b)(4), 
for the taxable year the qualified property is placed in service by the 
taxpayer is not reduced by the allowed or allowable additional first 
year depreciation deduction for that taxable year. See Sec.  1.168(d)-
1(b)(4).
    (h) Applicability dates--(1) In general. Except as provided in 
paragraphs (h)(2) and (3) of this section, this section applies to--
    (i) Depreciable property acquired after September 27, 2017, by the 
taxpayer and placed in service by the taxpayer during or after the 
taxpayer's taxable year that begins on or after January 1, 2021;
    (ii) A specified plant for which the taxpayer properly made an 
election to apply section 168(k)(5) and that is planted, or grafted to a 
plant that was previously planted, by the taxpayer during or after the 
taxpayer's taxable year that begins on or after January 1, 2021; and
    (iii) Components acquired or self-constructed after September 27, 
2017, of larger self-constructed property described in paragraph (c)(2) 
of this section and placed in service by the taxpayer during or after 
the taxpayer's taxable year that begins on or after January 1, 2021.
    (2) Applicability of this section for prior taxable years. For 
taxable years beginning before January 1, 2021, see Sec.  1.168(k)-2 as 
contained in 26 CFR part 1, revised as of April 1, 2020.
    (3) Early application of this section and Sec.  1.1502-68--(i) In 
general. Subject to paragraphs (h)(3)(ii) and (iii) of this section, and 
provided that all members of a consolidated group consistently apply the 
same set of rules, a taxpayer may choose to apply both the rules of this 
section and the rules of Sec.  1.1502-68 (to the extent relevant), in 
their entirety and in a consistent manner, to--
    (A) Depreciable property acquired after September 27, 2017, by the 
taxpayer and placed in service by the taxpayer during a taxable year 
ending on or after September 28, 2017;
    (B) A specified plant for which the taxpayer properly made an 
election to apply section 168(k)(5) and that is planted, or grafted to a 
plant that was previously planted, after September 27, 2017, by the 
taxpayer during a taxable year ending on or after September 28, 2017; 
and
    (C) Components acquired or self-constructed after September 27, 
2017, of larger self-constructed property described in paragraph (c)(2) 
of this section and placed in service by the taxpayer during a taxable 
year ending on or after September 28, 2017.
    (ii) Early application to certain transactions. In the case of 
property described in Sec.  1.1502-68(e)(2)(i) that is acquired in a 
transaction that satisfies the requirements of Sec.  1.1502-68(c)(1)(ii) 
or (c)(2)(ii), the taxpayer may apply the rules of this section and the 
rules of Sec.  1.1502-68 (to the extent relevant), in their entirety and 
in a consistent manner, to such property only if those rules are 
applied, in their entirety and in a consistent manner, by all parties to 
the transaction, including the transferor member, the transferee member, 
and the target, as applicable, and the consolidated groups of which they 
are members, for the taxable year(s) in which the transaction occurs and 
the taxable year(s) that includes the day after the deconsolidation 
date, as defined in Sec.  1.1502-68(a)(2)(iii).
    (iii) Bound by early application. Once a taxpayer applies the rules 
of this section and the rules of Sec.  1.1502-68 (to the extent 
relevant), in their entirety, for a taxable year, the taxpayer must 
continue to apply the rules of this section

[[Page 863]]

and the rules of Sec.  1.1502-68 (to the extent relevant), in their 
entirety, for the taxpayer's subsequent taxable years.

[T.D. 9874, 84 FR 50129, Sept. 24, 2019, as amended by T.D. 9916, 85 FR 
71753, Nov. 10, 2020]



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.
    (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

[[Page 864]]

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, 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.

[[Page 865]]

    (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 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]

[[Page 866]]



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 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

[[Page 867]]

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 
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

[[Page 868]]

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 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

[[Page 869]]

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 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

[[Page 870]]

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 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

[[Page 871]]

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 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.

[[Page 872]]

    (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, 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.

[[Page 873]]

    (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) 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

[[Page 874]]

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) (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

[[Page 875]]

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--
    (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

[[Page 876]]

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 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. 
Further, before computing the amortization deduction allowable under 
section 169, the adjusted basis for purposes of determining gain for a 
facility that is acquired and placed in service after September 27, 
2017, and that is qualified property under section 168(k), as amended by 
the Tax Cuts and Jobs Act, Public Law 115-97 (131 Stat. 2054 (December 
22, 2017)) (the ``Act''), or Sec.  1.168(k)-2, must be reduced by the 
amount of the additional first year depreciation deduction allowed or 
allowable, whichever is greater, under section 168(k), as amended by the 
Act.
    (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

[[Page 877]]

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 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

[[Page 878]]

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
(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

[[Page 879]]

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. The last sentence of paragraph 
(a) of this section applies to a certified pollution control facility 
that is qualified property under section 168(k)(2) and placed in service 
by a taxpayer during or after the taxpayer's taxable year that includes 
September 24, 2019. However, a taxpayer may choose to apply the last 
sentence of paragraph (a) of this section to a certified pollution 
control facility that is qualified property under section 168(k)(2) and 
acquired and placed in service after September 27, 2017, by the taxpayer 
during taxable years ending on or after September 28, 2017. A taxpayer 
may rely on the last sentence in paragraph (a) of this section in 
regulation project REG-104397-18 (2018-41 IRB 558) (see Sec.  
601.601(d)(2)(ii)(b) of this chapter) for a certified pollution control 
facility that is qualified property under section 168(k)(2) and acquired 
and placed in service after September 27, 2017, by the taxpayer during 
taxable years ending on or after September 28, 2017, and ending before 
the taxpayer's taxable year that includes September 24, 2019.

[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; T.D. 9874, 84 FR 50149, Sept. 24, 2019]



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 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;

[[Page 880]]

    (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 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

[[Page 881]]

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 883]]



                              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 885]]



                    Table of CFR Titles and Chapters




                      (Revised as of April 1, 2022)

                      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 886]]

     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 887]]

    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  U.S. International Development Finance 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 888]]

     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 (Parts 10100--10199)
       CII  U.S. Office of Special Counsel (Parts 10200--10299)

                      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  Agricultural Marketing Service (Federal Grain 
                Inspection Service, Fair Trade Practices Program), 
                Department of Agriculture (Parts 800--899)

[[Page 889]]

        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  [Reserved]
      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  [Reserved]
       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 890]]

         L  Rural Business-Cooperative Service, and Rural 
                Utilities Service, Department of Agriculture 
                (Parts 5000--5099)

                    Title 8--Aliens and Nationality

         I  Department of Homeland Security (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  Agricultural Marketing Service (Fair Trade Practices 
                Program), 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  [Reserved]
        VI  Farm Credit Administration (Parts 600--699)
       VII  National Credit Union Administration (Parts 700--799)
      VIII  Federal Financing Bank (Parts 800--899)
        IX  (Parts 900--999) [Reserved]
         X  Bureau of Consumer Financial Protection (Parts 1000--
                1099)

[[Page 891]]

        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)
       XIV  Farm Credit System Insurance Corporation (Parts 1400--
                1499)
        XV  Department of the Treasury (Parts 1500--1599)
       XVI  Office of Financial Research, Department of the 
                Treasury (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)

[[Page 892]]

      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)
      XIII  East-West Foreign Trade Board (Parts 1300--1399)
       XIV  Minority Business Development Agency (Parts 1400--
                1499)
        XV  Office of the Under-Secretary for Economic Affairs, 
                Department of Commerce (Parts 1500--1599)
            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]

[[Page 893]]

                     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)
        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  United States Agency for Global Media (Parts 500--599)
       VII  U.S. International Development Finance 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)

[[Page 894]]

                          Title 23--Highways

         I  Federal Highway Administration, Department of 
                Transportation (Parts 1--999)
        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)
         X  Office of Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Interstate Land Sales 
                Registration Program) (Parts 1700--1799) 
                [Reserved]
       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]

[[Page 895]]

        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)

                           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--799)

                   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)

[[Page 896]]

        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)
        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

[[Page 897]]

         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)
      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  Department of Defense, 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  Great Lakes St. Lawrence Seaway Development 
                Corporation, Department of Transportation (Parts 
                400--499)

[[Page 898]]

                          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)
        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  [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)

[[Page 899]]

       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)

                       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)
        IX  Federal Permitting Improvement Steering Council (Part 
                1900)

          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)

[[Page 900]]

       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--Federal Acquisition Supply Chain Security
       201  Federal Acquisition Security Council (Part 201)
            Subtitle E [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)
       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)

[[Page 901]]

                       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)
         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)

[[Page 902]]

                      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)

           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)

[[Page 903]]

        51  Department of the Army Acquisition Regulations (Parts 
                5100--5199) [Reserved]
        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)

                       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)

[[Page 904]]

        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 905]]





           Alphabetical List of Agencies Appearing in the CFR




                      (Revised as of April 1, 2022)

                                                  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, VIII, IX, X, XI; 9, 
                                                  II
Agricultural Research Service                     7, V
Agriculture, Department of                        2, IV; 5, LXXIII
  Advocacy and Outreach, Office of                7, XXV
  Agricultural Marketing Service                  7, I, VIII, IX, X, XI; 9, 
                                                  II
  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
  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 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
Appalachian Regional Commission                   5, IX
Architectural and Transportation Barriers         36, XI
   Compliance Board
[[Page 906]]

Arctic Research Commission                        45, XXIII
Armed Forces Retirement Home                      5, XI; 38, II
Army, Department of                               32, V
  Engineers, Corps of                             33, II; 36, III
  Federal Acquisition Regulation                  48, 51
Benefits Review Board                             20, VII
Bilingual Education and Minority Languages        34, V
     Affairs, Office of
Blind or Severely Disabled, Committee for         41, 51
     Purchase from People Who Are
  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 Hazard Investigation Board    40, VI
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
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 Affairs, Office of the Under-          15, XV
       Secretary for
  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
Council of the Inspectors General on Integrity    5, XCVIII
     and Efficiency
Court Services and Offender Supervision Agency    5, LXX; 28, VIII
     for the District of Columbia
Customs and Border Protection                     19, I
Defense, Department of                            2, XI; 5, XXVI; 32, 
                                                  Subtitle A; 40, VII
  Advanced Research Projects Agency               32, I
  Air Force Department                            32, VII
  Army Department                                 32, V; 33, II; 36, III; 
                                                  48, 51
  Defense Acquisition Regulations System          48, 2
  Defense Intelligence Agency                     32, I

[[Page 907]]

  Defense Logistics Agency                        32, I, XII; 48, 54
  Engineers, Corps of                             33, II; 36, III
  National Imagery and Mapping Agency             32, I
  Navy, Department of                             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 Affairs, Office of the Under-Secretary   15, XV
     for
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, II
  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

[[Page 908]]

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 Acquisition Security Council              41, 201
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 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 Permitting Improvement Steering Council   40, IX
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
  Contract Appeals, Board of                      48, 61
  Federal Acquisition Regulation                  48, 5
  Federal Management Regulation                   41, 102

[[Page 909]]

  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
Great Lakes St. Lawrence Seaway Development       33, IV
     Corporation
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, Office of, and Multifamily Housing       24, IV
     Assistance Restructuring, Office 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 910]]

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 Environmental Enforcement, Bureau    30, II
       of
  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 Development Finance Corporation,    5, XXXIII; 22, VII
     U.S.
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
  Benefits Review Board                           20, VII
  Employee Benefits Security Administration       29, XXV
  Employees' Compensation Appeals Board           20, IV
  Employment and Training Administration          20, V
  Federal Acquisition Regulation                  48, 29

[[Page 911]]

  Federal Contract Compliance Programs, Office    41, 60
       of
  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, VI
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
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; 47, II

[[Page 912]]

National Technical Information Service            15, XI
National Telecommunications and Information       15, XXIII; 47, III, IV, V
     Administration
National Transportation Safety Board              49, VIII
Natural Resource Revenue, Office of               30, XII
Natural Resources Conservation Service            7, VI
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
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, IV, XXXV; 45, VIII
  Federal Acquisition Regulation                  48, 17
  Federal Employees Group Life Insurance Federal  48, 21
       Acquisition Regulation
  Federal Employees Health Benefits Acquisition   48, 16
       Regulation
  Human Resources Management and Labor Relations  5, XCVII
       Systems, Department of Homeland Security
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 and Indian Housing, Office of Assistant    24, IX
     Secretary for
Public Contracts, Department of Labor             41, 50
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 Utilities Service                           7, XVII, XVIII, XLII
Safety and Environmental Enforcement, Bureau of   30, II
Science and Technology Policy, Office of          32, XXIV; 47, II
Secret Service                                    31, IV
Securities and Exchange Commission                5, XXXIV; 17, II
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

[[Page 913]]

  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 Acquisition Security Council              41, 201
  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
  Great Lakes St. Lawrence Seaway Development     33, IV
       Corporation
  Maritime Administration                         46, II
  National Highway Traffic Safety Administration  23, II, III; 47, IV; 49, V
  Pipeline and Hazardous Materials Safety         49, I
       Administration
  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 Agency for Global Media             22, V
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
U.S. Office of Special Counsel                    5, CII
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 915]]







                      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

[[Page 916]]

 
                                                               1545-0241
                                                               1545-0244
                                                               1545-0797
1.52-2.....................................................    1545-0219
1.52-3.....................................................    1545-0219
1.56(g)-1..................................................    1545-1233
1.57-5.....................................................    1545-0227
1.58-1.....................................................    1545-0175
1.59-1.....................................................    1545-1903
1.61-2.....................................................    1545-0771
1.61-4.....................................................    1545-0187
1.61-15....................................................    1545-0074
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1.63-1.....................................................    1545-0074
1.66-4.....................................................    1545-1770
1.67-2T....................................................    1545-0110
1.67-3.....................................................    1545-1018
1.67-3T....................................................    1545-0118
1.71-1T....................................................    1545-0074
1.72-4.....................................................    1545-0074
1.72-6.....................................................    1545-0074
1.72-9.....................................................    1545-0074
1.72-17....................................................    1545-0074
1.72-17A...................................................    1545-0074
1.72-18....................................................    1545-0074
1.74-1.....................................................    1545-1100
1.79-2.....................................................    1545-0074
1.79-3.....................................................    1545-0074
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1.83-5.....................................................    1545-0074
1.83-6.....................................................    1545-1448
1.103-10...................................................    1545-0123
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1.103A-2...................................................    1545-0720
1.105-4....................................................    1545-0074
1.105-5....................................................    1545-0074
1.105-6....................................................    1545-0074
1.108-4....................................................    1545-1539
1.108-5....................................................    1545-1421
1.108-7....................................................    1545-2155
1.108(i)-1.................................................    1545-2147
1.108(i)-2.................................................    1545-2147
1.110-1....................................................    1545-1661
1.117-5....................................................    1545-0869
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                                                               1545-0091
1.121-5....................................................    1545-0072
1.127-2....................................................    1545-0768
1.132-2....................................................    1545-0771
1.132-5....................................................    1545-0771
1.132-9(b).................................................    1545-1676
1.141-1....................................................    1545-1451
1.141-12...................................................    1545-1451
1.142-2....................................................    1545-1451
1.142(f)(4)-1..............................................    1545-1730
1.148-0....................................................    1545-1098
1.148-1....................................................    1545-1098
1.148-2....................................................    1545-1098
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1.148-3....................................................    1545-1098
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1.148-4....................................................    1545-1098
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1.148-5....................................................    1545-1098
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1.148-6....................................................    1545-1098
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1.148-7....................................................    1545-1098
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1.148-8....................................................    1545-1098
1.148-11...................................................    1545-1098
                                                               1545-1347
1.149(e)-1.................................................    1545-0720
1.150-1....................................................    1545-1347
1.151-1....................................................    1545-0074
1.152-3....................................................    1545-0071
                                                               1545-1783
1.152-4....................................................    1545-0074
1.152-4T...................................................    1545-0074
1.162-1....................................................    1545-0139
1.162-2....................................................    1545-0139
1.162-3....................................................    1545-0139
1.162-4....................................................    1545-0139
1.162-5....................................................    1545-0139
1.162-6....................................................    1545-0139
1.162-7....................................................    1545-0139
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1.162-9....................................................    1545-0139
1.162-10...................................................    1545-0139
1.162-11...................................................    1545-0139
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1.162-24...................................................    1545-2115
1.162-27...................................................    1545-1466
1.163-5....................................................    1545-0786
                                                               1545-1132
1.163-8T...................................................    1545-0995
1.163-10T..................................................    1545-0074
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1.163(d)-1.................................................    1545-1421
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1.165-11...................................................    1545-0074
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1.166-1....................................................    1545-0123
1.166-2....................................................    1545-1254
1.166-4....................................................    1545-0123
1.166-10...................................................    1545-0123
1.167(a)-5T................................................    1545-1021
1.167(a)-7.................................................    1545-0172
1.167(a)-11................................................    1545-0152
                                                               1545-0172
1.167(a)-12................................................    1545-0172
1.167(d)-1.................................................    1545-0172
1.167(e)-1.................................................    1545-0172
1.167(f)-11................................................    1545-0172
1.167(l)-1.................................................    1545-0172
1.168(d)-1.................................................    1545-1146
1.168(i)-1.................................................    1545-1331
1.168-5....................................................    1545-0172
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1.170-1....................................................    1545-0074
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1.170-3....................................................    1545-0123
1.170A-1...................................................    1545-0074
1.170A-2...................................................    1545-0074
1.170A-4(A)(b).............................................    1545-0123
1.170A-8...................................................    1545-0074
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1.170A-13(f)...............................................    1545-1464
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1.175-3....................................................    1545-0187
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1.179-2....................................................    1545-1201
1.179-3....................................................    1545-1201
1.179-5....................................................    1545-0172
                                                               1545-1201
1.179B-1T..................................................    1545-2076
1.179C-1...................................................    1545-2103
1.179C-1T..................................................    1545-2103
1.180-2....................................................    1545-0074
1.181-1....................................................    1545-2059
1.181-2....................................................    1545-2059
1.181-3....................................................    1545-2059
1.182-6....................................................    1545-0074
1.183-1....................................................    1545-0195
1.183-2....................................................    1545-0195
1.183-3....................................................    1545-0195
1.183-4....................................................    1545-0195
1.190-3....................................................    1545-0074
1.194-2....................................................    1545-0735
1.194-4....................................................    1545-0735
1.195-1....................................................    1545-1582
1.197-1T...................................................    1545-1425
1.197-2....................................................    1545-1671
1.199-6....................................................    1545-1966
1.213-1....................................................    1545-0074
1.215-1T...................................................    1545-0074
1.217-2....................................................    1545-0182
1.243-3....................................................    1545-0123
1.243-4....................................................    1545-0123
1.243-5....................................................    1545-0123
1.248-1....................................................    1545-0172
1.261-1....................................................    1545-1041
1.263(a)-1.................................................    1545-2248
1.263(a)-3.................................................    1545-2248
1.263(a)-5.................................................    1545-1870
1.263(e)-1.................................................    1545-0123
1.263A-1...................................................    1545-0987
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
1.266-1....................................................    1545-0123
1.267(f)-1.................................................    1545-0885
1.268-1....................................................    1545-0184
1.274-1....................................................    1545-0139
1.274-2....................................................    1545-0139
1.274-3....................................................    1545-0139
1.274-4....................................................    1545-0139
1.274-5....................................................    1545-0771
1.274-5A...................................................    1545-0139
                                                               1545-0771
1.274-5T...................................................    1545-0074
                                                               1545-0172
                                                               1545-0771
1.274-6....................................................    1545-0139
                                                               1545-0771
1.274-6T...................................................    1545-0074
                                                               1545-0771
1.274-7....................................................    1545-0139
1.274-8....................................................    1545-0139
1.279-6....................................................    1545-0123
1.280C-4...................................................    1545-1155
1.280F-3T..................................................    1545-0074
1.280G-1...................................................    1545-1851
1.281-4....................................................    1545-0123
1.302-4....................................................    1545-0074
1.305-3....................................................    1545-0123
1.305-5....................................................    1545-1438
1.307-2....................................................    1545-0074
1.312-15...................................................    1545-0172
1.316-1....................................................    1545-0123
1.331-1....................................................    1545-0074
1.332-4....................................................    1545-0123
1.332-6....................................................    1545-2019
1.336-2....................................................    1545-2125
1.336-4....................................................    1545-2125
1.337(d)-1.................................................    1545-1160
1.337(d)-2.................................................    1545-1160
                                                               1545-1774
1.337(d)-4.................................................    1545-1633
1.337(d)-5.................................................    1545-1672
1.337(d)-6.................................................    1545-1672
1.337(d)-7.................................................    1545-1672
1.338-2....................................................    1545-1658
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
1.351-3....................................................    1545-2019
1.355-5....................................................    1545-2019
1.362-2....................................................    1545-0123
1.362-4....................................................    1545-2247
1.367(a)-1T................................................    1545-0026
1.367(a)-2T................................................    1545-0026
1.367(a)-3.................................................    1545-0026
                                                               1545-1478
1.367(a)-3T................................................    1545-2183
1.367(a)-6T................................................    1545-0026
1.367(a)-7.................................................    1545-2183
1.367(a)-7T................................................    1545-2183
1.367(a)-8.................................................    1545-1271
                                                               1545-2056
                                                               1545-2183
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1.367(b)-3T................................................    1545-1666
1.367(d)-1T................................................    1545-0026
1.367(e)-1.................................................    1545-1487
1.367(e)-2.................................................    1545-1487
1.368-1....................................................    1545-1691
1.368-3....................................................    1545-2019
1.371-1....................................................    1545-0123
1.371-2....................................................    1545-0123
1.374-3....................................................    1545-0123
1.381(b)-1.................................................    1545-0123
1.381(c)(4)-1..............................................    1545-0123
                                                               1545-0152
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1.381(c)(5)-1..............................................    1545-0123
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1.381(c)(6)-1..............................................    1545-0123
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1.381(c)(8)-1..............................................    1545-0123
1.381(c)(10)-1.............................................    1545-0123
1.381(c)(11)-1(k)..........................................    1545-0123
1.381(c)(13)-1.............................................    1545-0123
1.381(c)(17)-1.............................................    1545-0045
1.381(c)(22)-1.............................................    1545-1990
1.381(c)(25)-1.............................................    1545-0045
1.382-1T...................................................    1545-0123
1.382-2....................................................    1545-0123
1.382-2T...................................................    1545-0123
1.382-3....................................................    1545-1281
                                                               1545-1345
1.382-4....................................................    1545-1120
1.382-6....................................................    1545-1381
1.382-8....................................................    1545-1434
1.382-9....................................................    1545-1120
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1.382-11...................................................    1545-2019
1.382-91...................................................    1545-1260
                                                               1545-1324
1.383-1....................................................    1545-0074
                                                               1545-1120
1.401-1....................................................    1545-0020
                                                               1545-0197
                                                               1545-0200
                                                               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
                                                               1545-1069
                                                               1545-1669
                                                               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
                                                               1545-0134
                                                               1545-0152
                                                               1545-0820
                                                               1545-1748
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
                                                               1545-1855
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
                                                               1545-1134
1.453A-3...................................................    1545-0963
1.454-1....................................................    1545-0074
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[[Page 919]]

 
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1.456-2....................................................    1545-0123
1.456-6....................................................    1545-0123
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
                                                               1545-1572
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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
                                                               1545-0152
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 920]]

 
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 921]]

 
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 922]]

 
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 923]]

 
                                                               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
1.1445-6...................................................    1545-0902
                                                               1545-1060
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
1.1461-1...................................................    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
                                                               1545-0885
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1.1502-16..................................................    1545-0123
1.1502-18..................................................    1545-0123
1.1502-19..................................................    1545-0123
                                                               1545-1774
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
                                                               1545-1774
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
                                                               1545-0133
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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
                                                               1545-2019
1.1563-3...................................................    1545-0123
1.5000A-3..................................................    1545-0074
1.5000A-4..................................................    1545-0074
1.5000C-2..................................................    1545-0096
                                                               1545-2263
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
1.6012-1...................................................    1545-0067
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1.6012-2...................................................    1545-0047
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1.6012-3...................................................    1545-0047
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1.6012-4...................................................    1545-0067
1.6012-5...................................................    1545-0067
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1.6012-6...................................................    1545-0067
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1.6013-2...................................................    1545-0091
1.6013-6...................................................    1545-0074
1.6013-7...................................................    1545-0074
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
                                                               1545-0087
                                                               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
                                                               1545-1023
1.6038-2...................................................    1545-1617
                                                               1545-2020
1.6038-3...................................................    1545-1617
1.6038A-2..................................................    1545-1191
1.6038A-3..................................................    1545-1191
                                                               1545-1440
1.6038B-1..................................................    1545-1617
                                                               1545-2183
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
                                                               1545-0115
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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1.6042-4...................................................    1545-0110
1.6043-1...................................................    1545-0041
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1.6043-3...................................................    1545-0047
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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
1.6046-3...................................................    1545-0704
1.6046A....................................................    1545-1646
1.6047-1...................................................    1545-0119
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1.6047-2...................................................    1545-2234
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1.6049-4...................................................    1545-0096
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1.6049-5...................................................    1545-0096
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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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1.6055-1...................................................    1545-2252
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1.6060-1(a)(1).............................................    1545-1231
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1.6081-4...................................................    1545-0188
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1.6081-6...................................................    1545-0148
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1.6091-3...................................................    1545-0089
1.6107-1...................................................    1545-0074
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1.6109-1...................................................    1545-0074
1.6109-2...................................................    1545-2176
1.6115-1...................................................    1545-1464
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1.6164-5...................................................    1545-0135
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1.6302-2...................................................    1545-0098
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1.6411-2...................................................    1545-0098
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1.6411-3...................................................    1545-0098
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1.6411-4...................................................    1545-0582
1.6414-1...................................................    1545-0096
1.6425-1...................................................    1545-0170
1.6425-2...................................................    1545-0170
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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1.6851-2...................................................    1545-0086
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1.7476-1...................................................    1545-0197
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1.7519-2T..................................................    1545-1036
1.7520-1...................................................    1545-1343
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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
                                                               1545-0531
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
                                                               1545-0181
                                                               1545-1707
20.6091-1..................................................    1545-0015
20.6107-1..................................................    1545-1231
20.6161-1..................................................    1545-0015
                                                               1545-0181
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
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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
                                                               1545-0065

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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 931]]

 
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 933]]



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, 2017 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.

                                  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

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
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

                                  2020

26 CFR
                                                                   85 FR
                                                                    Page
Chapter I
1.152-2 (b) revised; (e) added.....................................64386
1.162-15 (a) and (d) revised.......................................48472
1.162-27 Heading, (a), and (j)(1) revised..........................86492
1.162-33 Added.....................................................86492
1.163(j)-0 Added...................................................56756
1.163(j)-1 Added...................................................56760
1.163(j)-2 Added...................................................56760
1.163(j)-3 Added...................................................56760
1.163(j)-4 Added...................................................56760
1.163(j)-5 Added...................................................56760
1.163(j)-6 Added...................................................56760
1.163(j)-7 Added...................................................56760
1.163(j)-8 Added...................................................56760
1.163(j)-9 Added...................................................56760
1.163(j)-10 Added..................................................56760
1.163(j)-11 Added..................................................56760
1.164-3 (j) added..................................................48473

[[Page 934]]

1.168(b)-1 (a)(5)(i)(A) revised; (b)(2)(i) amended; (b)(2)(iv) 
        added......................................................71752
1.168(i)-1 (e)(2)(viii)(A) and (m)(1) amended; (m)(5) redesignated 
        as (m)(6); new (m)(5) added................................77378
1.168(i)-8 (c)(4)(i) and (j)(1) amended; (j)(5) redesignated as 
        (j)(6); new (j)(5) added...................................77378
1.168(k)-0 (b)(3)(iii)(C), (v), (5)(iii)(G), (v), (c), (1), (2), 
        (i) through (iv), (3), (i) through (iii), (4), (i), (ii), 
        (5), (i), (ii), (6), (i), (ii), (7), (i), (ii), (8), (9), 
        (d)(4), (f)(7), (g)(11), and (h)(3)(i) through (iii) 
        added; (d)(3)(iv), (h)(2), and (3) revised.................71752
1.168(k)-2 (a)(1), (2)(iv)(B), (C), (D), (b)(3)(iii)(B)(1), 
        (5)(ii)(A), (iii)(A), (B), (iv)(C)(1), (2), (viii) 
        introductory text, (e)(1)(iii), (f)(1)(ii)(D), (G), and 
        (g)(1)(i) amended; (a)(2)(iv)(E) removed; (b)(2)(ii)(F), 
        (G), and (h)(1) through (3) revised; (d)(3)(iv) 
        redesignated as (d)(4); (b)(2)(iii)(F) through (I), 
        (b)(3)(iii)(B)(4), (C), (v), (vii)(Y) through (OO), 
        (5)(iii)(G), (v), (c), new (d)(3)(iv), (f)(7), and (g)(11) 
        added......................................................71753

                                  2021

26 CFR
                                                                   86 FR
                                                                    Page
Chapter I
1.162-21 Revised....................................................4984
1.163(j)-0 Amended..................................................5522
1.163(j)-1 (b)(1)(iv)(A)(1) and (c)(1) amended; (b)(1)(iv)(A)(2) 
        and (3), (B), (C), (D), (viii)(A) through (D) revised; 
        (b)(1)(iv)(A)(4), (E), (F), (G), (viii)(E), (22)(iii)(F), 
        (35), and (c)(4) added......................................5523
1.163(j)-2 (k) redesignated as (k)(1); (b)(3)(iii), (iv), (d)(3), 
        new (k) heading, and (2) added; new (k)(1) heading revised
                                                                    5529
1.163(j)-6 (c)(3) and (p) redesignated as (c)(4) and (p)(1); 
        (c)(1), (2), new (3), (d)(3) through (5), (e)(5), 
        (f)(1)(iii), (g)(4), (n), (o)(24), through (26), new 
        (p)(1) heading, and (2) added; (p) heading revised..........5529
1.163 (a) and (m) revised; (c) through (f), (g)(3) and (4), (h), 
        (k), and (l) added..........................................5532
1.163(j)-10 (c)(5)(ii)(D) and (f) redesignated as (c)(5)(ii)(D)(1) 
        and (f)(1); new (c)(5)(ii)(D) heading, (2), new (f) 
        heading, and (2) added; new (f)(1) heading revised..........5539
1.163-15 Added......................................................5521
1.165-11 (b)(1) and (h) revised....................................31150

                                  2022

   (Regulations published from January 1, 2022, through April 1, 2022)

26 CFR
                                                                   87 FR
                                                                    Page
Chapter I
1.164-2 (d) revised; (i) added.......................................317


                                  [all]