[Federal Register Volume 61, Number 107 (Monday, June 3, 1996)]
[Proposed Rules]
[Pages 27834-27850]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-13719]



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


DEPARTMENT OF THE TREASURY
26 CFR Part 1

[IA-292-84]
RIN 1545-AU11


Section 467 Rental Agreements

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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

SUMMARY: This document contains proposed regulations relating to the 
treatment of rent and interest under certain agreements for the lease 
of tangible property. The proposed regulations apply to certain rental 
agreements that provide increasing or decreasing rents, or deferred or 
prepaid rent. This document also provides notice of a public hearing on 
these regulations.

DATES: Written comments, requests to appear and outlines of topics to 
be discussed at the public hearing scheduled for September 25, 1996, 
must be received by September 3, 1996.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (IA-292-84), room 5228, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. In the alternative, submissions may be hand delivered between 
the hours of 8 a.m. and 5 p.m. to CC:DOM:CORP:R (IA-292-84), Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue NW., 
Washington, DC. The public hearing will be held in the Commissioner's 
Conference Room, 3rd Floor, 1111 Constitution Avenue NW., Washington, 
DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Forest Boone of the Office of Assistant Chief Counsel (Income Tax and 
Accounting) at (202) 622-4960; concerning submissions and the public 
hearing, Mike Slaughter at (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR part 1) relating to section 467 of the Internal 
Revenue Code (Code). This section was added by the Tax Reform Act of 
1984. In general, section 467 requires parties to certain rental 
agreements to accrue rent and interest in accordance with the rules 
specified in section 467. These proposed regulations provide guidance 
regarding the applicability of section 467, and the amount of rent and 
interest required to be accrued under section 467. No inference should 
be drawn from any provision in the proposed regulations concerning 
whether an arrangement constitutes a lease for Federal income tax 
purposes.

Explanation of Provisions

1. Section 467 Rental Agreements

    Section 467(a) provides that, if a rental agreement is a section 
467 rental agreement, the lessor and lessee must take into account for 
a taxable year the section 467 rent and the section 467 interest for 
that year. A section 467 rental agreement is a rental agreement that 
has increasing or decreasing rents, or prepaid or deferred rents. A 
rental agreement has increasing or decreasing rents if the annualized 
fixed rent allocated to any rental period exceeds the annualized fixed 
rent allocated to any other rental period in the lease term. The 
proposed regulations provide that a rent holiday at the beginning of 
the lease term is disregarded in determining whether the rental 
agreement has increasing or decreasing rent if the rent holiday period 
is three months or less.
    In addition, the proposed regulations provide that a rental 
agreement has increasing or decreasing rent if it requires (or may 
require) the payment of contingent rent, other than contingent rent 
that is contingent due to (a) a provision computing rent based on a 
percentage of the lessee's gross or net receipts (but only if the 
percentage does not vary throughout the term of the lease); (b) 
adjustments based on a reasonable price index; or (c) a provision 
requiring the lessee to pay real estate taxes, insurance premiums, 
maintenance costs, or any other cost (other than a debt service cost) 
that relates to the leased property and is not within the control of 
the lessor or lessee or a person related to the lessor or lessee.
    Section 467(d)(1)(A) provides that a rental agreement has deferred 
rent if rent allocated to a calendar year is payable after the close of 
the succeeding calendar year. The proposed regulations provide that 
there is prepaid rent if rent allocated to a calendar year is payable 
prior to the beginning of the prior calendar year.
    Section 467(d)(2) provides that section 467 does not apply to a 
rental agreement if the aggregate rental payments and other 
consideration to be received for the use of the property do not exceed 
$250,000.

2. Section 467 Rent

    Under the proposed regulations, the section 467 rent for a taxable 
year is the sum of the fixed rent for any rental periods that begin and 
end in the taxable year, a ratable portion of the fixed rent for other 
rental periods beginning or ending in the taxable year, and any 
contingent rent that accrues in the taxable year. In general, the 
proposed regulations provide that rental periods may be of any length 
as long as (a) the rental periods are one year or less, cover the 
entire lease term, and do not overlap, and (b) each scheduled

[[Page 27835]]

payment under the rental agreement occurs within 30 days of the 
beginning or end of a rental period. The amount of fixed rent for a 
rental period depends on the terms of the rental agreement.
A. Disqualified Leaseback or Long-Term Agreement
    Section 467 provides that if the section 467 rental agreement is a 
leaseback or long-term agreement and has increasing or decreasing rents 
a principal purpose of which is tax avoidance (a disqualified leaseback 
or long-term agreement), the fixed rent for each rental period is the 
constant rental amount. The proposed regulations provide that (a) the 
Commissioner, rather than the parties to the rental agreement, will 
determine whether a rental agreement is a disqualified leaseback or 
long-term agreement and (b) a rental agreement will not be disqualified 
unless it requires more than $2,000,000 in rental payments and other 
consideration. The proposed regulations also provide that, if either 
the lessor or the lessee is not subject to Federal income tax on its 
income or is a tax- exempt entity (within the meaning of section 
168(h)(2)), the rental agreement will be closely scrutinized, and clear 
and convincing evidence will be required to establish that tax 
avoidance is not a principal purpose for providing increasing or 
decreasing rent.
    Section 467(b)(5) provides that regulations should set forth 
circumstances under which section 467 rental agreements will not be 
treated as disqualified leasebacks or long-term agreements, including 
circumstances relating to the use of price indices, percentage rents, 
reasonable rent holidays, or changes in amounts paid to third parties. 
In addition to these safe harbors, which have been included in the 
proposed regulations, the Conference Committee Report stated that the 
Committee anticipated that regulations under section 467 would adopt 
standards under which leases providing for fluctuations in rents by no 
more than a reasonable percentage above or below the average rent over 
the term of the lease will be deemed not motivated by tax avoidance. 
The report cited the standards for advance rulings on leveraged lease 
transactions set forth in Rev. Proc. 75-21 (1975-1 C.B. 715), and 
stated that such standards may not be appropriate for real estate 
leases. H.R. Rep. No. 861, 98th Cong., 2d Sess. 893 (1984).
    The proposed regulations contain a safe harbor providing that tax 
avoidance will not be considered to be a principal purpose for 
providing increasing or decreasing rents if the rents allocable to each 
calendar year of the lease do not vary from the average annual rents 
over the entire lease term by more than 10 percent. This safe harbor is 
based on, but is not identical to, the safe harbor contained in Rev. 
Proc. 75-21. The proposed regulations do not provide a safe harbor 
specifically applicable to real estate leases. The IRS and the Treasury 
Department invite comments regarding the nature and extent of a safe 
harbor for such leases, as well as comments on whether additional safe 
harbors are appropriate either generally or for particular industries.
    Section 467(e)(1) provides that the constant rental amount is the 
amount that, if paid at the end of each rental period, would result in 
a present value equal to the present value of all amounts payable under 
the disqualified leaseback or long-term agreement. If constant rental 
accrual is required, all rental periods must be equal in length except 
for an initial or final short rental period.
B. Agreements Without Adequate Interest
    If the section 467 rental agreement is not a disqualified leaseback 
or long-term agreement and does not provide adequate interest for 
prepaid or deferred rent, the proposed regulations provide that the 
fixed rent for each rental period is the proportional rental amount. 
The proportional rental amount is the fixed rent allocated to the 
rental period under the rental agreement multiplied by a fraction, the 
numerator of which is the present value of the amounts payable as fixed 
rent and interest on fixed rent under the rental agreement and the 
denominator of which is the present value of the fixed rent allocated 
to each rental period under the rental agreement. Under the proposed 
regulations, a rental agreement provides adequate interest if (a) no 
deferred or prepaid rent is required under the agreement, (b) there is 
deferred or prepaid rent but the agreement requires the payment of 
interest at an adequate single fixed rate, or (c) there is deferred or 
prepaid rent but the present values of rent payments and rent accruals 
meet certain tests set forth in the proposed regulations.
C. Rental Agreement Accrual
    The proposed regulations provide that if neither the constant 
rental amount nor the proportional rental amount is required to be 
accrued, the fixed rent for a rental period is the fixed rent allocated 
to that rental period in accordance with the section 467 rental 
agreement. The amount of fixed rent allocated to a rental period by the 
rental agreement depends on whether the agreement provides a specific 
allocation of fixed rent. The proposed regulations provide that if a 
rental agreement provides a specific allocation of fixed rent, the 
amount of fixed rent allocated to each rental period during the lease 
term is the amount of rent allocated to that period by the agreement. 
For this purpose, a rental agreement that allocates rent to a period is 
treated as allocating rent ratably within that period. Thus, if a 
rental agreement provides that $120,000 is allocated to each calendar 
year in the lease term, $10,000 of rent is allocated to each calendar 
month. In general, under the proposed regulations, a rental agreement 
specifically allocates fixed rent if the agreement unambiguously 
specifies, for periods of no longer than a year, a fixed amount of rent 
for which the lessee becomes liable on account of the use of the 
property during that period.
    If a section 467 rental agreement does not provide a specific 
allocation of fixed rent, the amount of fixed rent allocated to a 
rental period is the amount of fixed rent payable during that rental 
period.

3. Section 467 Interest

    The section 467 interest for a taxable year is the sum of the 
interest on fixed rent for any rental period that begins and ends in 
the taxable year, a ratable portion of the interest on fixed rent for 
any other rental period beginning or ending in the taxable year, and 
any interest that accrues on contingent rent during the taxable year. 
If a section 467 rental agreement provides an adequate stated rate of 
interest, the interest on fixed rent for a rental period is the 
interest provided in the agreement for that period. If no adequate 
stated rate of interest is provided, the interest on fixed rent for a 
rental period is determined under the section 467 loan rules.
    Under the proposed regulations, there is a deemed loan (a section 
467 loan) in a rental period if, at the beginning of that period, there 
is a difference between the amount of fixed rent payable under the 
section 467 rental agreement and the amount of fixed rent required to 
be accrued under the proposed regulations. For rental periods in which 
there is a section 467 loan, the interest for the rental period is 
equal to the product of the principal balance of the section 467 loan 
at the beginning of the rental period and the yield of the section 467 
loan.
    In general, the principal balance of a section 467 loan as of the 
beginning of any rental period is the difference between the cumulative 
amount of accrued fixed rent and interest and the

[[Page 27836]]

cumulative amount of fixed rent and interest payable under the section 
467 rental agreement. The yield of a section 467 loan is the discount 
rate at which the sum of the present values of all amounts payable by 
the lessee as fixed rent and interest on fixed rent, plus the sum of 
the negative present values of all amounts payable by the lessor as 
interest on prepaid fixed rent, equals the sum of the present values of 
the fixed rent allocated to the rental periods.
    The amount constituting a section 467 loan may be either positive 
or negative. For purposes of applying any aspect of the proposed 
regulations relating to a section 467 loan, the principal balance of 
the loan should be clearly identified as either positive or negative. 
For example, if the principal balance of a loan at the beginning of a 
rental period is a negative number, the interest on the loan for that 
period will also be a negative number.

4. Rental Agreements With Variable Rates of Interest

    The proposed regulations provide rules for section 467 rental 
agreements that provide for certain types of variable rates of 
interest. The rules in the proposed regulations are similar to the 
rules provided in Sec. 1.1275-5 for the computation of original issue 
discount (OID) for variable rate debt instruments providing for 
interest at qualified floating rates. Under the proposed regulations, a 
rental agreement provides variable interest if the rental agreement 
provides for stated interest that is paid or compounded at least 
annually at a rate or rates that meet the requirements of Sec. 1.1275-
5(a)(3)(i) (A) or (B) and Sec. 1.1275-5(a)(4). If a rental agreement 
provides for fluctuations in interest other than pursuant to one or 
more qualified floating rates the interest will be subject to the rules 
for contingent payments.
    Under the proposed regulations, if a section 467 rental agreement 
provides variable interest, the fixed rate substitutes (determined in 
the same manner as under Sec. 1.1275-5(e) treating the agreement date 
as the issue date) for the variable rates of interest called for by the 
agreement must be used in computing the proportional rental amount, the 
constant rental amount, the principal balance of a section 467 loan, 
and the yield of a section 467 loan. Further, in determining the 
interest on fixed rent for any rental period, the variable interest 
adjustment amount must be taken into account. The variable interest 
adjustment amount for a rental period is the difference between (a) the 
amount of interest that would have accrued during the rental period 
under the terms of the rental agreement, and (b) the amount of interest 
that would have accrued during the rental period under the terms of the 
agreement using the fixed rate substitutes.

5. Rental Agreements With Contingent Payments

    The proposed regulations reserve on the issue of the section 467 
treatment of contingent rent. The IRS and the Treasury Department 
anticipate that regulations addressing this issue will provide rules 
for contingent rent similar to those provided for computing OID for 
contingent payment debt instruments in Sec. 1.1275-4. The IRS and the 
Treasury Department invite comments regarding the application of the 
Sec. 1.1275-4 rules to section 467 rental agreements.

6. Recapture

    Section 467(c) provides that if a section 467 rental agreement is a 
leaseback or long-term agreement providing for increasing rent but is 
not subject to constant rental accrual, and the property subject to the 
agreement is disposed of, a portion of the gain realized on the 
disposition is required to be recaptured by the lessor as ordinary 
income. Accordingly, a leaseback or long-term agreement could be 
subject to section 467(c) even though it does not require more than 
$2,000,000 in rental payments and other consideration and is thus not 
subject to constant rental accrual.
    The recapture amount is equal to the lesser of the prior 
understated inclusions or the section 467 gain. The prior understated 
inclusions are the excess of (a) the aggregate amount of section 467 
rent and section 467 interest for the period during which the lessor 
held the property, determined as if the section 467 rental agreement 
were a disqualified leaseback or long-term agreement, over (b) the 
aggregate amount of section 467 rent and section 467 interest accrued 
by the lessor during that period. The section 467 gain is the excess of 
(a) the amount realized from the disposition, over (b) the sum of the 
adjusted basis of the property and the amount of any gain from the 
disposition that is treated as ordinary income under any provision of 
subtitle A of the Code other than section 467(c) (e.g., section 1245 or 
1250).
    In the case of a disposition that is not a sale, exchange, or 
involuntary conversion, the section 467 gain is the excess of (a) the 
fair market value of the property on the date of disposition, over (b) 
the sum of the adjusted basis of the property and the amount of any 
gain from the disposition that is treated as ordinary income under Code 
provisions other than section 467(c). The regulations provide 
exceptions to this recapture rule for dispositions by gift, transfers 
at death, and certain tax-free transactions.

7. Other Disposition Rules

    Under the proposed regulations, if property subject to a section 
467 rental agreement is sold, exchanged, or otherwise disposed of, the 
section 467 rent for a period is taken into account by the owner of the 
property during the period. The lessee, however, must continue to take 
section 467 rent and section 467 interest into account without regard 
to the change of ownership.
    Further, if there is a sale, exchange or other disposition of 
property subject to a section 467 rental agreement, the beginning 
balance of the transferor's section 467 loan after the transfer equals 
the net present value at the time of the transfer of all amounts 
subsequently payable as fixed rent and interest on fixed rent to the 
transferor and all amounts subsequently payable as interest on prepaid 
fixed rent by the transferor. The transferor must continue to take into 
account interest on the transferor's section 467 loan balance after the 
transfer. The beginning balance of the transferee's section 467 loan is 
equal to the principal balance of the section 467 loan immediately 
before the transfer reduced by the beginning balance of the 
transferor's section 467 loan after the transfer. Amounts payable to 
the transferor after the transfer are not taken into account in 
adjusting the transferee's section 467 loan balance.
    Finally, under the proposed regulations, if there is a disposition 
of property subject to a section 467 rental agreement, the transferor 
and transferee must treat the beginning balance of the transferee's 
section 467 loan as a liability that is either assumed in connection 
with the transfer of the property or secured by the property acquired 
subject to the liability (if negative) and as a reduction in the 
consideration for the transfer of the property (if positive). In the 
case of a positive section 467 loan balance, a reduction in the 
consideration for the transfer of the property is appropriate because 
the transferee will also be deemed to have acquired an asset other than 
the property itself, i.e., the loan, and a portion of the total 
consideration should be allocated to the loan balance. Similar rules 
apply to transfers of leasehold interests under section 467 rental 
agreements.
    In order to account for any timing differences that may exist 
between a schedule of payments under a section

[[Page 27837]]

467 rental agreement and a separate schedule providing an allocation of 
rent, it will be necessary, in appropriate cases, to determine the 
amount of a section 467 loan balance even if the rental agreement does 
not have either deferred or prepaid rent or if the rental agreement has 
deferred or prepaid rent but provides adequate stated interest. The 
proposed regulations provide that the section 467 loan rules apply to 
rental agreements described in the preceding sentence, but only for 
purposes of the rules relating to dispositions of property subject to a 
section 467 rental agreement and the rules relating to transfers of 
leasehold interests under a section 467 rental agreement.
    Although the proposed regulations contain rules applicable to all 
dispositions of property subject to a section 467 rental agreement and 
all transfers of leasehold interests under a section 467 rental 
agreement, the regulations reserve guidance on the question of whether 
special rules should be provided for transfers of property and 
leasehold interests in transactions in which gain or loss is not 
recognized in whole or in part. Examples of these transactions would 
include transfers between a partnership and one or more of its 
partners, transfers to a controlled corporation under section 351, 
transfers pursuant to a reorganization described in section 368(a), 
like-kind exchanges subject to section 1031, and transfers by gift or 
upon the death of the owner of the property or the holder of the 
leasehold interest. The IRS and Treasury Department invite comments on 
whether special rules should be provided for any of these transactions.

8. Proposed Effective Date

    The regulations are proposed to be effective for (1) rental 
agreements entered into after the date that final regulations under 
section 467 are published and (2) disqualified leasebacks and long-term 
agreements entered into after June 3, 1996. No inference should be 
drawn from the proposed effective date concerning the treatment of 
rental agreements entered into before the regulations are applicable. 
Moreover, the IRS will, in appropriate circumstances, apply the 
provisions of section 467 requiring constant rental accrual to rental 
agreements entered into on or before June 3, 1996.

9. Issues Not Addressed

    The proposed regulations do not address the application of section 
467 to payments for services. The IRS and the Treasury Department 
invite comments on the appropriate scope of rules under section 467 for 
transactions involving deferred payments for services in light of the 
scope of section 404. In addition, the IRS and the Treasury Department 
invite comments on whether rules should be provided for transactions 
involving prepayments for services.
    The proposed regulations do not address the application of section 
467 to transactions sometimes referred to as ``lease strips'' or 
``stripping transactions'', as described in Notice 95-53 (1995-44 
I.R.B. 21). Notice 95-53 provides that regulations will be issued 
pursuant to section 7701(l) (and, as appropriate, other sections of the 
Code) recharacterizing stripping transactions. The IRS and the Treasury 
Department invite comments on whether rules should be provided that 
would apply section 467 to such transactions.
    The proposed regulations do not provide for an adjustment to 
section 467 rent and interest where a section 467 rental agreement is 
modified. The IRS and the Treasury Department invite comments on the 
appropriate treatment of the lessor and lessee in these cases.
    The proposed regulations do not provide rules addressing the 
treatment of payments by the lessor to induce a lessee to enter into a 
rental agreement.

Special Analyses

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

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are submitted timely to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for September 25, 1996 at 10 
a.m. in the Commissioner's Conference Room, 1111 Constitution Avenue 
NW., Washington, DC. Because of access restrictions, visitors will not 
be admitted beyond the Internal Revenue Building lobby more than 15 
minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons 
that wish to present oral comments at the hearing must submit written 
comments and submit an outline of the topics to be discussed and the 
time to be devoted to each topic by September 3, 1996. A period of 10 
minutes will be allotted to each person for making comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these proposed regulations is Forest Boone 
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.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be 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 1.467-1 is also issued under 26 U.S.C. 467.
    Section 1.467-2 is also issued under 26 U.S.C. 467.
    Section 1.467-3 is also issued under 26 U.S.C. 467.
    Section 1.467-4 is also issued under 26 U.S.C. 467.
    Section 1.467-5 is also issued under 26 U.S.C. 467.
    Section 1.467-6 is also issued under 26 U.S.C. 467.
    Section 1.467-7 is also issued under 26 U.S.C. 467.
    Section 1.467-8 is also issued under 26 U.S.C. 467.
* * * * *
    Par. 2. In Sec. 1.61-8, the first sentence of paragraph (b) is 
revised to read as follows:


Sec. 1.61-8  Rents and royalties.

* * * * *
    (b) * * * Except as provided in section 467 and the regulations 
thereunder, gross income includes advance rentals, which must be 
included in income for the year of receipt regardless of the period 
covered

[[Page 27838]]

or the method of accounting employed by the taxpayer. * * *
* * * * *
    Par. 3. In Sec. 1.451-1, paragraph (g) is added to read as follows:


Sec. 1.451-1  General rule for taxable year of inclusion.

* * * * *
    (g) Timing of income from section 467 rental agreements. For the 
timing of income with respect to section 467 rental agreements, see 
section 467 and the regulations thereunder.
    Par. 4. Section 1.461-1 is amended by:
    1. Adding a sentence at the end of paragraph (a)(1).
    2. Adding paragraph (a)(2)(iii)(E).
    The additions read as follows:


Sec. 1.461-1  General rule for taxable year of deduction.

    (a) * * * (1) * * * See section 467 and the regulations thereunder 
for rules under which a liability arising out of the use of property 
pursuant to a section 467 rental agreement is taken into account.
    (2) * * *
    (iii) * * *
    (E) Except as otherwise provided by regulations or other published 
guidance issued by the Commissioner, in the case of a liability arising 
out of the use of property pursuant to a section 467 rental agreement, 
the all events test (including economic performance) is considered met 
in the taxable year in which the liability is to be taken into account 
under section 467 and the regulations thereunder.
* * * * *
    Par. 5. Section 1.461-4 is amended by:
    1. Revising the heading of paragraph (d)(3)(ii).
    2. Redesignating the text of paragraph (d)(3)(ii) following the 
heading as paragraph (d)(3)(ii)(A) and adding a heading for newly 
designated paragraph (d)(3)(ii)(A).
    2. Adding paragraph (d)(3)(ii)(B).
    3. Adding sentence at the end of the introductory text of paragraph 
(d)(7).
    The revisions and additions read as follows:


Sec. 1.461-4  Economic performance.

* * * * *
    (d) * * *
    (3) * * *
    (ii) Exceptions--(A) Volume, frequency of use, or income. * * *
    (B) Section 467 rental agreements. In the case of a liability 
arising out of the use of property pursuant to a section 467 rental 
agreement, economic performance occurs as provided in Sec. 1.461-
1(a)(2)(iii)(E).
* * * * *
    (7) * * * Assume further that the examples do not involve section 
467 rental agreements and, therefore, section 467 is not applicable.
* * * * *
    Par. 6. Sections 1.467-0 through 1.467-8 are added to read as 
follows:


Sec. 1.467-0  Table of contents.

    This section lists the major captions that appear in Secs. 1.467-1 
through 1.467-8.

Sec. 1.467-1  Treatment of lessors and lessees generally.

    (a) Overview.
    (1) In general.
    (2) Cases in which rules are inapplicable.
    (3) Limited effect for rental agreements with total rents 
between $250,000 and $2,000,000.
    (4) Summary of rules.
    (i) Basic rules.
    (ii) Special rules.
    (b) Method of accounting for section 467 rental agreements.
    (c) Section 467 rental agreements.
    (1) In general.
    (2) Increasing or decreasing rent.
    (i) Fixed rent.
    (A) In general.
    (B) Certain rent holidays disregarded.
    (ii) Fixed rent allocated to a rental period.
    (A) Specific allocation.
    (1) In general.
    (2) Rental agreements specifically allocating fixed rent.
    (B) No specific allocation.
    (iii) Contingent rent.
    (A) In general.
    (B) Certain contingent rent disregarded.
    (3) Deferred or prepaid rent.
    (i) Deferred rent.
    (ii) Prepaid rent.
    (iii) Rent allocated to a calendar year.
    (iv) Examples.
    (4) Rental agreements involving total payments of $250,000 or 
less.
    (i) In general.
    (ii) Special rules in computing amount described in paragraph 
(c)(4)(i).
    (d) Section 467 rent.
    (1) In general.
    (2) Fixed rent for a rental period.
    (i) Constant rental accrual.
    (ii) Proportional rental accrual.
    (iii) Section 467 rental agreement accrual.
    (e) Section 467 interest.
    (1) In general.
    (2) Interest on fixed rent for a rental period.
    (i) In general.
    (ii) Section 467 rental agreements with adequate interest.
    (3) Treatment of interest.
    (f) Modification of a rental agreement.
    (g) Treatment of amounts payable by lessor to lessee.
    (1) Interest.
    (2) Other amounts. [Reserved]
    (h) Meaning of terms.
    (i) [Reserved]
    (j) Computational rules.
    (1) Counting conventions.
    (2) Conventions regarding timing of rent and payments.
    (i) In general.
    (ii) Time amount is payable.
    (3) Annualized fixed rent.
    (4) Allocation of fixed rent within a period.
    (5) Rental period length.

Sec. 1.467-2  Rent accrual for section 467 rental agreements 
without adequate interest.

    (a) Section 467 rental agreement for which proportional rental 
accrual is required.
    (b) Adequate interest on fixed rent.
    (1) In general.
    (2) Section 467 rental agreements that provide for a variable 
rate of interest.
    (c) Computation of proportional rental amount.
    (1) In general.
    (2) Section 467 rental agreements that provide for a variable 
rate of interest.
    (d) Present value.
    (e) Applicable Federal rate.
    (1) In general.
    (2) Source of applicable Federal rates.
    (3) 110 percent of applicable Federal rate.
    (4) Term of the section 467 rental agreement.
    (i) In general.
    (ii) Section 467 rental agreements with variable interest.
    (f) Examples.

Sec. 1.467-3  Disqualified leasebacks and long-term agreements.

    (a) General rule.
    (b) Disqualified leaseback or long-term agreement.
    (1) In general.
    (2) Leaseback.
    (3) Long-term agreement.
    (i) In general.
    (ii) Statutory recovery period.
    (A) In general.
    (B) Special rule for leases of properties having different 
statutory recovery periods.
    (c) Tax avoidance as principal purpose for increasing or 
decreasing rent.
    (1) In general.
    (2) Safe harbors.
    (d) Calculating constant rental amount.
    (1) In general.
    (2) Initial or final short periods.
    (3) Method to determine constant rental amount; no short 
periods.
    (i) Step 1.
    (ii) Step 2.
    (iii) Step 3.
    (e) Example.

Sec. 1.467-4  Section 467 loan.

    (a) In general.
    (1) Overview.
    (2) No section 467 loan in the case of certain section 467 
rental agreements.
    (3) Rental agreements subject to constant rental accrual.
    (4) Special rule in applying the provisions of Sec. 1.467-7(e) 
or Sec. 1.467-7(f).
    (b) Principal balance.
    (1) In general.
    (2) Section 467 rental agreements that provide for prepaid fixed 
rent and adequate stated interest.
    (3) Timing of payments.

[[Page 27839]]

    (c) Yield.
    (1) In general.
    (i) Method of determining yield.
    (ii) Method of stating yield.
    (iii) Rounding adjustments.
    (2) Yield of section 467 rental agreements for which constant 
rental amount or proportional rental amount is computed.
    (3) Determination of present values.
    (d) Contingent payments.
    (e) Section 467 rental agreements that call for payments before 
or after the lease term.
    (f) Examples.

Sec. 1.467-5  Section 467 rental agreements with variable interest.

    (a) Variable interest on deferred or prepaid rent.
    (1) In general.
    (2) Exceptions.
    (b) Variable rate treated as fixed.
    (1) In general.
    (2) Variable interest adjustment amount.
    (i) In general.
    (ii) Sign of adjustment.
    (3) Section 467 loan balance.
    (c) Examples.

Sec. 1.467-6  Section 467 rental agreements with contingent 
payments.

    [Reserved]

Sec. 1.467-7  Section 467 recapture and other rules relating to 
dispositions.

    (a) Section 467 recapture.
    (b) Recapture amount.
    (1) In general.
    (2) Prior understated inclusions.
    (i) In general.
    (ii) Partial rental periods.
    (3) Section 467 gain.
    (i) In general.
    (ii) Certain dispositions.
    (c) Special rules.
    (1) Gifts.
    (2) Dispositions at death.
    (3) Certain tax-free exchanges.
    (i) In general.
    (ii) Dispositions covered.
    (4) Dispositions by transferee.
    (5) Like-kind exchanges and involuntary conversions.
    (6) Installment sales.
    (7) Dispositions covered by sections 170(e), 341(e)(12), or 
751(c).
    (d) Examples.
    (e) Other rules relating to dispositions.
    (1) In general.
    (2) Treatment of section 467 loan.
    (3) Special rules for transfers in certain nonrecognition 
transactions. [Reserved]
    (f) Treatment of assignments by lessee and lessee-financed 
renewals.
    (1) Substitute lessee use.
    (2) Lessor use.
    (3) Special rules for transfers in certain nonrecognition 
transactions. [Reserved]

Sec. 1.467-8  Effective date.

Sec. 1.467-1  Treatment of lessors and lessees generally.

    (a) Overview--(1) In general. When applicable, section 467 requires 
a lessor and lessee of tangible property to treat rents consistently 
and to use the accrual method of accounting regardless of their overall 
method of accounting. In addition, in certain cases involving tax 
avoidance, the lessor and lessee must take rent and stated or imputed 
interest into account under a constant rental method, pursuant to which 
time value of money principles are applied to treat the rent as having 
accrued ratably over the entire lease term.
    (2) Cases in which rules are inapplicable. Section 467 applies only 
to leases (or other similar arrangements) that constitute section 467 
rental agreements as defined in paragraph (c) of this section. For 
example, a rental agreement is not a section 467 rental agreement, and, 
therefore, is not subject to the provisions of this section and 
Secs. 1.467-2 through 1.467-8 (the section 467 regulations), if it 
specifies equal amounts of rent for each month (or other similar 
period) throughout the lease term and all payments of rent are due in 
the year to which the rent relates (or in the preceding or succeeding 
year). In addition, the section 467 regulations do not apply to a 
rental agreement that requires total rents of $250,000 or less 
determined, for this purpose, by disregarding any adjustments based on 
a reasonable price index and the amount of any rent resulting from the 
lessee's obligation to pay certain third-party expenses of the lessor.
    (3) Limited effect for rental agreements with total rents between 
$250,000 and $2,000,000. A rental agreement is a section 467 rental 
agreement, and, therefore, the section 467 regulations generally apply, 
if the agreement requires total rents of more than $250,000 and does 
not specify equal amounts of rent for each month (or other similar 
period) throughout the lease term. If, however, the rental agreement 
requires total rents of $2,000,000 or less (determined by disregarding 
adjustments and excluding the same types of rent that are disregarded 
or excluded for purposes of the $250,000 threshold requirement) and all 
payments of rent are due in the year to which the rent relates (or in 
the preceding or succeeding year), the only effect of the section 467 
regulations is to require the lessor and lessee to take rent into 
account in the year to which the rent relates.
    (4) Summary of rules--(i) Basic rules. Paragraph (c) of this 
section provides rules for determining whether a rental agreement is a 
section 467 rental agreement. Paragraphs (d) and (e) of this section 
provide rules for determining the amount of rent and interest, 
respectively, required to be taken into account by a lessor and lessee 
under a section 467 rental agreement. Paragraphs (f) through (h) and 
(j) of this section provide various definitions and special rules 
relating to the application of the section 467 regulations.
    (ii) Special rules. Section 1.467-2 provides rules for section 467 
rental agreements that have deferred or prepaid rents without providing 
for adequate interest. Section 1.467-3 provides rules for application 
of the constant rental accrual requirement, including criteria for 
determining whether an agreement is subject to this requirement. 
Section 1.467-4 provides rules for establishing and adjusting a section 
467 loan, the amount that a lessor is deemed to have loaned to the 
lessee, or vice versa, pursuant to the application of the section 467 
regulations. Sections 1.467-5 and 1.467-6 provide rules for applying 
the section 467 regulations where a rental agreement requires variable 
interest or certain contingent payments. Section 1.467-7 provides rules 
for the treatment of dispositions by a lessor of property subject to a 
section 467 rental agreement and the treatment of assignments by 
lessees and certain lessee- financed renewals of a section 467 rental 
agreement. Finally, Sec. 1.467-8 provides the effective date rules for 
the section 467 regulations.
    (b) Method of accounting for section 467 rental agreements. If a 
rental agreement is a section 467 rental agreement, as described in 
paragraph (c) of this section, the lessor and lessee must each take 
into account for any taxable year--
    (1) The section 467 rent for the taxable year (as defined in 
paragraph (d) of this section); and
    (2) The section 467 interest for the taxable year (as defined in 
paragraph (e) of this section).
    (c) Section 467 rental agreements--(1) In general. Except as 
otherwise provided in paragraph (c)(4) of this section, the term 
section 467 rental agreement means a rental agreement, as defined in 
paragraph (h) of this section, that has increasing or decreasing rents 
(as described in paragraph (c)(2) of this section), or prepaid or 
deferred rents (as described in paragraph (c)(3) of this section).
    (2) Increasing or decreasing rent--(i) Fixed rent--(A) In general. 
A rental agreement has increasing or decreasing rent if the annualized 
fixed rent, as described in paragraph (j)(3) of this section, allocated 
to any rental period exceeds the annualized fixed rent allocated to any 
other rental period in the lease term.
    (B) Certain rent holidays disregarded. Notwithstanding the 
provisions of paragraph (c)(2)(i)(A) of this section, a rental 
agreement does not have

[[Page 27840]]

increasing or decreasing rent if the increasing or decreasing rent is 
solely attributable to a rent holiday provision allowing reduced rent 
(including no rent) for a period at the beginning of the lease term, 
but only if the duration of the rent holiday does not exceed three 
months.
    (ii) Fixed rent allocated to a rental period--(A) Specific 
allocation--(1) In general. If a rental agreement provides a specific 
allocation of fixed rent, as described in paragraph (c)(2)(ii)(A)(2) of 
this section, the amount of fixed rent allocated to each rental period 
during the lease term is the amount of fixed rent allocated to that 
period by the rental agreement.
    (2) Rental agreements specifically allocating fixed rent. A rental 
agreement specifically allocates fixed rent if the rental agreement 
unambiguously specifies, for periods no longer than a year, a fixed 
amount of rent for which the lessee becomes liable on account of the 
use of the property during that period, and the total amount of fixed 
rent specified is equal to the total amount of fixed rent payable under 
the lease. For example, a rental agreement providing that rent is 
$100,000 per calendar year, and that provides for total payments of 
fixed rent equal to the total amount specified, specifically allocates 
rent. Similarly, a rental agreement that states the amount of rent 
accruing each month or the amount of rent allocated to each year 
contains a specific allocation if the total payments of fixed rent 
equal the total amount specified. A rental agreement stating only when 
rent is payable does not specifically allocate rent.
    (B) No specific allocation. If a rental agreement does not provide 
a specific allocation of fixed rent (for example, because the total 
amount of fixed rent specified is not equal to the total amount of 
fixed rent payable under the lease), the amount of fixed rent allocated 
to a rental period is the amount of fixed rent payable during that 
rental period. If an amount of fixed rent is payable before the 
beginning of the lease term, it is allocated to the first rental period 
in the lease term. If an amount of fixed rent is payable after the end 
of the lease term, it is allocated to the last rental period in the 
lease term.
    (iii) Contingent rent--(A) In general. A rental agreement has 
increasing or decreasing rent if it requires (or may require) the 
payment of contingent rent (as defined in paragraph (h) of this 
section), other than contingent rent described in paragraph 
(c)(2)(iii)(B) of this section.
    (B) Certain contingent rent disregarded. Contingent rent is 
disregarded for purposes of this paragraph (c)(2)(iii) to the extent--
    (1) The rent is contingent solely as the result of a provision 
pursuant to which the rent is equal to a percentage of the lessee's 
receipts (gross or net), but only if the percentage does not vary 
throughout the term of the lease;
    (2) The rent is contingent solely as the result of an adjustment 
based on a reasonable price index, as defined in paragraph (h) of this 
section; or
    (3) The rent is contingent solely as the result of a provision 
requiring the lessee to pay third-party costs, as defined in paragraph 
(h) of this section.
    (3) Deferred or prepaid rent--(i) Deferred rent. A rental agreement 
has deferred rent under this paragraph (c)(3) if the amount of rent 
allocated to a calendar year (determined under paragraph (c)(3)(iii) of 
this section), when added to the rent allocated to all preceding 
calendar years, exceeds the cumulative amount of rent payable as of the 
close of the succeeding calendar year.
    (ii) Prepaid rent. A rental agreement has prepaid rent under this 
paragraph (c)(3) if the amount of rent allocated to a calendar year 
(determined under paragraph (c)(3)(iii) of this section), when added to 
the rent allocated to all preceding calendar years, is less than the 
cumulative amount of rent payable before the beginning of the preceding 
calendar year.
    (iii) Rent allocated to a calendar year. For purposes of this 
paragraph (c)(3), the rent allocated to a calendar year is the sum of--
    (A) The fixed rent allocated to any rental period (determined under 
paragraph (c)(2)(ii) of this section) that begins and ends in the 
calendar year;
    (B) A ratable portion of the fixed rent allocated to any other 
rental period that begins or ends in the calendar year; and
    (C) Any contingent rent that accrues during the calendar year as 
provided in Sec. 1.467-6.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (c)(3):

    Example 1. (i) A and B enter into a rental agreement that 
provides for the lease of property to begin on January 1, 1997, and 
end on December 31, 2000. The rental agreement provides that rent of 
$100,000 accrues during each year of the lease term. Under the 
rental agreement, no rent is payable during calendar year 1997, a 
payment of $100,000 is to be made on December 31, 1998, and December 
31, 1999, and a payment of $200,000 is to be made on December 31, 
2000. A and B both select the calendar year as their rental period. 
Thus, under paragraph (c)(3)(iii) of this section, the amount of 
rent allocated to each rental period under paragraph (c)(2)(ii) of 
this section is $100,000. Therefore, the rental agreement does not 
have increasing or decreasing rent as described in paragraph 
(c)(2)(i) of this section.
    (ii) Under paragraph (c)(3)(i) of this section, a rental 
agreement has deferred rent if, at the close of a calendar year, the 
cumulative amount of rent allocated under paragraph (c)(3)(iii) of 
this section exceeds the cumulative amount of rent payable as of the 
close of the succeeding year. In this example, there is no deferred 
rent: the rent allocated to 1997 ($100,000) does not exceed the 
cumulative rent payable as of December 31, 1998 ($100,000); the rent 
allocated to 1998 and preceding years ($200,000) does not exceed the 
cumulative rent payable as of December 31, 1999 ($200,000); the rent 
allocated to 1999 and preceding years ($300,000) does not exceed the 
cumulative rent payable as of December 31, 2000 ($400,000); and the 
rent allocated to 2000 and preceding years ($400,000) does not 
exceed the cumulative rent payable as of December 31, 2001 
($400,000). Therefore, because the rental agreement does not have 
increasing or decreasing rent and does not have prepaid or deferred 
rent, the rental agreement is not a section 467 rental agreement.
    Example 2. (i) A and B enter into a rental agreement that 
provides for the lease of personal property for ten years, beginning 
on January 1, 1997, and ending on December 31, 2006. The rental 
agreement provides for accruals of rent of $10,000 during each month 
of the lease term. Under paragraph (c)(3)(iii) of this section, 
$120,000 is allocated to each calendar year. The rental agreement 
provides for a $1,200,000 payment on December 31, 1997.
    (ii) The rental agreement does not have increasing or decreasing 
rent as described in paragraph (c)(2)(i) of this section. The rental 
agreement provides prepaid rent under paragraph (c)(3)(ii) of this 
section because an amount of rent allocated to a calendar year, when 
added to the rent allocated to all preceding calendar years, is less 
than the cumulative amount of rent payable before the beginning of 
the preceding calendar year. For example, the rent allocated to 1999 
and preceding calendar years ($360,000) is less than the cumulative 
amount of rent payable before the beginning of the preceding 
calendar year ($1,200,000 is payable on December 31, 1997). 
Accordingly, the rental agreement is a section 467 rental agreement.

    (4) Rental agreements involving total payments of $250,000 or 
less--(i) In general. A rental agreement is not a section 467 rental 
agreement if, taking into account any payments of contingent rent, and 
any other contingent consideration, the sum of the aggregate amount of 
rental payments under the rental agreement and the aggregate value of 
other consideration to be received for the use of property is not 
reasonably expected, as of the agreement date (as defined in paragraph 
(h) of this section), to exceed $250,000.
    (ii) Special rules in computing amount described in paragraph 
(c)(4)(i). The following rules apply in

[[Page 27841]]

determining the amount described in paragraph (c)(4)(i) of this 
section--
    (A) Stated interest on deferred rent is not taken into account. 
However, the Commissioner may recharacterize a portion of stated 
interest as additional rent if a rental agreement provides for interest 
on deferred rent at a rate that, in light of all of the facts and 
circumstances, is clearly greater than the arm's-length rate of 
interest that would have been charged in a lending transaction between 
the lessor and lessee.
    (B) Consideration that does not involve a cash payment is taken 
into account at its fair market value. A liability that is either 
assumed or secured by property acquired subject to the liability is 
taken into account at its remaining principal amount or, in the case of 
an obligation originally issued at a discount, at its adjusted issue 
price.
    (C) All leases that are part of the same transaction or a series of 
related transactions are treated as a single lease. Whether two or more 
leases are part of the same transaction or a series of related 
transactions depends on all the facts and circumstances.
    (D) Any increase or decrease in rent payable solely as a result of 
an adjustment based on a reasonable price index is not taken into 
account.
    (E) Contingent rent described in paragraph (c)(2)(iii)(B)(3) of 
this section is not taken into account.
    (d) Section 467 rent--(1) In general. The section 467 rent for a 
taxable year is the sum of--
    (i) The fixed rent for any rental period (determined under 
paragraph (d)(2) of this section) that begins and ends in the taxable 
year;
    (ii) A ratable portion of the fixed rent for any other rental 
period beginning or ending in the taxable year; and
    (iii) In the case of a section 467 rental agreement that provides 
for contingent rent, the contingent rent that accrues during the 
taxable year as provided in Sec. 1.467-6.
    (2) Fixed rent for a rental period--(i) Constant rental accrual. In 
the case of a section 467 rental agreement that is a disqualified 
leaseback or long-term agreement (as described in Sec. 1.467-3(b)), the 
fixed rent for a rental period is the constant rental amount (as 
determined under Sec. 1.467-3(d)).
    (ii) Proportional rental accrual. In the case of a section 467 
rental agreement that is not described in paragraph (d)(2)(i) of this 
section, and does not provide adequate interest on fixed rent (as 
determined under Sec. 1.467-2(b)), the fixed rent for a rental period 
is the proportional rental amount (as determined under Sec. 1.467-
2(c)).
    (iii) Section 467 rental agreement accrual. In the case of a 
section 467 rental agreement that is not described in paragraph 
(d)(2)(i) or (ii) of this section, the fixed rent for a rental period 
is the amount of fixed rent allocated to the rental period under the 
rental agreement, as determined under paragraph (c)(2)(ii) of this 
section.
    (e) Section 467 interest--(1) In general. The section 467 interest 
for a taxable year is the sum of--
    (i) The interest on fixed rent for any rental period that begins 
and ends in the taxable year;
    (ii) A ratable portion of the interest on fixed rent for any other 
rental period beginning or ending in the taxable year; and
    (iii) In the case of a section 467 rental agreement that provides 
for contingent rent, any interest that accrues on the contingent rent 
during the taxable year as provided in Sec. 1.467-6.
    (2) Interest on fixed rent for a rental period--(i) In general. 
Except as provided in paragraph (e)(2)(ii) of this section and 
Sec. 1.467-5(b)(1)(ii), the interest on fixed rent for a rental period 
is equal to the product of--
    (A) The principal balance of the section 467 loan (as described in 
Sec. 1.467-4(b)) at the beginning of the rental period; and
    (B) The yield of the section 467 loan (as described in Sec. 1.467-
4(c)).
    (ii) Section 467 rental agreements with adequate interest. Except 
in the case of a section 467 rental agreement that is a disqualified 
leaseback or long-term agreement, if a section 467 rental agreement 
provides adequate interest under Sec. 1.467-2(b)(1)(i) (agreements with 
no deferred or prepaid rent) or Sec. 1.467-2(b)(1)(ii) (agreements with 
adequate stated interest at a single fixed rate), the interest on fixed 
rent for a rental period is the amount of interest provided in the 
rental agreement for the period.
    (3) Treatment of interest. If the section 467 interest for a rental 
period is a positive amount, the lessor has interest income and the 
lessee has an interest expense. If the section 467 interest for a 
rental period is a negative amount, the lessee has interest income and 
the lessor has an interest expense.
    (f) Modification of a rental agreement. If, after the lease date, 
the lessor and lessee agree to a substantial modification of the terms 
of a lease, the modified lease is treated, except as provided in this 
paragraph (f), as a new rental agreement for purposes of this section 
and Secs. 1.467-2 through 1.467-8. If a principal purpose of such a 
modification is to avoid the purpose or intent of section 467, the 
Commissioner may treat the original and modified lease as a single 
rental agreement for purposes of this section and Secs. 1.467-2 through 
1.467-8.
    (g) Treatment of amounts payable by lessor to lessee--(1) Interest. 
For purposes of determining present value, any amounts payable by the 
lessor to the lessee as interest on prepaid rent are treated as 
negative amounts.
    (2) Other amounts. [Reserved]
    (h) Meaning of terms. The following meanings apply for purposes of 
this section and Secs. 1.467-2 through 1.467-8--
    (1) Agreement date means the earlier of the lease date or the first 
date on which there is a binding written contract that substantially 
sets forth the terms under which the property will be leased.
    (2) Contingent rent means any rent that is not fixed rent, 
including any amount reflecting an adjustment based on a reasonable 
price index.
    (3) Fixed rent means any rent to the extent its amount and the time 
at which it will be paid are fixed and determinable under the terms of 
the section 467 rental agreement as of the lease date, as defined in 
paragraph (h)(4) of this section. For this purpose, the possibility of 
a breach or other early termination of the rental agreement and any 
provision that makes adjustments based on a reasonable price index are 
disregarded in determining whether amounts specified in the agreement 
are fixed rent.
    (4) Lease date means the date on which the lessee first has the 
right to use property that is the subject of the section 467 rental 
agreement.
    (5) Lease term means the period during which the lessee has the use 
of property subject to the section 467 rental agreement. An option 
period is included in the lease term only if it is expected, as of the 
agreement date, that the option will be exercised by either the lessor 
or the lessee. For this purpose, a lessor is generally expected to 
exercise an option if, for example, as of the agreement date, the rent 
in effect for the option period exceeds the expected market rental for 
the property during such period. Similarly, a lessee is generally 
expected to exercise an option if, for example, as of the agreement 
date, the rent for the option period is less than the expected market 
rental for such period. The lessor's or lessee's determination that an 
option period is either included in or excluded from the lease term is 
not binding on the Commissioner. If the lessee (or a related person) 
agrees that one or both of them will or could be obligated to make 
payments in the nature of rent (within

[[Page 27842]]

the meaning of Sec. 1.168(i)-2(b)(2)) for a period when another lessee 
(the substitute lessee) or the lessor will have use of the property 
subject to the rental agreement, the Commissioner may, in appropriate 
cases, treat the period when the substitute lessee or lessor will have 
use of the property as part of the lease term. See paragraph 
Sec. 1.467-7(f) for special rules applicable to the lessee, substitute 
lessee, and lessor.
    (6) An adjustment is based on a reasonable price index if the 
adjustment reflects inflation or deflation occurring over a period 
during the lease term and is determined consistently under any 
generally recognized index for measuring inflation or deflation.
    (7) Except as otherwise provided in this paragraph (h)(7), two 
persons are related persons if they either have a relationship to each 
other that is specified in section 267(b) or section 707(b)(1) or are 
related entities within the meaning of sections 168(h)(4) (A), (B), or 
(C). For purposes of determining whether a section 467 rental agreement 
is a leaseback within the meaning of Sec. 1.467-3(b)(2), two persons 
are related persons if they are related persons within the meaning of 
section 465(b)(3)(C).
    (8) Rental agreement includes any agreement, whether written or 
oral, that provides for the use of tangible property and is treated as 
a lease for Federal income tax purposes.
    (9) Third-party costs include any real estate taxes, insurance 
premiums, maintenance costs, or any other cost (other than a debt 
service cost) that relates to the leased property and is not within the 
control of the lessor or lessee or any related person.
    (i) [Reserved].
    (j) Computational rules. For purposes of this section and 
Secs. 1.467-2 through 1.467-8, the following rules apply--
    (1) Counting conventions. Any reasonable counting convention may be 
used (e.g., 30 days per month/360 days per year) to determine the 
length of a rental period or to perform any computation. Rental periods 
of the same descriptive length, for example annual, semiannual, 
quarterly, or monthly, may be treated as being of equal length.
    (2) Conventions regarding timing of rent and payments--(i) In 
general. For purposes of determining present values and yield--
    (A) Except as otherwise provided in this section and Secs. 1.467-2 
through 1.467-7, the rent allocated to a rental period is taken into 
account on the last day of the rental period;
    (B) Any amount payable during the first half of the first rental 
period is treated as payable on the first day of that rental period;
    (C) Any amount payable during the first half of any other rental 
period is treated as payable on the last day of the preceding rental 
period; and
    (D) Any amount payable during the second half of a rental period is 
treated as payable on the last day of the rental period.
    (ii) Time amount is payable. For purposes of this paragraph (j)(2), 
an amount is payable on the last day for timely payment (that is, the 
last day such amount may be paid without incurring interest, computed 
at an arm's-length rate, or a substantial penalty charge) and an amount 
payable at the midpoint of a rental period is treated as payable during 
the first half of the rental period.
    (3) Annualized fixed rent. Annualized fixed rent is determined by 
multiplying the fixed rent allocated to the rental period under 
paragraph (c)(2)(ii) of this section by a number that represents the 
ratio of one year to the length of the rental period. Thus, if the 
fixed rent allocated to a rental period is $100,000 and the rental 
period is one month, the annualized fixed rent allocated to the rental 
period is $1,200,000.
    (4) Allocation of fixed rent within a period. A rental agreement 
that allocates fixed rent to any period is treated as allocating fixed 
rent ratably within that period. Thus, if a rental agreement provides 
that $120,000 is allocated to each calendar year in the lease term, 
$10,000 of rent is allocated to each calendar month.
    (5) Rental period length. Except as provided in Sec. 1.467-3(d)(1) 
(relating to agreements for which constant rental accrual is required), 
rental periods may be of any length and may vary in length as long as--
    (i) The rental periods are one year or less, cover the entire lease 
term, and do not overlap;
    (ii) Each scheduled payment under the rental agreement (other than 
a payment scheduled to occur before or after the lease term) occurs 
within 30 days of the beginning or end of a rental period; and
    (iii) In the case of a rental agreement that does not provide a 
specific allocation of fixed rent, the rental periods selected do not 
cause the agreement to be treated as a section 467 rental agreement 
unless all alternative rental period schedules would result in such 
treatment.


Sec. 1.467-2  Rent accrual for section 467 rental agreements without 
adequate interest.

    (a) Section 467 rental agreement for which proportional rental 
accrual is required. Under Sec. 1.467-1(d)(2)(ii), the fixed rent for 
each rental period is the proportional rental amount, defined under 
paragraph (c) of this section, if--
    (1) The section 467 rental agreement is not a disqualified 
leaseback or long-term agreement under Sec. 1.467-3(b); and
    (2) The section 467 rental agreement does not provide adequate 
interest on fixed rent under paragraph (b) of this section.
    (b) Adequate interest on fixed rent--(1) In general. A section 467 
rental agreement provides adequate interest on fixed rent if, 
disregarding any contingent rent--
    (i) The rental agreement has no prepaid or deferred rent as 
described in Sec. 1.467-1(c)(3);
    (ii) The rental agreement has prepaid or deferred rent, and--
    (A) The rental agreement provides interest (the stated rate of 
interest) on deferred or prepaid fixed rent at a single fixed rate (as 
defined in Sec. 1.1273-1(c)(1)(iii));
    (B) The stated rate of interest on fixed rent is no lower than 110 
percent of the applicable Federal rate (as defined in paragraph (e)(3) 
of this section);
    (C) The amount of deferred or prepaid fixed rent on which interest 
is charged is adjusted at least annually to reflect the amount of 
deferred or prepaid fixed rent as of a date no earlier than the date of 
the preceding adjustment and no later than the date of the succeeding 
adjustment; and
    (D) The rental agreement requires interest to be paid or compounded 
at least annually;
    (iii) The rental agreement provides for deferred rent but no 
prepaid rent, and the sum of the present values of all amounts payable 
by the lessee as fixed rent (and interest, if any, thereon) is equal to 
or greater than the sum of the present values of the fixed rent 
allocated to each rental period; or
    (iv) The rental agreement provides for prepaid rent but no deferred 
rent, and the sum of the present values of all amounts payable by the 
lessee as fixed rent, plus the sum of the negative present values of 
all amounts payable by the lessor as interest, if any, on prepaid fixed 
rent, is equal to or less than the sum of the present values of the 
fixed rent allocated to each rental period.
    (2) Section 467 rental agreements that provide for a variable rate 
of interest. For purposes of the adequate interest test under paragraph 
(b)(1) of this section, if a section 467 rental

[[Page 27843]]

agreement provides for variable interest, the rental agreement is 
treated as providing for fixed rates of interest on deferred or prepaid 
fixed rent equal to the fixed rate substitutes (determined in the same 
manner as under Sec. 1.1275-5(e) treating the agreement date as the 
issue date) for the variable rates called for by the rental agreement. 
For purposes of this section, a rental agreement provides for variable 
interest if the rental agreement provides for stated interest that is 
paid or compounded at least annually at a rate or rates that meet the 
requirements of Sec. 1.1275-5(a)(3)(i)(A) or (B) and Sec. 1.1275-
5(a)(4).
    (c) Computation of proportional rental amount--(1) In general. The 
proportional rental amount for a rental period is the amount of fixed 
rent allocated to the rental period under Sec. 1.467-1(c)(2)(ii), 
multiplied by a fraction. The numerator of the fraction is the sum of 
the present values of the amounts payable under the terms of the 
section 467 rental agreement as fixed rent and interest thereon. The 
denominator of the fraction is the sum of the present values of the 
fixed rent allocated to each rental period under the rental agreement.
    (2) Section 467 rental agreements that provide for a variable rate 
of interest. To calculate the proportional rental amount for a section 
467 rental agreement that provides for a variable rate of interest, see 
Sec. 1.467-5.
    (d) Present value. For purposes of determining adequate interest 
under paragraph (b) of this section or the proportional rental amount 
under paragraph (c) of this section, present values are determined as 
of the first day a fixed rent payment is called for by the section 467 
rental agreement if the rental agreement calls for payments of fixed 
rent prior to the lease term. Otherwise, present values are determined 
as of the first day of the first rental period in the lease term. The 
present value of any amount is determined using a discount rate equal 
to 110 percent of the applicable Federal rate. For purposes of the 
present value determination under paragraph (b)(1)(iv) of this section, 
the fixed rent allocated to a rental period must be discounted from the 
first day of the rental period. For other conventions and rules 
relating to the determination of present value, see Sec. 1.467-1(g) and 
(j).
    (e) Applicable Federal rate--(1) In general. The applicable Federal 
rate for a section 467 rental agreement is the applicable Federal rate 
in effect on the agreement date. Except as otherwise provided in this 
section, the applicable Federal rate for a rental agreement means--
    (i) The Federal short-term rate if the term of the rental agreement 
is not over 3 years;
    (ii) The Federal mid-term rate if the term of the rental agreement 
is over 3 years but not over 9 years; and
    (iii) The Federal long-term rate if the term of the rental 
agreement is over 9 years.
    (2) Source of applicable Federal rates. The Internal Revenue 
Service publishes the applicable Federal rates, based on annual, 
semiannual, quarterly, and monthly compounding, each month in the 
Internal Revenue Bulletin (see Sec. 601.601(d) of this chapter. 
However, the applicable Federal rates may be based on any compounding 
assumption. To convert a rate based on one compounding assumption to an 
equivalent rate based on a different compounding assumption, see 
Sec. 1.1272-1(j), Example 1.
    (3) 110 percent of applicable Federal rate. For purposes of 
Sec. 1.467-1, this section and Secs. 1.467-3 through 1.467-8, 110 
percent of the applicable Federal rate means 110 percent of the 
applicable Federal rate based on semiannual compounding, or any rate 
based on a different compounding assumption that is equivalent to 110 
percent of the applicable Federal rate based on semiannual compounding.
    (4) Term of the section 467 rental agreement--(i) In general. For 
purposes of determining 110 percent of the applicable Federal rate 
under this paragraph (e), the term of the section 467 rental agreement 
includes the lease term, any period before the lease term beginning 
with the first day an amount of fixed rent is payable under the terms 
of the rental agreement, and any period after the lease term ending 
with the last day an amount of fixed rent or interest thereon is 
payable under the rental agreement.
    (ii) Section 467 rental agreements with variable interest. If a 
section 467 rental agreement provides variable interest on prepaid or 
deferred fixed rent, the term of the rental agreement for purposes of 
calculating 110 percent of the applicable Federal rate is determined in 
accordance with paragraph (e)(4)(i) of this section by substituting for 
the term of the rental agreement, the longest period between interest 
rate adjustment dates, or, if the rental agreement provides an initial 
fixed rate of interest on prepaid or deferred fixed rent, the period 
between the agreement date and the last day the fixed rate applies, if 
this period is longer. If, as described in Sec. 1.1274-4(c)(2)(ii), the 
rental agreement provides for a qualified floating rate (as defined in 
Sec. 1.1275-5(b)) that in substance resembles a fixed rate, 110 percent 
of the applicable Federal rate is determined by reference to the lease 
term.
    (f) Examples. The following examples illustrate the application of 
this section. In each of these examples it is assumed that constant 
rental accrual does not apply:

    Example 1. (i) C agrees to lease property from D for five years 
beginning on January 1, 1998, and ending on December 31, 2002. The 
section 467 rental agreement provides that rent of $100,000 accrues 
in each calendar year in the lease term and that rent of $500,000 
plus $120,000 of interest is payable on December 31, 2002. Assume 
that the parties select the calendar year as the rental period and 
that 110 percent of the applicable Federal rate based on annual 
compounding is 10 percent.
    (ii) The rental agreement has deferred rent under Sec. 1.467- 
1(c)(3)(i) because the fixed rent allocated to calendar years 1998, 
1999, and 2000 is not paid until 2002. In addition, because the 
rental agreement does not state an interest rate, the rental 
agreement does not satisfy the requirements of paragraph (b)(1)(ii) 
of this section. Thus, the adequacy of interest must be determined 
under paragraph (b)(1)(iii) of this section.
    (iii)(A) Because the rental agreement has deferred fixed rent 
and no prepaid rent, the agreement has adequate interest only if the 
present value rules provided in paragraph (b)(1)(iii) are met. The 
present value of all fixed rent and interest payable under the 
rental agreement is $384,971.22, determined as follows: $384,971.22 
= $620,000/(1.10)\5\. The present value of all fixed rent allocated 
under the rental agreement (discounting the amount of fixed rent 
allocated to a rental period from the last day of the rental period) 
is $379,078.68, determined as follows:
[GRAPHIC] [TIFF OMITTED] TP03JN96.008

    (B) Accordingly, the sum of the present values of amounts 
payable exceeds the sum of the present values of fixed rent 
allocated. The rental agreement provides adequate interest on fixed 
rent.
    (iv) For an example illustrating the computation of the yield on 
the rental agreement and the allocation of the interest and rent 
provided for under the rental agreement, see Sec. 1.467-4(f), 
Example 2.
    Example 2. (i) E and F enter into a section 467 rental agreement 
for the lease of equipment beginning on January 1, 1998, and ending 
on December 31, 2002. The rental agreement provides that rent of 
$100,000 accrues for each calendar month during the lease term. All 
rent is payable on December 31, 2002, together with interest on 
accrued rent at a qualified floating rate set at a current value (as 
defined in Sec. 1.1275-5(a)(4)) that is compounded at the end of 
each calendar month and adjusted at the beginning of each calendar 
month throughout the lease term. Therefore, the rental agreement 
provides for variable interest within the meaning of paragraph 
(b)(2) of this section.

[[Page 27844]]

    (ii) On the agreement date the qualified floating rate is 7.5 
percent, and 110 percent of the applicable Federal rate, as defined 
in paragraph (e)(3) of this section, based on monthly compounding, 
is 7 percent. Under paragraph (b)(2) of this section, the fixed rate 
substitute for the qualified floating rate is 7.5 percent and the 
agreement is treated as providing for interest at this fixed rate 
for purposes of determining whether adequate interest is provided 
under paragraph (b) of this section. Accordingly, the requirements 
of paragraph (b)(1)(ii) of this section are satisfied, and the 
rental agreement has adequate interest.
    Example 3. (i) X and Y enter into a section 467 rental agreement 
for the lease of real property beginning on January 1, 1998, and 
ending on December 31, 2000. The rental agreement provides that rent 
of $80,000 is allocable to 1998, $100,000 is allocable to 1999, and 
$120,000 is allocable to 2000. Under the rental agreement, Y must 
make a $300,000 payment on December 31, 2000. Assume that both X and 
Y choose the calendar year as the rental period, X and Y are 
calendar year taxpayers, and 110 percent of the applicable Federal 
rate is 8.5 percent compounded annually. Assume further that the 
rental agreement fails to provide adequate interest under paragraph 
(b)(1) of this section. Therefore, under Sec. 1.467-1(d)(2)(ii), the 
fixed rent for each rental period is the proportional rental amount.
    (ii)(A) The proportional rental amount is computed under 
paragraph (c) of this section. Because the rental agreement does not 
call for any fixed rent payments prior to the lease term, under 
paragraph (d) of this section, present value is determined as of the 
first day of the first rental period in the lease term. The sum of 
the present values of the amounts payable by the lessee under the 
rental agreement is computed as follows:
[GRAPHIC] [TIFF OMITTED] TP03JN96.009

    (B) The sum of the present values of the fixed rent allocated to 
each rental period (discounting the fixed rent allocated to a rental 
period from the last day of such rental period) is computed as 
follows:
[GRAPHIC] [TIFF OMITTED] TP03JN96.010

    (C) Thus, the fraction for determining the proportional rental 
amount is .9297194 ($234,872.43/$252,627.22). The section 467 fixed 
rents for the taxable years within the lease term are:

------------------------------------------------------------------------
           Taxable year                       Section 467 rent          
------------------------------------------------------------------------
1998.............................  $74,377.55 ($80,000  x  .9297194)    
1999.............................  92,971.94 ($100,000  x  .9297194)    
2000.............................  111,566.33 ($120,000  x  .9297194)   
------------------------------------------------------------------------

Sec. 1.467-3  Disqualified leasebacks and long-term agreements.

    (a) General rule. Under Sec. 1.467-1(d)(2)(i), constant rental 
accrual (as described under paragraph (d) of this section) must be used 
to determine the fixed rent for each rental period in the lease term if 
the section 467 rental agreement is a disqualified leaseback or long-
term agreement within the meaning of paragraph (b) of this section.
    (b) Disqualified leaseback or long-term agreement--(1) In general. 
A leaseback (as defined in paragraph (b)(2) of this section) or a long-
term agreement (as defined in paragraph (b)(3) of this section) is 
disqualified only if--
    (i) The amount determined with respect to the section 467 rental 
agreement under Sec. 1.467-1(c)(4) (relating to the exception for 
rental agreements involving total payments of $250,000 or less) exceeds 
$2,000,000;
    (ii) A principal purpose for providing increasing or decreasing 
rent is the avoidance of Federal income tax (as described in paragraph 
(c) of this section); and
    (iii) The Commissioner determines that it is appropriate to treat 
the section 467 rental agreement as a disqualified leaseback or long-
term agreement.
    (2) Leaseback. A section 467 rental agreement is a leaseback if the 
lessee (or a related person) had any interest (other than a de minimis 
interest) in the property at any time during the two-year period ending 
on the agreement date. For this purpose, interests in property include 
options and agreements to purchase the property (whether or not the 
lessee or related person was considered the owner of the property for 
Federal income tax purposes) and, in the case of subleased property, 
any interest as a sublessor.
    (3) Long-term agreement--(i) In general. A section 467 rental 
agreement is a long-term agreement if the lease term exceeds 75 percent 
of the statutory recovery period for the property.
    (ii) Statutory recovery period--(A) In general. The term statutory 
recovery period means--
    (1) In the case of property depreciable under section 168, the 
applicable period determined under section 467(e)(3)(A);
    (2) In the case of land, 19 years; and
    (3) In the case of any other tangible property, the period that 
would apply under section 467(e)(3)(A) if the property were property to 
which section 168 applied.
    (B) Special rule for leases of properties having different 
statutory recovery periods. In the case of a lease of two or more 
related properties that have different statutory recovery periods, the 
statutory recovery period for purposes of paragraph (b)(3)(ii)(A) of 
this section is the weighted average, based on the fair market values 
of the properties on the lease date, of the statutory recovery periods 
of each of the properties.
    (c) Tax avoidance as principal purpose for increasing or decreasing 
rent--(1) In general. Whether tax avoidance is a principal purpose for 
providing increasing or decreasing rent in a leaseback or long-term 
agreement is based on all of the facts and circumstances. However, if 
either the lessee or the lessor is not subject to Federal income tax on 
its income or is a tax- exempt entity (within the meaning of section 
168(h)(2)), the agreement will be closely scrutinized and clear and 
convincing evidence will be required to establish that tax avoidance is 
not a principal purpose for providing increasing or decreasing rent.
    (2) Safe harbors. Tax avoidance is not considered to be a principal 
purpose for providing increasing or decreasing rent if--
    (i) The rent allocated to each calendar year (determined without 
regard to any increase or decrease attributable to a provision 
described in paragraph (c)(2)(ii)(C) of this section) does not vary 
from the average rent allocated to all calendar years by more than 10 
percent (for this purpose, the rent allocated to a partial calendar 
year is adjusted by

[[Page 27845]]

multiplying the rent by the number of partial years in a full calendar 
year); or
    (ii) All of the increases and decreases in rent are attributable to 
one or more of the following provisions--
    (A) A provision requiring an increase in rent equal to a percentage 
of the lessee's receipts (gross or net) if the percentage does not vary 
throughout the term of the lease;
    (B) A provision requiring an adjustment based on a reasonable price 
index as described in Sec. 1.467-1(h);
    (C) A provision requiring the lessee to pay third-party costs as 
described in Sec. 1.467-1(h); or
    (D) A rent holiday provision allowing reduced rent (including no 
rent) for an interim period at the beginning of the lease term, but 
only if the duration of the rent holiday does not exceed the lesser of 
24 months or 10 percent of the lease term and there is a substantial 
business purpose for the rent holiday provision.
    (d) Calculating constant rental amount--(1) In general. Except as 
provided in paragraph (d)(2) of this section, the constant rental 
amount is the amount that, if paid at the end of each rental period, 
would result in a present value equal to the present value of all 
amounts payable under the disqualified leaseback or long-term agreement 
as rent and interest. In computing the constant rental amount, the 
rules for determining present value are the same as those provided in 
Sec. l.467-2(d) for computing the proportional rental amount. If 
constant rental accrual is required, all rental periods (other than an 
initial or final short period of not more than one month) must be equal 
in length and satisfy the requirements of Sec. 1.467-1(j)(5).
    (2) Initial or final short periods. If a disqualified leaseback or 
long-term agreement has an initial or final short rental period, the 
constant rental amount for the initial or final short period may be 
determined under any reasonable method. However, the sum of the present 
values of all the constant rental amounts must equal the present values 
of all amounts payable under the disqualified leaseback or long-term 
agreement as rent and interest. Any adjustment necessary to eliminate 
the section 467 loan balance because of the method used to determine 
the constant rental amount for short periods must be taken into account 
as section 467 rent for the final rental period.
    (3) Method to determine constant rental amount; no short periods--
(i) Step 1. Determine the present value of amounts payable under the 
disqualified leaseback or long-term agreement as rent or interest.
    (ii) Step 2. Determine the present value of $1 to be received at 
the end of each rental period during the lease term as of the first day 
of the first rental period during the lease term (or, if earlier, the 
first day a rent payment is required under the rental agreement).
    (iii) Step 3. Divide the amount determined in paragraph (d)(3)(i) 
of this section (Step 1) by the number of dollars determined in 
paragraph (d)(3)(ii) of this section (Step 2).
    (e) Example. The following example illustrates the application of 
paragraph (d) of this section:

    Example. (i) X and Y enter into a disqualified leaseback for a 
5-year lease of personal property beginning on January 1, 1998, and 
ending on December 31, 2002. The rental agreement provides that $0 
of rent is allocated to years 1998, 1999, and 2000, and that rent of 
$17,500,000 is allocated to years 2001 and 2002. The rental 
agreement provides that the rent allocated to each year is payable 
on December 31 of that year. Assume all rental periods are the 
calendar year. Assume also that 110 percent of the applicable 
Federal rate based on annual compounding is 12 percent.
    (ii) Step 1 in calculating the constant rental amount is to 
determine the present value of the two payments due under the rental 
agreement as follows:
[GRAPHIC] [TIFF OMITTED] TP03JN96.011

    (iii) Because no amounts of rent are payable before the lease 
term, Step 2 in calculating the constant rental amount is to 
determine the present value as of the first day of the lease term of 
$1 to be received at the end of each rental period during the lease 
term. This results in a present value of $3.6047762. In Step 3 the 
amount determined in Step 1 is divided by the number of dollars 
determined in Step 2. Thus, the constant rental amount is $5,839,901 
for each calendar year during the lease term computed as follows:
[GRAPHIC] [TIFF OMITTED] TP03JN96.012

Sec. 1.467-4  Section 467 loan.

    (a) In general--(1) Overview. Except as provided in paragraph 
(a)(2) of this section, the section 467 loan rules of this section 
apply to a section 467 rental agreement if, as of the first day of that 
period, there is a difference between the amount of fixed rent payable 
under the rental agreement on or before the first day and the amount of 
fixed rent required to be accrued in accordance with Sec. 1.467-1(d)(2) 
before the first day. Paragraph (b) of this section provides rules for 
computing the principal balance of a section 467 loan at the beginning 
of any rental period. The principal balance of a section 467 loan may 
be positive or negative. For purposes of the Code, if the principal 
balance is positive, the amount represents a loan from the lessor to 
the lessee and, if the principal balance is negative, the amount 
represents a loan from the lessee to the lessor.
    (2) No section 467 loan in the case of certain section 467 rental 
agreements. Except as provided in paragraph (a)(3) and (4) of this 
section, this section does not apply to section 467 rental agreements 
that provide adequate interest under Sec. 1.467-2(b)(1)(i) (agreements 
with no deferred or prepaid rent) or Sec. 1.467-2(b)(1)(ii) (agreements 
with deferred or prepaid rent that provide adequate stated interest at 
a single fixed rate).
    (3) Rental agreements subject to constant rental accrual. 
Notwithstanding the provisions of paragraph (a)(2) of this section, 
this section applies to rental agreements subject to constant rental 
accrual under Sec. 1.467-3.
    (4) Special rule in applying the provisions of Sec. 1.467-7(e) or 
(f). Notwithstanding the provisions of paragraph (a)(2) of this 
section, this section applies to rental agreements that provide 
adequate interest under Sec. 1.467-2(b)(1) (i) or (ii), but only for 
purposes of applying the provisions of

[[Page 27846]]

Sec. 1.467-7(e) (relating to dispositions of property subject to a 
section 467 rental agreement) or Sec. 1.467-7(f) (relating to 
assignments by lessees and lessee-financed renewals) to a transaction 
described therein. Further, for section 467 rental agreements that 
provide adequate interest under Sec. 1.467-2(b)(1)(i) or (ii), the 
section 467 interest that accrues on the section 467 loan balance after 
the sale, exchange, or other disposition under Sec. 1.467-7(e) or the 
assignment or renewal under Sec. 1.467-7(f) is the section 467 interest 
that accrues under the terms of the rental agreement (if any).
    (b) Principal balance--(1) In general. Except as provided in 
paragraph (b)(2) of this section or in Sec. 1.467-7(e) or (f), the 
principal balance of the section 467 loan at the beginning of a rental 
period equals the fixed rent accrued in preceding rental periods--
    (i) Increased by the interest on fixed rent includible in the gross 
income of the lessor for preceding rental periods and any amount 
payable by the lessor on or before the first day of the rental period 
as interest on prepaid fixed rent; and
    (ii) Decreased by the interest on prepaid fixed rent includible in 
the gross income of the lessee for preceding rental periods and any 
amount payable by the lessee on or before the first day of the rental 
period as fixed rent or interest thereon.
    (2) Section 467 rental agreements that provide for prepaid fixed 
rent and adequate stated interest. If a section 467 rental agreement 
calls for prepaid fixed rent and provides adequate interest under 
Sec. 1.467-2(b)(1)(iv), the principal balance of the section 467 loan 
at the beginning of a rental period equals the principal balance 
determined under paragraph (b)(1) of this section, plus the fixed rent 
accrued for that rental period.
    (3) Timing of payments. For purposes of this paragraph (b), the day 
on which an amount is payable is determined under the rules of 
Sec. 1.467-1(j)(2).
    (c) Yield--(1) In general--(i) Method of determining yield. Except 
as provided in paragraph (c)(2) of this section, the yield of a section 
467 loan is the discount rate at which the sum of the present values of 
all amounts payable by the lessee as fixed rent and interest on fixed 
rent, plus the sum of the present values of all amounts payable by the 
lessor as interest on prepaid fixed rent, equals the sum of the present 
values of the fixed rent that accrues in accordance with Sec. 1.467-
1(d)(2). The yield must be constant over the term of the section 467 
rental agreement, and, when expressed as a percentage, must be 
calculated to at least two decimal places.
    (ii) Method of stating yield. In determining the section 467 
interest for a rental period, the yield of the section 467 loan must be 
stated appropriately by taking into account the length of the rental 
period. Section 1.1272-1(j) Example 1 provides a formula for converting 
a yield based on a period of one length to an equivalent yield based on 
a period of a different length.
    (iii) Rounding adjustments. Any adjustment necessary to eliminate 
the section 467 loan because of rounding the yield to two or more 
decimal places must be taken into account as section 467 interest for 
the final rental period determined as provided in paragraph (e) of this 
section.
    (2) Yield of section 467 rental agreements for which constant 
rental amount or proportional rental amount is computed. In the case of 
a section 467 rental agreement to which Sec. 1.467- 1(d)(2) (i) or (ii) 
applies, the yield of the section 467 loan equals 110 percent of the 
applicable Federal rate (based on a compounding period equal to the 
rental period).
    (3) Determination of present values. The rules for determining 
present value in computing the yield of a section 467 loan are the same 
as those provided in Sec. 1.467-2(d) for computing the proportional 
rental amount.
    (d) Contingent payments. Except as otherwise required under 
Sec. 1.467-6, contingent payments are not taken into account in 
calculating either the yield or the principal balance of a section 467 
loan.
    (e) Section 467 rental agreements that call for payments before or 
after the lease term. If a section 467 rental agreement calls for the 
payment of fixed rent or interest thereon before the beginning of the 
lease term, this section must be applied by treating the period 
beginning on the first day an amount is payable and ending on the day 
before the beginning of the first rental period of the lease term as 
one or more rental periods. If a rental agreement calls for the payment 
of fixed rent or interest thereon after the end of the lease term, this 
section must be applied by treating the period beginning on the day 
after the end of the last rental period of the lease term and ending on 
the last day an amount of fixed rent or interest thereon is payable as 
one or more rental periods. Rental period length for the period before 
the lease term or after the lease term is determined in accordance with 
the rules of Sec. 1.467-1(j)(5).
    (f) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i)(A) A leases property to B for a three-year period 
beginning on January 1, 1998, and ending on December 31, 2000. The 
section 467 rental agreement has the following rent allocation 
schedule and payment schedule:

------------------------------------------------------------------------
                                                   Rent                 
                                                allocation     Payment  
------------------------------------------------------------------------
1998..........................................    $400,000  ............
1999..........................................     600,000  ............
2000..........................................     800,000    $1,800,000
------------------------------------------------------------------------

    (B) The rental agreement requires a $1.8 million payment to be 
made on December 31, 2000, but does not provide for interest on 
deferred rent. Assume A and B choose the calendar year as the rental 
period length. Assume further that 110 percent of the applicable 
Federal rate based on annual compounding is 10 percent.
    (ii) The rental agreement is not a disqualified leaseback or 
long-term agreement because it does not provide for the payment of 
more than $2,000,000 in rent (determined pursuant to Sec. 1.467-
3(b)(1)(i)). Because the section 467 rental agreement does not 
provide adequate interest under Sec. 1.467-2(b) and is not subject 
to constant rental accrual, the fixed rent that accrues during each 
rental period is the proportional rental amount as described in 
Sec. 1.467-2(c). The proportional rental amounts for each rental 
period are as follows:

1998   $370,370.37
1999   555,555.56
2000   740,740.74

    (iii) A section 467 loan arises at the beginning of the second 
rental period because the rent payable on or before that day (zero) 
is less than the fixed rent accrued under Sec. 1.467-1(d)(2) in all 
preceding rental periods ($370,370.37). Under paragraph (c)(2) of 
this section, the yield of the loan is equal to 110 percent of the 
applicable Federal rate (10 percent compounded annually). Because no 
payments are treated as made on or before the first day of the 
second rental period, the principal balance of the loan at the 
beginning of the second rental period is $370,370.37. The interest 
for the second rental period on fixed rent is $37,037.04 (.10 x 
$370,370.37) and, under Sec. 1.467-1(e)(3), is treated as interest 
income of the lessor and as an interest expense of the lessee.
    (iv) Because no payments are made on or before the first day of 
the third rental period, the principal balance of the loan at the 
beginning of the third rental period is equal to the fixed rent 
accrued during the first and second rental periods plus the lessor's 
interest income on fixed rent for the second rental period 
($962,962.97 = $370,370.37 + $555,555.56 + $37,037.04). The interest 
for the third rental period on fixed rent is $96,296.30 (.10 x 
$962,962.97). Thus, the sum of the fixed rent and interest on fixed 
rent for the three rental periods is equal to the total amount paid 
over the lease term (first year fixed rent accrual, $370,370.37, 
plus second year fixed rent and interest accrual, $555,555.56 + 
$37,037.04, plus third year fixed rent and interest accrual, 
$740,740.74 + $96,296.30, equals $1,800,000). B takes the amounts of 
interest and rent into account as expense and A takes such amounts 
into account as income for the

[[Page 27847]]

calendar years identified above, regardless of their respective 
methods of accounting.
    Example 2. (i) The facts are the same as in Example 1, 
Sec. 1.467-2(f).
    (ii)(A) Pursuant to paragraph (c)(1) of this section, the yield 
of the section 467 loan is 10.775078%, compounded annually. The 
following is a schedule of the rent allocable to each rental period 
during the lease term, the balance of the section 467 loan as of the 
end of each rental period (determined, in the case of the calendar 
year 2002, without regard to the single payment of rent and interest 
in the amount of $620,000 payable on the last day of the lease 
term), and the interest on the section 467 loan allocable to each 
rental period:

----------------------------------------------------------------------------------------------------------------
                                                                    Section 467     Section 467     Section 467 
                          Calendar year                              interest          rent        loan balance 
----------------------------------------------------------------------------------------------------------------
1998............................................................              $0     $100,000.00     $100,000.00
1999............................................................       10,775.08      100,000.00      210,775.08
2000............................................................       22,711.18      100,000.00      333,486.26
2001............................................................       35,933.41      100,000.00      469,419.67
2002............................................................       50,580.33      100,000.00      620,000.00
----------------------------------------------------------------------------------------------------------------

    (B) C takes the amounts of interest and rent into account as 
expense and D takes such amounts into account as income for the 
calendar years identified above, regardless of their respective 
methods of accounting.


Sec. 1.467-5   Section 467 rental agreements with variable interest.

    (a) Variable interest on deferred or prepaid rent--(1) In general. 
This section provides rules for computing section 467 rent and interest 
in the case of section 467 rental agreements providing variable 
interest. For purposes of this section, a rental agreement provides for 
variable interest if the rental agreement provides for stated interest 
that is paid or compounded at least annually at a rate or rates that 
meet the requirements of Sec. 1.1275-5(a)(3)(i) (A) or (B) and 
Sec. 1.1275-5(a)(4). If a section 467 rental agreement provides for 
interest that is neither variable interest nor determined by reference 
to a fixed rate, the amount of any interest will be treated as a 
contingent payment subject to Sec. 1.467-6.
    (2) Exceptions. This section is not applicable to section 467 
rental agreements that provide adequate interest under Sec. 1.467-
2(b)(1)(i) (agreements with no deferred or prepaid rent) or Sec. 1.467-
2(b)(1)(ii) (rental agreements with stated interest at a single fixed 
rate). The exceptions in this paragraph (a)(2) do not apply to rental 
agreements subject to constant rental accrual under Sec. 1.467-3.
    (b) Variable rate treated as fixed--(1) In general. If a section 
467 rental agreement provides variable interest--
    (i) The fixed rate substitutes (determined in the same manner as 
under Sec. 1.1275-5(e) treating the agreement date as the issue date) 
for the variable rates of interest on prepaid or deferred fixed rent 
provided by the rental agreement must be used in computing the 
proportional rental amount under Sec. 1.467-2(c), the constant rental 
amount under Sec. 1.467-3(d), the principal balance of a section 467 
loan under Sec. 1.467-4(b), and the yield of a section 467 loan under 
Sec. 1.467-4(c); and
    (ii) The interest on fixed rent for any rental period is equal to 
the amount that would be determined under Sec. 1.467-1(e)(2) if the 
section 467 rental agreement did not provide variable interest, using 
the fixed rate substitutes determined under paragraph (b)(1)(i) of this 
section in place of the variable rates called for by the rental 
agreement, plus the variable interest adjustment amount provided in 
paragraph (b)(2) of this section.
    (2) Variable interest adjustment amount--(i) In general. The 
variable interest adjustment amount for a rental period equals the 
difference between--
    (A) The amount of interest that, without regard to section 467, 
would have accrued during the rental period under the terms of the 
section 467 rental agreement; and
    (B) The amount of interest that, without regard to section 467, 
would have accrued during the rental period under the terms of the 
section 467 rental agreement using the fixed rate substitutes 
determined under paragraph (b)(1)(i) of this section in place of the 
variable interest rates called for by the rental agreement.
    (ii) Sign of adjustment. If the amount determined under paragraph 
(b)(2)(i)(A) of this section is greater than the amount determined 
under paragraph (b)(2)(i)(B) of this section, the variable interest 
adjustment amount is positive. If the amount determined under paragraph 
(b)(2)(i)(A) of this section is less than the amount determined under 
paragraph (b)(2)(i)(B) of this section, the variable interest 
adjustment amount is negative.
    (3) Section 467 loan balance. The variable interest adjustment 
amount is not taken into account in determining the principal balance 
of a section 467 loan under Sec. 1.467-4(b). Instead, the section 467 
loan balance is computed as if all amounts payable under the section 
467 rental agreement were based on the fixed rate substitutes 
determined under paragraph (b)(1)(i) of this section.
    (c) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i) X and Y enter into a section 467 rental agreement 
for the lease of personal property beginning on January 1, 1998, and 
ending on December 31, 2000. It allocates $100,000 of rent to 1998, 
$200,000 to 1999, and $100,000 to 2000, and requires the lessee to 
pay all $400,000 of rent on December 31, 2000. The rental agreement 
requires the accrual of interest on unpaid accrued rent at two 
different qualified floating rates (as defined in Sec. 1.1275-5(b)), 
one for 1999 and the other for 2000, such interest to be paid on 
December 31 of the year it accrues. The rental agreement provides 
that the qualified floating rate is set at a current value within 
the meaning of Sec. 1.1275-5(a)(4). Assume that on the agreement 
date, 110 percent of the applicable Federal rate is 10 percent, 
compounded annually.
    (ii) The rental agreement is not a disqualified leaseback or 
long-term agreement because it does not provide for the payment of 
more than $2,000,000 in rent (determined pursuant to Sec. 1.467-
3(b)(1)(i)). To determine if the section 467 rental agreement 
provides for adequate interest under Sec. 1.467-2(b), Sec. 1.467-
2(b)(2) requires the use of fixed rate substitutes (in this example 
determined in the same manner as under Sec. 1.1275-5(e)(3)(i) 
treating the agreement date as the issue date) in place of the 
variable rates called for by the rental agreement. Assume that on 
the agreement date the qualified floating rates, and therefore the 
fixed rate substitutes, relating to 1999 and 2000 are 10 and 15 
percent compounded annually. Taking into account the fixed rate 
substitutes, the sum of the present values of all amounts payable by 
the lessee as fixed rent and interest thereon is greater than the 
sum of the present values of the fixed rent allocated to each rental 
period. Accordingly, the rental agreement provides adequate interest 
under Sec. 1.467-2(b)(1)(iii) and the fixed rent accruing in each 
calendar year during the rental agreement is the fixed rent 
allocated under the rental agreement.
    (iii) Because the section 467 rental agreement provides for 
variable interest on unpaid accrued fixed rent at qualified floating 
rates and the qualified floating rates are set at a current value, 
the requirements of Sec. 1.1275-5(a)(3)(i)(A) and (4) are met and 
the rental agreement provides for variable

[[Page 27848]]

interest within the meaning of paragraph (a)(1) of this section. 
Therefore, under paragraph (b)(1)(i) of this section, the yield of 
the section 467 loan is computed based on the fixed rate 
substitutes. Under Sec. 1.467-4(c), the constant yield (rounded to 
two decimal places) equals 13.63 percent compounded annually. Based 
on the fixed rate substitutes, the fixed rent, interest on fixed 
rent, and the principal balance of the section 467 loan, for each 
calendar year during the lease term, are as follows:

----------------------------------------------------------------------------------------------------------------
                                                            Accrued      Accrued       Projected      Cumulative
                                                              rent       interest       payment          loan   
----------------------------------------------------------------------------------------------------------------
1998....................................................     $100,000           $0              $0      $100,000
1999....................................................      200,000       13,630         (10,000)      303,630
2000....................................................      100,000       41,370        (445,000)            0
----------------------------------------------------------------------------------------------------------------

    (iv) To compute the actual reported interest on fixed rent for 
each calendar year, the variable interest adjustment amount, as 
described in paragraph (b)(2) of this section, must be added to the 
accrued interest determined in paragraph (iii) of this Example 1. 
Assume that the variable rates for 1999 and 2000 are actually 11 and 
14 percent, respectively. Without regard to section 467, the 
interest that would have accrued during each calendar year under the 
terms of the section 467 rental agreement, and the interest that 
would have accrued under the terms of the rental agreement using the 
fixed rate substitutes determined under paragraph (b)(1)(i) are as 
follows:

------------------------------------------------------------------------
                                                  Accrued      Accrued  
                                                  interest     interest 
                                                   under     using fixed
                                                   rental        rate   
                                                 agreement   substitutes
------------------------------------------------------------------------
1998..........................................           $0           $0
1999..........................................       11,000       10,000
2000..........................................       42,000       45,000
------------------------------------------------------------------------

    (v) Under paragraph (b)(2) of this section, the variable 
interest adjustment amount is $1,000 ($11,000-$10,000) for 1999 and 
is -$3,000 ($42,000-$45,000) for 2000. Thus, under paragraph 
(b)(1)(ii) of this section, the actual interest on fixed rent for 
1999 is $14,630 ($13,630+$1,000) and for 2000 is $38,370 
($41,370-$3,000).
    Example 2. (i) The facts are the same as in Example 1 except 
that 110 percent of the applicable Federal rate is 15 percent 
compounded annually and the section 467 rental agreement does not 
provide adequate interest under Sec. 1.467-2(b). Consequently, the 
fixed rent for each calendar year during the lease is the 
proportional rental amount.
    (ii) The sum of the present values of the fixed rent provided 
for each calendar year during the lease term, discounted at 15 
percent compounded annually, equals $303,936.87.
    (iii)(A) Paragraph (b)(1)(i) of this section requires the 
proportional rental amount to be computed based on the assumption 
that interest will accrue and be paid based on the fixed rate 
substitutes. Thus, the sum of the present values of the projected 
payments under the section 467 rental agreement equals $300,156.16, 
computed as follows:

$10,000/(1.15)2..............         =                   $7,561.44     
445,000/(1.15)3..............         =                  292,594.72     
                                              --------------------------
  ...........................                            300,156.16     
                                                                        

    (B) The fraction for computing the proportional rental amount 
equals .9875609 ($300,156.16/$303,936.87).
    (iv) Based on the fixed rate substitutes, the fixed rent, 
interest on fixed rent, and the balance of the section 467 loan for 
each calendar year during the lease term are as follows:

----------------------------------------------------------------------------------------------------------------
                                                         Proportional    Accrued       Projected      Cumulative
                                                             rent        interest       payment          loan   
----------------------------------------------------------------------------------------------------------------
1998...................................................    $98,756.09        $0.00              $0    $98,756.09
1999...................................................    197,512.18    14,813.41         (10,000)   301,081.68
2000...................................................     98,756.09    45,162.23        (445,000)         0.00
----------------------------------------------------------------------------------------------------------------

    (v) The variable interest adjustment amount in this example is 
the same as in Example 1. Under paragraph (b)(1)(ii) of this 
section, the actual interest on fixed rent for 1999 is $15,813.41 
($14,813.41+$1,000) and for 2000 is $42,162.23 ($45,162.23-$3,000).


Sec. 1.467-6  Section 467 rental agreements with contingent payments. 
[Reserved]


Sec. 1.467-7  Section 467 recapture and other rules relating to 
dispositions.

    (a) Section 467 recapture. Notwithstanding any other provision of 
the Code, except as provided in paragraph (c) of this section, a lessor 
disposing of property in a transaction to which this section applies 
must recognize the recapture amount (determined under paragraph (b) of 
this section) and treat that amount as ordinary income. This section 
applies to any disposition of property subject to a section 467 rental 
agreement that--
    (1) Is a leaseback (as defined in Sec. 1.467-3(b)(2)) or a long-
term agreement (as defined in Sec. 1.467-3(b)(3));
    (2) Is not disqualified under Sec. 1.467-3(b)(1); and
    (3) Allocates to any rental period fixed rent that, when 
annualized, exceeds the annualized fixed rent allocated to any 
preceding rental period.
    (b) Recapture amount--(1) In general. The recapture amount for a 
disposition is the lesser of--
    (i) The prior understated inclusions (determined under paragraph 
(b)(2) of this section); or
    (ii) The section 467 gain (determined under paragraph (b)(3) of 
this section).
    (2) Prior understated inclusions--(i) In general. The prior 
understated inclusions are the excess (if any) of--
    (A) The aggregate amount of section 467 rent and section 467 
interest for the period during which the lessor held the property, 
determined as if the section 467 rental agreement were a disqualified 
leaseback or long-term agreement; over
    (B) The aggregate amount of section 467 rent and section 467 
interest accrued by the lessor during that period.
    (ii) Partial rental periods. For purposes of this paragraph (b)(2), 
the aggregate amounts described in paragraph (b)(2)(i)(A) and (B) of 
this section include a ratable portion of the section 467 rent and 
section 467 interest for any partial rental period during which the 
lessor held the property.
    (3) Section 467 gain--(i) In general. Except as otherwise provided 
in paragraph (b)(3)(ii) of this section, the section 467 gain is the 
excess (if any) of--
    (A) The amount realized from the disposition; over
    (B) The sum of the adjusted basis of the property and the amount of 
any gain from the disposition that is treated as ordinary income under 
any provision of subtitle A of the Code other than section 467(c) 
(e.g., section 1245 or 1250).

[[Page 27849]]

    (ii) Certain dispositions. In the case of a disposition that is not 
a sale, exchange, or involuntary conversion, the section 467 gain is 
the excess (if any) of the fair market value of the property on the 
date of disposition over the amount determined under paragraph 
(b)(3)(i)(B) of this section.
    (c) Special rules--(1) Gifts. Paragraph (a) of this section does 
not apply to a disposition by gift. However, see paragraph (c)(4) of 
this section for dispositions by transferees.
    (2) Dispositions at death. Paragraph (a) of this section does not 
apply to a disposition if the basis of the property in the hands of the 
transferee is determined under section 1014(a). In the case of items 
constituting income in respect of a decedent, see section 691.
    (3) Certain tax-free exchanges--(i) In general. The recapture 
amount in the case of a disposition to which this paragraph (c)(3) 
applies is limited to the amount of gain recognized to the transferor 
(determined without regard to paragraph (a) of this section), reduced 
by the amount of any gain from the disposition that is treated as 
ordinary income under any provision of subtitle A of the Code other 
than section 467(c).
    (ii) Dispositions covered. This paragraph (c)(3) applies to a 
disposition of property if the basis of the property in the hands of 
the transferee is determined by reference to its basis in the hands of 
the transferor by reason of the application of section 332, 351, 361, 
721, or 731.
    (4) Dispositions by transferee. If the recapture amount with 
respect to a disposition of property (the first disposition) is limited 
under paragraph (c)(1) or (3) of this section and the transferee 
subsequently disposes of the property in a transaction to which this 
section applies, the amount described in paragraph (b)(2)(i)(A) of this 
section must be increased for purposes of determining the recapture 
amount for such subsequent disposition by the excess (if any) of--
    (i) The recapture amount on the first disposition, determined 
without regard to the limitations of paragraphs (c)(1) and (3) of this 
section; over
    (ii) The recapture amount on the first disposition determined after 
application of such limitations.
    (5) Like-kind exchanges and involuntary conversions. If property is 
disposed of or converted and, before the application of paragraph (a) 
of this section, gain is not recognized in whole or in part under 
section 1031 or 1033, then the amount of section 467 gain taken into 
account by the lessor is limited to the sum of--
    (i) The amount of gain recognized on the disposition or conversion 
of the property (determined without regard to paragraph (a) of this 
section); plus
    (ii) The fair market value of property acquired that is not subject 
to a section 467 rental agreement and that is not taken into account 
under paragraph (c)(5)(i) of this section.
    (6) Installment sales. In the case of an installment sale of 
property to which paragraph (a) of this section applies--
    (i) The recapture amount is recognized and treated as ordinary 
income in the year of the disposition; and
    (ii) Any gain in excess of the recapture amount shall be reported 
under the installment method of accounting if and to the extent that 
method is otherwise available under section 453.
    (7) Dispositions covered by sections 170(e), 341(e)(12), or 751(c). 
For purposes of sections 170(e), 341(e)(12), and 751(c), amounts 
treated as ordinary income under paragraph (a) of this section must be 
treated in the same manner as amounts treated as ordinary income under 
section 1245 or 1250.
    (d) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i) X and Y enter into a section 467 rental agreement 
for a 5-year lease of personal property beginning on January 1, 
1997, and ending on December 31, 2001. The rental agreement provides 
that $0 of rent is allocated to 1997, 1998, and 1999, and $175,000 
is allocated to each of the years 2000 and 2001. The rental 
agreement provides that the calendar year will be the rental period 
and that the rent allocated to each calendar year is payable on the 
last day of that calendar year. Assume that both X and Y are 
calendar year taxpayers and that 110 percent of the applicable 
Federal rate is 11 percent, compounded annually. Assume further that 
the rental agreement is a long- term agreement (as defined in 
Sec. 1.467-3(b)(3)). The rental agreement is not a disqualified 
leaseback or long-term agreement because it does not provide for the 
payment of more than $2,000,000 in rent (determined pursuant to 
Sec. 1.467-3(b)(1)(i)). Therefore, the fixed rent allocated under 
Sec. 1.467-1(c)(2)(ii) is zero for the first three rental periods 
and $175,000 for the fourth and fifth rental periods.
    (ii) On December 31, 1999, X sells the property subject to the 
section 467 rental agreement to an unrelated person for $990,000. At 
the time of the sale, X's adjusted basis in the property is 
$550,000. Thus, X's gain on the sale of the property is $440,000. 
Assume that none of this gain would be treated as ordinary income 
under any provision of the Internal Revenue Code other than section 
467(c). Under paragraph (a) of this section, X is required to take 
the recapture amount into account as ordinary income. Under 
paragraph (b) of this section, the recapture amount is the lesser of 
the prior understated inclusions or the section 467 gain.
    (iii) (A) In computing the prior understated inclusions under 
paragraph (b)(2), assume that the section 467 rent and section 467 
interest (based on constant rental accrual) would be taken into 
account as follows if the section 467 rental agreement were a 
disqualified long-term agreement:

------------------------------------------------------------------------
                                               Section 467   Section 467
                                                  rent        interest  
------------------------------------------------------------------------
1997........................................    $59,290.59            $0
1998........................................     59,290.59      6,521.96
1999........................................     59,290.59     13,761.35
2000........................................     59,290.59     21,797.06
2001........................................     59,290.59     11,466.68
------------------------------------------------------------------------

    (B) The aggregate amount of the section 467 rent and section 467 
interest (based on constant rental accrual) for 1997, 1998, and 1999 
is $198,155.08 ((3 x $59,290.59) + $6,521.96 + $13,761.35). Since X 
did not take any section 467 rent or section 467 interest into 
account in 1997, 1998, and 1999, the prior understated inclusions 
are also $198,155.08. Since none of the gain is treated as ordinary 
income under any provision of the Code other than section 467(c), 
the entire amount of gain ($440,000) is section 467 gain. 
Accordingly, the recapture amount (, the lesser of the prior 
understated inclusions or the section 467 gain) treated as ordinary 
income is $198,155.08.
    Example 2. (i) The facts are the same as in Example 1 except 
that the section 467 rental agreement specifies that rents accrue 
and are paid in the following pattern:

------------------------------------------------------------------------
                                               Allocation      Payment  
------------------------------------------------------------------------
1997........................................       $60,000            $0
1998........................................        65,000             0
1999........................................        70,000             0
2000........................................        75,000       175,000
2001........................................        80,000       175,000
------------------------------------------------------------------------

    (ii) (A) Assume the section 467 rental agreement does not 
provide for adequate interest under Sec. 1.467-2(b), and, therefore, 
the fixed rent for a rental period is the proportional rental 
amount. See Sec. 1.467-1(d)(2)(ii). Assume that, under Sec. 1.467-
2(c), the following amounts would be required to be taken into 
account:

------------------------------------------------------------------------
                                               Section 467   Section 467
                                                  rent        interest  
------------------------------------------------------------------------
1997........................................    $51,585.97            $0
1998........................................     55,884.80      5,674.46
1999........................................     60,183.63     12,445.98
2000........................................     64,482.46     20,435.23
2001........................................     68,781.28     10,526.19
------------------------------------------------------------------------

    (B) The amount of section 467 rent and section 467 interest 
taken into account by A for 1997, 1998, and 1999 is $185,774.84. 
Thus, the prior understated inclusions are $12,380.24 (the excess of 
the aggregate amount of section 467 rent and section 467 interest, 
based on constant rental accrual, for these three years, , 
$198,155.08, over the aggregate amount of section 467 rent and 
section 467 interest actually taken into

[[Page 27850]]

account, $185,774.84). Since this amount is less than the section 
467 gain, the recapture amount treated as ordinary income is also 
$12,380.24.
    (e) Other rules relating to dispositions--(1) In general. If 
property subject to a section 467 rental agreement is sold, 
exchanged, or otherwise disposed of, the section 467 rent for a 
period is taken into account by the owner of the property during the 
period. The lessee, however, must continue to take section 467 rent 
and section 467 interest into account without regard to the change 
of ownership.

    (2) Treatment of section 467 loan. If there is a sale, exchange, or 
other disposition of property subject to a section 467 rental agreement 
(the transfer), the following rules apply in determining the amount of 
the section 467 loan for the period after the transfer, the amount 
realized by the transferor, and the transferee's basis in the property:
    (i) The beginning balance of the transferor's section 467 loan is 
equal to the net present value at the time of the transfer of all 
subsequent amounts payable as fixed rent and interest on fixed rent to 
the transferor and all subsequent amounts payable as interest on 
prepaid fixed rent by the transferor. The transferor must continue to 
take into account interest on the transferor's section 467 loan balance 
after the date of the transfer.
    (ii) The beginning balance of the transferee's section 467 loan is 
equal to the principal balance of the section 467 loan immediately 
before the transfer reduced (below zero, if appropriate) by the 
beginning balance of the transferor's section 467 loan. Amounts payable 
to the transferor are not taken into account in adjusting the 
transferee's section 467 loan balance.
    (iii) If the beginning balance of the transferee's section 467 loan 
is negative, the transferor and transferee must treat the balance as a 
liability that is either assumed in connection with the transfer of the 
property or secured by the property acquired subject to the liability. 
If the beginning balance of the transferee's section 467 loan is 
positive, the transferor and transferee must treat the balance as an 
additional asset acquired in connection with the transfer of the 
property. In the case of a positive beginning balance of the 
transferee's section 467 loan, the transferee will have an initial cost 
basis in the section 467 loan equal to the lesser of the beginning 
balance of the loan or the aggregate consideration for the transfer of 
the property subject to the section 467 rental agreement and the 
transfer of the transferor's interest in the section 467 loan.
    (3) Special rules for transfers in certain nonrecognition 
transactions. [Reserved]
    (f) Treatment of assignments by lessee and lessee-financed 
renewals--(1) Substitute lessee use. If a lessee assigns its interest 
in a section 467 rental agreement to a substitute lessee or a period 
when a substitute lessee has the use of property subject to a rental 
agreement is otherwise included in the lease term under Sec. 1.467-
1(h), the section 467 rent for a period is taken into account by the 
person having the use of the property during the period. In addition, 
the following rules apply in determining the amount of the section 467 
loan for the period when the substitute lessee has use of the property 
and in computing the taxable income of the lessee and substitute 
lessee--
    (i) The beginning balance of the lessee's section 467 loan is equal 
to the net present value, as of the date on which the substitute lessee 
first has use of the property, of all amounts subsequently payable by 
the lessee as fixed rent and interest on fixed rent and all amounts 
subsequently payable as interest on prepaid fixed rent to the lessee. 
For purposes of this paragraph (f), any amount otherwise payable by the 
lessee shall not be treated as an amount subsequently payable by the 
lessee to the extent that such payment, if made by the lessee, would 
give rise to a right of contribution or other similar claim against the 
substitute lessee or any other person. The lessee must continue to take 
into account interest on the lessee's section 467 loan balance after 
the substitute lessee first has use of the property.
    (ii) The beginning balance of the substitute lessee's section 467 
loan is equal to the principal balance of the section 467 loan 
immediately before the substitute lessee first has use of the property 
reduced (below zero, if appropriate) by the beginning balance of the 
lessee's section 467 loan. Amounts payable by the lessee to any person 
other than the substitute lessee (or a related person) or payable to 
the lessee by any person other than the substitute lessee (or a related 
person) are not taken into account in adjusting the substitute lessee's 
section 467 loan balance.
    (iii) If the beginning balance of the substitute lessee's section 
467 loan is positive, the beginning balance is treated as--
    (A) Gross income of the lessee for the taxable year in which the 
substitute lessee first has use of the property; and
    (B) A liability that is either assumed in connection with the 
transfer of the leasehold interest to the substitute lessee or secured 
by property acquired subject to the liability.
    (iv) If the beginning balance of the substitute lessee's section 
467 loan is negative--
    (A) The beginning balance is treated as an amount incurred by the 
lessee for the taxable year in which the substitute lessee first has 
use of the property; and
    (B) Repayments of the beginning balance are items of gross income 
of the substitute lessee in the taxable year in which the repayment 
occurs (determined by applying any repayment first to the beginning 
balance of the substitute lessee's section 467 loan).
    (v) For purposes of paragraph (f)(1)(iv)(B) of this section, 
repayments occur as the negative balance is amortized through the net 
accrual of rent and negative interest.
    (2) Lessor use. If a period when the lessor has the use of property 
subject to a section 467 rental agreement is included in the lease term 
under Sec. 1.467-1(h), the section 467 rent for the period is not taken 
into account and the lessor is treated as a substitute lessee for 
purposes of paragraph (f)(1) of this section.
    (3) Special rules for transfers in certain nonrecognition 
transactions. [Reserved]


Sec. 1.467-8  Effective date.

    Sections 1.467-1 through 1.467-7 are effective for--
    (a) Rental agreements entered into after the date these regulations 
are published as final regulations in the Federal Register; and
    (b) Disqualified leasebacks and long-term agreements entered into 
after June 3, 1996.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 96-13719 Filed 5-31-96; 8:45 am]
BILLING CODE 4830-01-U