[Federal Register Volume 61, Number 83 (Monday, April 29, 1996)]
[Rules and Regulations]
[Pages 18675-18678]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-10395]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8667]
RIN 1545-AT33


Lease Term; Exchanges of Tax-Exempt Use Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the lease 
term of tax-exempt use property. The final regulations also provide 
guidance regarding certain like-kind exchanges among related parties 
involving tax-exempt use property.

DATES: These regulations are effective April 29, 1996.
    For dates of applicability see ``Effective dates'' section under 
the SUPPLEMENTARY INFORMATION portion of the preamble and 
Secs. 1.168(h)-1(e) and 1.168(i)-2(g).

FOR FURTHER INFORMATION CONTACT: John M. Aramburu of the Office of 
Assistant Chief Counsel (Income Tax and Accounting) at (202) 622-4960 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains final regulations under section 168 of the 
Internal Revenue Code of 1986 (Code). The regulations provide guidance 
relating to certain exchanges of tax-exempt use property among related 
parties and the determination of lease term under certain 
circumstances. Proposed regulations (IA-18-95) were published in the 
Federal Register on April 21, 1995 (60 FR 19868). The IRS received a 
number of comments on the proposed regulations. A scheduled public 
hearing was cancelled because there were no requests to testify. After 
consideration of all the comments, the regulations proposed by IA-18-95 
are adopted as revised by this Treasury decision. The revisions are 
discussed below.

Overview

    Under section 168, property used in a trade or business, or held 
for the production of income, generally may be depreciated under the 
general depreciation system (GDS) using accelerated methods over 
relatively short recovery periods. However, certain property, including 
``tax-exempt use property,'' must be depreciated under the alternative 
depreciation system (ADS) described in section 168(g). Section 
168(h)(1)(A) generally defines tax-exempt use property to include 
tangible property (other than nonresidential real property) leased to a 
tax-exempt entity. For this purpose, certain foreign entities and 
persons are considered tax-exempt entities.
    Congress subjected tax-exempt use property to a slower depreciation 
system than GDS to prevent tax-exempt entities from indirectly claiming 
tax benefits (in the form of reduced rentals) ``from investment 
incentives for which they [would] not qualify directly, and effectively 
gain[ing] the advantage of taking income tax deductions and credits 
while having no corresponding liability to pay any tax on income from 
the property.'' S. Rep. No. 169 (Vol. 1), 98th Cong., 2d Sess. 123 
(1984).
    In particular, section 168(g)(3)(A) provides that tax-exempt use 
property subject to a lease must be depreciated using the straight-line 
method over a period equal to the greater of the property's class life 
or 125 percent of the lease term. Under section 168(i)(3), options to 
renew generally must be taken into account in determining the lease 
term and the periods of certain successive leases must be aggregated 
with the period of an original lease.

Lease Term

    The proposed regulations generally include an additional period of 
time during which a lessee may not continue to be the lessee in the 
lease term if the lessee (or a related person) 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. The 
arrangements described in the proposed regulations are frequently 
referred to as ``replacement leases.'' One commentator requested that 
the portion of the proposed regulations dealing with replacement leases 
be withdrawn. The commentator argued that Congress would not have 
intended that the term of the replacement lease be taken into account 
in determining lease term. The IRS and Treasury believe that the 
proposed regulations are consistent with Congressional intent, and thus 
the final regulations retain this portion of the proposed regulations.
    Another commentator indicated that application of the proposed 
regulations was unclear where property is subject to multiple leases, 
possibly involving multiple parties. The final regulations clarify that 
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 shall include all periods described in 
one or more of such leases. Thus, 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 is 20 years, and during the period of tax-exempt 
use it must be depreciated using the straight line method over the 
greater of its class life or 25 years.
    Finally, the final regulations provide that lease term also 
includes any period during which the lessee (or a related party) has 
assumed or retained any risk of loss with respect to the property 
(including, for example, by holding a note secured by the property). 
The IRS and Treasury believe that such an arrangement is generally 
similar to the replacement leases described in the proposed 
regulations. As in the case of a replacement lease, the lessee is 
assuming risk with respect to the value of the property at the 
termination of the initial lease term. In addition, the term of the 
debt provides an objective indication that the useful life of the 
property exceeds the original term of the lease, in which case failure 
to include the term of the debt in the lease term

[[Page 18676]]

could allow a tax-exempt lessee to benefit from depreciation deductions 
that exceed economic depreciation, which would be contrary to 
Congressional intent.

Like-kind Exchanges

    The proposed regulations also address certain transactions between 
related persons that are designed to circumvent the tax-exempt use 
property rules through the use of a like-kind exchange described in 
section 1031. The proposed regulations provide that property (tainted 
property) transferred directly or indirectly to the taxpayer by a 
related person (the related party) as part of, or in connection with, a 
transaction described in section 1031 where 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 rule, 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.
    The rule applies only with respect to direct or indirect transfers 
of property involving related persons where (1) section 1031 applies to 
any party, and (2) a principal purpose of the transfer is to avoid or 
limit the application of ADS. For purposes of this rule, a person is 
related to another person if they bear a relationship specified in 
section 267(b) or section 707(b)(1). An exchange between members of a 
consolidated group in a taxable year beginning on or after July 12, 
1995, will not be subject to this provision because section 1031 does 
not apply to intercompany transactions. See Sec. 1.1502-80(f).
    No comments were received with respect to the treatment of like-
kind exchanges under the proposed regulations. Accordingly, these 
provisions of the proposed regulations are adopted without modification 
by this Treasury decision.

Effective Dates

    The definition of lease term is generally applicable to leases 
entered into on or after April 20, 1995. The changes made by the final 
regulations apply to leases entered into after April 26, 1996. The 
treatment of like-kind exchanges is applicable to transfers made on or 
after April 20, 1995. No inference is intended by these effective dates 
as to the treatment of any transaction under prior law. The regulations 
do not preclude the application of common law doctrines (such as the 
substance over form or step transaction doctrines) and other 
authorities to transactions described in the regulations (e.g., as to 
whether a particular transaction should be characterized as a lease or 
a conditional sale for federal income tax purposes).

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It has also been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to 
these regulations, and therefore, a Regulatory Flexibility Analysis is 
not required. Pursuant to section 7805(f) of the Internal Revenue Code, 
the notice of proposed rulemaking preceding these regulations was 
submitted to the Small Business Administration for comment on its 
impact on small business.

    Drafting Information: The principal author of these regulations 
is John M. Aramburu of the Office of Assistant Chief Counsel (Income 
Tax and Accounting). However, other personnel from the IRS and 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *.

    Section 1.168(h)-1 also issued under 26 U.S.C. 168. * * *
    Section 1.168(i)-2 also issued under 26 U.S.C. 168. * * *
    Par. 2. Sections 1.168(h)-1 and 1.168(i)-2 are added to read as 
follows:


Sec. 1.168(h)-1  Like-kind exchanges involving tax-exempt use property.

    (a) Scope. (1) This section applies with respect to a direct or 
indirect transfer of property among related persons, including 
transfers made through a qualified intermediary (as defined in 
Sec. 1.1031(k)-1(g)(4)) or other unrelated person, (a transfer) if--
    (i) Section 1031 applies to any party to the transfer or to any 
related transaction; and
    (ii) A principal purpose of the transfer or any related transaction 
is to avoid or limit the application of the alternative depreciation 
system (within the meaning of section 168(g)).
    (2) For purposes of this section, a person is related to another 
person if they bear a relationship specified in section 267(b) or 
section 707(b)(1).
    (b) Allowable depreciation deduction for property subject to this 
section--(1) In general. Property (tainted property) transferred 
directly or indirectly to a taxpayer by a related person (related 
party) as part of, or in connection with, a transaction in which the 
related party receives tax-exempt use property (related tax-exempt use 
property) will, if the tainted property is subject to an allowance for 
depreciation, be treated in the same manner as the related tax-exempt 
use property for purposes of determining the allowable depreciation 
deduction under section 167(a). Under this paragraph (b), the tainted 
property is depreciated by the taxpayer over the remaining recovery 
period of, and using the same depreciation method and convention as 
that of, the related tax-exempt use property.
    (2) Limitations--(i) Taxpayer's basis in related tax-exempt use 
property. The rules of this paragraph (b) apply only with respect to so 
much of the taxpayer's basis in the tainted property as does not exceed 
the taxpayer's adjusted basis in the related tax-exempt use property 
prior to the transfer. Any excess of the taxpayer's basis in the 
tainted property over its adjusted basis in the related tax-exempt use 
property prior to the transfer is treated as property to which this 
section does not apply. This paragraph (b)(2)(i) does not apply if the 
related tax-exempt use property is not acquired from the taxpayer 
(e.g., if the taxpayer acquires the tainted property for cash but 
section 1031 nevertheless applies to the related party because the 
transfer involves a qualified intermediary).
    (ii) Application of section 168(i)(7). This section does not apply 
to so much of the taxpayer's basis in the tainted property as is 
subject to section 168(i)(7).
    (c) Related tax-exempt use property. (1) For purposes of paragraph 
(b) of this section, related tax-exempt use property includes--
    (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

[[Page 18677]]

was intended that the property become tax-exempt use property.
    (2) For purposes of determining the remaining recovery period of 
the related tax-exempt use property in the circumstances described in 
paragraph (c)(1)(ii) of this section, the related tax-exempt use 
property will be treated as having, prior to the transfer, a lease term 
equal to the term of any lease that causes such property to become tax-
exempt use property.
    (d) Examples. The following examples illustrate the application of 
this section. The examples do not address common law doctrines or other 
authorities that may apply to recharacterize or alter the effects of 
the transactions described therein. Unless otherwise indicated, parties 
to the transactions are not related to one another.

    Example 1. (i) X owns all of the stock of two subsidiaries, B 
and Z. X, B and Z do not file a consolidated federal income tax 
return. On May 5, 1995, B purchases an aircraft (FA) for $1 million 
and leases it to a foreign airline whose income is not subject to 
United States taxation and which is a tax-exempt entity as defined 
in section 168(h)(2). On the same date, Z owns an aircraft (DA) with 
a fair market value of $1 million, which has been, and continues to 
be, leased to an airline that is a United States taxpayer. Z's 
adjusted basis in DA is $0. The next day, at a time when each 
aircraft is still worth $1 million, B transfers FA to Z (subject to 
the lease to the foreign airline) in exchange for DA (subject to the 
lease to the airline that is a United States taxpayer). Z realizes 
gain of $1 million on the exchange, but that gain is not recognized 
pursuant to section 1031(a) because the exchange is of like-kind 
properties. Assume that a principal purpose of the transfer of DA to 
B or of FA to Z is to avoid the application of the alternative 
depreciation system. Following the exchange, Z has a $0 basis in FA 
pursuant to section 1031(d). B has a $1 million basis in DA.
    (ii) B has acquired property from Z, a related person; Z's gain 
is not recognized pursuant to section 1031(a); Z has received tax-
exempt use property as part of the transaction; and a principal 
purpose of the transfer of DA to B or of FA to Z is to avoid the 
application of the alternative depreciation system. Accordingly, the 
transaction is within the scope of this section. Pursuant to 
paragraph (b) of this section, B must recover its $1 million basis 
in DA over the remaining recovery period of, and using the same 
depreciation method and convention as that of, FA, the related tax-
exempt use property.
    (iii) If FA did not become tax-exempt use property until after 
the exchange, it would still be related tax-exempt use property and 
paragraph (b) of this section would apply if, at the time of the 
exchange, it was intended that FA become tax-exempt use property.
    Example 2. (i) X owns all of the stock of two subsidiaries, B 
and Z. X, B and Z do not file a consolidated federal income tax 
return. B and Z each own identical aircraft. B's aircraft (FA) is 
leased to a tax-exempt entity as defined in section 168(h)(2) and 
has a fair market value of $1 million and an adjusted basis of 
$500,000. Z's aircraft (DA) is leased to a United States taxpayer 
and has a fair market value of $1 million and an adjusted basis of 
$10,000. On May 1, 1995, B and Z exchange aircraft, subject to their 
respective leases. B realizes gain of $500,000 and Z realizes gain 
of $990,000, but neither person recognizes gain because of the 
operation of section 1031(a). Moreover, assume that a principal 
purpose of the transfer of DA to B or of FA to Z is to avoid the 
application of the alternative depreciation system.
    (ii) As in Example 1, B has acquired property from Z, a related 
person; Z's gain is not recognized pursuant to section 1031(a); Z 
has received tax-exempt use property as part of the transaction; and 
a principal purpose of the transfer of DA to B or of FA to Z is to 
avoid the application of the alternative depreciation system. Thus, 
the transaction is within the scope of this section even though B 
has held tax-exempt use property for a period of time and, during 
that time, has used the alternative depreciation system with respect 
to such property. Pursuant to paragraph (b) of this section, B, 
which has a substituted basis determined pursuant to section 1031(d) 
of $500,000 in DA, must depreciate the aircraft over the remaining 
recovery period of FA, using the same depreciation method and 
convention. Z holds tax-exempt use property with a basis of $10,000, 
which must be depreciated under the alternative depreciation system.
    (iii) Assume the same facts as in paragraph (i) of this Example 
2, except that B and Z are members of an affiliated group that files 
a consolidated federal income tax return. Of B's $500,000 basis in 
DA, $10,000 is subject to section 168(i)(7) and therefore not 
subject to this section. The remaining $490,000 of basis is subject 
to this section. But see Sec. 1.1502-80(f) making section 1031 
inapplicable to intercompany transactions occurring in consolidated 
return years beginning on or after July 12, 1995.

    (e) Effective date. This section applies to transfers made on or 
after April 20, 1995.


Sec. 1.168(i)-2  Lease term.

    (a) In general. For purposes of section 168, a lease term is 
determined under all the facts and circumstances. Paragraph (b) of this 
section and Sec. 1.168(j)-1T, Q&A 17, describe certain circumstances 
that will result in a period of time not included in the stated 
duration of an original lease (additional period) nevertheless being 
included in the lease term. These rules do not prevent the inclusion of 
an additional period in the lease term in other circumstances.
    (b) Lessee retains financial obligation--(1) In general. An 
additional period of time during which a lessee may not continue to be 
the lessee will nevertheless be included in the lease term if the 
lessee (or a related person)--
    (i) Has agreed that one or both of them will or could be obligated 
to make a payment of rent or a payment in the nature of rent with 
respect to such period; or
    (ii) Has assumed or retained any risk of loss with respect to the 
property for such period (including, for example, by 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.

[[Page 18678]]

    (f) Example. The following example illustrates the principles of 
this section. The example does not address common law doctrines or 
other authorities that may apply to cause an additional period to be 
included in the lease term or to recharacterize a lease as a 
conditional sale or otherwise for federal income tax purposes. Unless 
otherwise indicated, parties to the transactions are not related to one 
another.

    Example. Financial obligation with respect to an additional 
period--(i) Facts. X, a taxable corporation, and Y, a foreign 
airline whose income is not subject to United States taxation, enter 
into a lease agreement under which X agrees to lease an aircraft to 
Y for a period of 10 years. The lease agreement provides that, at 
the end of the lease period, Y is obligated to find a subsequent 
lessee (replacement lessee) to enter into a subsequent lease 
(replacement lease) of the aircraft from X for an additional 10-year 
period. The provisions of the lease agreement require that any 
replacement lessee be unrelated to Y and that it not be a tax-exempt 
entity as defined in section 168(h)(2). The provisions of the lease 
agreement also set forth the basic terms and conditions of the 
replacement lease, including its duration and the required rental 
payments. In the event Y fails to secure a replacement lease, the 
lease agreement requires Y to make a payment to X in an amount 
determined under the lease agreement.
    (ii) Application of this section. The lease agreement between X 
and Y obligates Y to make a payment in the event the aircraft is not 
leased for the period commencing after the initial 10-year lease 
period and ending on the date the replacement lease is scheduled to 
end. Accordingly, pursuant to paragraph (b) of this section, the 
term of the lease between X and Y includes such additional period, 
and the lease term is 20 years for purposes of section 168.
    (iii) Facts modified. Assume the same facts as in paragraph (i) 
of this Example, except that Y is required to guarantee the payment 
of rentals under the 10-year replacement lease and to make a payment 
to X equal to the present value of any excess of the replacement 
lease rental payments specified in the lease agreement between X and 
Y, over the rental payments actually agreed to be paid by the 
replacement lessee. Pursuant to paragraph (b) of this section, the 
term of the lease between X and Y includes the additional period, 
and the lease term is 20 years for purposes of section 168.
    (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.

Margaret Milner Richardson,
Commissioner of Internal Revenue.
    Approved: March 26, 1996.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 96-10395 Filed 4-26-96; 8:45 am]
BILLING CODE 4830-01-U