[Federal Register Volume 64, Number 95 (Tuesday, May 18, 1999)]
[Rules and Regulations]
[Pages 26845-26876]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-11891]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8820]
RIN 1545-AU11


Section 467 Rental Agreements; Treatment of Rent and Interest 
Under Certain Agreements for the Lease of Tangible Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
treatment of rent and interest under certain agreements for the lease 
of tangible property. The regulations apply to certain rental 
agreements that provide increasing or decreasing rents, or deferred or 
prepaid rent, and provide guidance for lessees and lessors of tangible 
property.

DATES: Effective Date: These regulations are effective on May 18, 1999.
    Applicability Date: For dates of applicability of these 
regulations, see Effective Dates under SUPPLEMENTARY INFORMATION.

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

SUPPLEMENTARY INFORMATION:

Background

    Section 467 was added to the Internal Revenue Code by section 92(a) 
of the Tax Reform Act of 1984 (Pub. L. 98-369 (98 Stat. 609)). On June 
3, 1996, the IRS and Treasury Department issued a notice of proposed 
rulemaking (61 FR 27834 [IA-292-84, 1996-2 C.B. 462]) relating to 
section 467. The proposed regulations provide guidance regarding the 
applicability of section 467, and the amount of rent and interest 
required to be accrued under section 467. Comments responding to the 
notice were received, and a public hearing was held on September 25, 
1996.
    The IRS and Treasury Department issued interim guidance in Notice 
97-72 (1997-2 C.B. 334), which informed taxpayers of certain conditions 
under which a refinancing of indebtedness incurred by a lessor to 
acquire property that is the subject of a rental agreement will not be 
considered a substantial modification of that agreement for purposes of 
section 467. After considering the comments that were received in 
response to the notice of proposed rulemaking and the statements made 
at the public hearing, the proposed regulations are adopted as revised 
by this Treasury decision. The significant comments and revisions are 
discussed below.

Explanation of Provisions

1. Section 467 Rental Agreements

    Under the proposed and final regulations, section 467 applies to 
any rental agreement with increasing or decreasing rent and aggregate 
rental payments or other consideration of more than $250,000. 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.
    In determining whether a rental agreement has increasing or 
decreasing rent, the proposed regulations provide that a rent holiday 
at the beginning of the lease term is disregarded if the rent holiday 
period is three months or less. Several commentators requested that the 
rent holiday period be lengthened, arguing that it should be the same 
as the rent holiday period permitted for determining whether a 
leaseback or long-term agreement has tax-motivated increasing rents 
(the lesser of 24 months or 10 percent of the lease term). The final 
regulations do not adopt this suggestion.
    Section 467(d)(1)(B) provides that a rental agreement will be 
treated as a section 467 rental agreement if there are increases in the 
amount to be paid as rent under the agreement. Except for the $250,000 
de minimis exception set forth in section 467(d)(2), section 467 does 
not contain any exceptions to the rule that rental agreements with 
increasing rent are section 467 rental agreements. The three-month rent 
holiday exception was added in the proposed regulations to prevent 
relatively insubstantial rent holidays from causing a rental agreement 
to be treated as a section 467 rental agreement. Accordingly, the 
three-month rent holiday exception is intended merely as a de minimis 
exception and a rule of administrative convenience. In contrast, 
Congress specifically directed that a rent holiday safe harbor should 
be provided for

[[Page 26846]]

normal commercial practices in determining whether a leaseback or long-
term agreement has tax-motivated increasing rents. Thus, since the 
policies that support a rent holiday exception for disqualified 
leasebacks and long-term agreements are clearly not the same as the 
policies that support a rent holiday exception for whether an agreement 
has increasing rent and is therefore a section 467 rental agreement, 
the IRS and Treasury Department do not believe the rent holiday periods 
should be the same.
    The proposed regulations also 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. Several commentators requested 
additional exceptions for other types of payments, as well as an 
expansion of the existing exceptions.
    The final regulations provide several additional types of 
contingent payments that will not be taken into account in determining 
whether a rental agreement has increasing or decreasing rent. Because 
of the relationship between these contingent rent provisions and the 
contingent rent provisions that are disregarded in determining whether 
an agreement is a disqualified leaseback or long-term agreement, the 
new contingent rent exceptions will be discussed below in connection 
with the discussion of disqualified leasebacks and long-term 
agreements.

2. Section 467 Rent

    Under the proposed and final 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. The amount of 
fixed rent for a rental period depends on the terms of the rental 
agreement and, under the regulations, will be either the amount of 
fixed rent allocated to the period under the agreement, the constant 
rental amount, or the proportional rental amount.
A. Disqualified Leaseback or Long-term Agreement
    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 a disqualified leaseback or long-
term agreement 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. The proposed regulations include as safe 
harbors only the provisions set forth in section 467(b)(5) and an 
uneven rent test based on Rev. Proc. 75-21 (1975-1 C.B. 715). Other 
factors that would be considered as evidence of tax avoidance were not 
provided.
    Several commentators requested additional safe harbors for other 
types of payments, as well as an expansion of the existing safe 
harbors. In response to these comments, several changes have been made 
in the final regulations to the tax avoidance and safe harbor 
provisions.
    (i) Determining tax avoidance. The proposed regulations do not 
provide any substantive rules for determining tax avoidance because a 
leaseback or long-term agreement will not be treated as disqualified in 
the absence of an affirmative determination by the Commissioner. As a 
result, the objective of consistency of treatment between the lessee 
and lessor would have been met without the need to promulgate factors 
or other rules that taxpayers could use to determine whether tax 
avoidance was present. While the final regulations retain the rule that 
only the Commissioner may make a tax avoidance determination, the IRS 
and Treasury Department believe that the combination of substantive 
guidance on tax avoidance and additional safe harbors will permit 
taxpayers to determine more readily whether their leasebacks or long-
term agreements will be determined to be disqualified by the 
Commissioner. Accordingly, substantive provisions have been added to 
the final regulations prescribing the circumstances in which Federal 
income tax avoidance will be treated as a principal purpose for 
providing increasing or decreasing rent.
    The final regulations provide that, if a significant difference 
between the marginal Federal income tax rates of the lessor and lessee 
can reasonably be expected at some time during the lease term, 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. The regulations 
provide rules to determine when there is a significant difference in 
marginal tax rates of the lessor and lessee. Under these rules, the 
marginal tax rates are determined not only by reference to the Federal 
income tax status of the taxpayer (for example, as a corporation, 
partnership, or individual), but also to the specific circumstances of 
the taxpayer. Thus, if a corporation either is subject to the 
alternative minimum tax or has available net operating losses or 
credits to carry forward from an earlier taxable year, the 
corporation's marginal tax rate will differ from other corporations not 
subject to the alternative minimum tax and not having available net 
operating losses or credits. Further, in the case of an S corporation 
or partnership, the marginal tax rate will be determined by taking into 
account the amounts of income or deduction allocable to its 
shareholders or partners, respectively, and the marginal tax rates of 
the shareholders or partners.
    Finally, as noted above, the final regulations retain the rule of 
the proposed regulations that only the Commissioner may determine that 
a section 467 rental agreement should be treated as a disqualified 
leaseback or long-term agreement. The final regulations also provide 
that such determination may be made either on a case-by-case basis or 
in regulations or other guidance published by the Commissioner 
providing that a certain type or class of leaseback or long-term 
agreement will be treated as disqualified and subject to constant 
rental accrual.
    (ii) Safe harbors. In response to comments, the final regulations 
include several safe harbor provisions not included in the proposed 
regulations. The new safe harbors are intended to cover a variety of 
payments that could be made under the terms of a rental agreement. 
Under the final regulations, tax avoidance is not considered a 
principal purpose for providing increasing or decreasing rent if the 
increase or decrease in rent is described in one of the contingent rent 
safe harbor provisions. The IRS and Treasury Department believe that 
these additional safe harbors and the expansion of the

[[Page 26847]]

existing safe harbors appropriately balance the need to provide a 
degree of certainty for taxpayers with the need to limit the potential 
for tax avoidance.
    The final regulations add several safe harbors for various types of 
contingent payments that either are intended to compensate the lessor 
for costs unrelated to the lessor's continuing investment in the leased 
property or are so contingent that they should not be taken into 
account for purposes of section 467 until the liability for such 
payment becomes fixed. Accordingly, subject to the limitations in the 
regulations, safe harbors are provided for payments required to be made 
by the lessee: in the event of damage, destruction, or loss of the 
leased property; in the case of a qualified motor vehicle operating 
agreement within the meaning of section 7701(h)(2)(A), for the failure 
of the property to maintain a specified residual value; for the failure 
of the property to be returned to the lessor at the end of the lease 
term in the condition specified in the agreement; or for the failure of 
the lessor to obtain the income tax benefits contemplated by the 
agreement. In addition, a provision requiring late payment charges is 
also not taken into account in determining whether tax avoidance is 
present in a leaseback or long-term agreement. Limitations on the scope 
of these safe harbors are provided in order to ensure that these 
provisions are included in the agreement for a valid business purpose 
and that the provisions are not used to achieve tax avoidance.
    Several commentators suggested that rent adjustments based on the 
lessor's indebtedness, which itself bears interest at a variable rate, 
are not tax motivated. In response, a safe harbor has also been added 
for certain variable interest rate provisions. Under this safe harbor, 
a rent adjustment provision will be disregarded if it is based solely 
on the dollar amount of changes in the lessor's interest costs, and 
only if the lessor and the lender are not related and the indebtedness 
is evidenced by a variable rate debt instrument (within the meaning of 
Sec. 1.1275-5(a)(1)). However, no inference may be drawn from this safe 
harbor (or any other provision of the regulations relating to a 
variable interest rate adjustment) concerning the effect of such an 
adjustment on the classification of the rental agreement as a lease for 
Federal income tax purposes.
    In addition, the final regulations expand the scope of the safe 
harbors provided in the proposed regulations relating to percentage 
rents, inflation adjustments, and reasonable rent holidays. A provision 
in a lease will not fail to qualify for the percentage rent safe harbor 
because, for example, it applies to receipts or sales after making 
certain limited deductions, it applies different percentages to 
different departments or floors, or it applies to receipts or sales in 
excess of a determinable amount. In addition, a provision will not fail 
to qualify as an increase based on a reasonable price index because it 
may limit the adjustment to a fixed percentage in some years. However, 
this inflation adjustment safe harbor will not apply if the limitation 
in the rental agreement represents, in substance, a series of fixed 
increases in rent. For example, if the limitation on an annual 
inflation adjustment is substantially below the level of inflation 
reasonably expected during the lease term, the limitation is, in 
substance, a series of fixed increases in rent.
    The proposed regulations include a rent holiday safe harbor for the 
determination of tax avoidance, which provision applies only if there 
is a substantial business purpose for the rent holiday. Commentators 
objected to this requirement because the requirement of a business 
purpose was not set forth in the legislative history accompanying the 
enactment of section 467. The final regulations delete the requirement 
that there be a substantial business purpose for the rent holiday, but 
add the requirement that was set forth in the legislative history. H.R. 
Conf. Rep. No. 861, 98th Cong., 2d Sess. 893 (1984). Under the 
additional rule in the final regulations, the reasonableness of the 
rent holiday is determined by reference to the commercial practice (as 
of the agreement date) in the locality where the use of the property 
occurs. This commercial reasonableness requirement does not apply, 
however, in the case of a rent holiday of three months or less at the 
beginning of the lease term.
    The proposed regulations also limit the rent holiday safe harbor to 
rent holidays at the beginning of the lease term. The final regulations 
remove this limitation and permit one consecutive period at any point 
during the lease term to qualify for the rent holiday safe harbor if 
the commercial reasonableness requirement is satisfied and the rent 
holiday period does not exceed the lesser of 24 months or 10 percent of 
the lease term.
    Finally, except in the case of the rent holiday safe harbor, the 
safe harbor provisions discussed above also apply in determining 
whether a rental agreement has increasing or decreasing rent and is 
thus subject to section 467. Accordingly, if a type of contingent rent 
in a rental agreement meets the requirements of the applicable safe 
harbor provision, it is not taken into account in determining whether 
the agreement has increasing or decreasing rent for purposes of both 
the application of section 467 and the determination of whether the 
agreement is a disqualified leaseback or long-term agreement.
    (iii) Uneven rent test. 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 ``uneven rent test'' is derived from the Conference 
Committee Report, which 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 to be motivated by tax avoidance. The report cited 
the standards for advance rulings on leveraged lease transactions in 
Rev. Proc. 75-21, and stated that such standards may not be appropriate 
for real estate leases. H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 
893 (1984). The proposed regulations do not provide a safe harbor 
specifically applicable to real estate leases but comments were 
requested on whether a different uneven rent test should be established 
for real estate leases.
    Commentators requested that the basic ``90-110'' test in Rev. Proc. 
75-21 be adopted without modification. The principal modification to 
the basic 90-110 test in the proposed regulations identified by the 
commentators was the use of the calendar year rather than the lease 
year to test for uneven rents. These commentators also requested that 
the alternate uneven rent test (sometimes referred to as the ``\2/3\-
\1/3\'' test) be adopted as an additional safe harbor. Finally, these 
commentators requested clarification of the application of these uneven 
rent tests in certain circumstances.
    In response to these comments, the final regulations expand and 
clarify the scope of the uneven rent test in the proposed regulations. 
First, the final regulations allow a rent holiday period at the 
beginning of the lease term to be ignored in applying the uneven rent 
test if its duration is not more than three months. Further, all but 
two of the contingent rent provisions ignored for purposes of 
determining tax avoidance are also disregarded in applying the uneven 
rent test. Rules are also

[[Page 26848]]

provided to assist taxpayers in applying the uneven rent test if the 
rental agreement contains a variable rent provision.
    For long-term leases of real estate, the final regulations provide 
a modified uneven rent test. Under the final regulations, all of the 
rules relating to the uneven rent test will be applied to long-term 
leases of real estate, except that a 15 percent variance will be 
permitted in lieu of the 10 percent variance (the ``85-115'' test) and 
a rent holiday will be disregarded if it is commercially reasonable and 
its duration does not exceed the lesser of 24 months or 10 percent of 
the lease term.
    The final regulations do not adopt the suggestion that the 
alternative \2/3\-\1/3\ test also be made available as an additional 
safe harbor. Section 467 evidences recognition that tax avoidance may 
result from the use of either increasing or decreasing rents in a 
section 467 rental agreement, depending on the circumstances of the 
lessor and lessee in the particular transaction. The IRS and Treasury 
Department believe that the use of the \2/3\-\1/3\ test may, in some 
cases, result in substantial decreases in rent. Thus, the \2/3\-\1/3\ 
test is not included in the final regulations.
    Furthermore, the final regulations retain the use of the calendar 
year as the basis for applying the uneven rent test. The IRS and 
Treasury Department believe that use of the calendar year is most 
consistent with the structure of section 467, which provides the 
calendar year as the basis for determining whether rent is deferred.
    Some commentators requested additional safe harbors and other 
special rules for leases of real estate, including the allowance of 
fixed increases that approximate the parties' expectations of general 
price increases during the lease term. The final regulations do not 
provide any additional provisions relating to real estate leases except 
for the modified 85-115 uneven rent test and the expanded rent holiday 
safe harbor. The IRS and Treasury Department believe that any fixed 
increases in a real estate lease that exceed the permitted variance 
under the relaxed safe harbor should be tested for tax avoidance under 
the general standards.
    (iv) The $2,000,000 limitation. The proposed regulations provide 
that, among other limitations, a rental agreement will not be treated 
as a disqualified leaseback or long-term agreement unless it requires 
more than $2,000,000 in rental payments and other consideration.
    Although the $2,000,000 limitation has been retained in the final 
regulations, the IRS and Treasury no longer believe such a limitation 
is appropriate. Accordingly, the IRS and Treasury are issuing proposed 
regulations that would eliminate the $2,000,000 limitation on a 
prospective basis.
B. Rental Agreement Accrual
    Under the proposed and final regulations, if neither the constant 
rental amount nor the proportional rental amount is required to be 
accrued, the rent to be accrued for a rental period is the rent 
allocated to that rental period in accordance with the section 467 
rental agreement. The amount of rent allocated to a rental period by 
the rental agreement depends on whether the agreement provides a 
specific allocation of fixed rent. If a rental agreement provides a 
specific allocation of fixed rent, the amount of rent allocated to each 
rental period during the lease term is the amount of fixed rent 
allocated to that period by the agreement. In general, 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.
    The proposed regulations provide that, in the absence of a specific 
allocation of fixed rent, the amount of rent allocated to each rental 
period during the lease term is the amount of fixed rent payable during 
that rental period. A number of commentators requested that the rule 
for allocating rent in the absence of a specific allocation of fixed 
rent be amended. The commentators stated that, if a rental agreement 
contains only a rent payment schedule without a separate rent 
allocation schedule, the agreement should be treated as one that does 
not provide for an allocation of rents. In these circumstances, the 
commentators contend that the agreement should be subject to constant 
rental accrual under section 467(b)(3)(B).
    The final regulations do not adopt this suggestion. Instead, the 
final regulations, like the proposed regulations, provide that, in the 
absence of 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. The IRS and Treasury Department believe that 
it is inappropriate to apply the constant rental accrual rules solely 
because a rental agreement does not include a specific allocation of 
fixed rent, whether as a result of inadvertence, failure to obtain 
professional tax advice, or otherwise. Further, while the constant 
rental accrual method is not available unless the Commissioner makes a 
tax avoidance determination, parties wishing to accrue rent in 
accordance with the constant rental accrual method may provide for an 
allocation schedule in their rental agreement with tax consequences 
that approximate the use of the constant rental accrual method.
C. Other Applicable Limitations
    Some commentators suggested that the final regulations provide that 
rental agreements will be closely scrutinized for substantial economic 
effect in appropriate cases. For example, a rental agreement may 
provide a specific allocation of fixed rent (or no specific allocation 
of fixed rent) that, under the regulations, would result in significant 
back-loaded or front-loaded rent, but would not be subject to constant 
rental accrual because it is not a leaseback or long-term agreement. In 
general, the rules of section 467 represent exceptions to the general 
rules of tax accounting applicable to income and expense associated 
with rental agreements. However, the IRS and Treasury Department do not 
believe that section 467 and the regulations thereunder override other 
principles of Federal tax law in the case of income and expense 
associated with rental agreements. Thus, the final regulations 
explicitly provide that the Commissioner may apply authorities other 
than section 467 and the regulations thereunder, such as section 446(b) 
clear-reflection-of-income principles, section 482, and the substance-
over-form doctrine, to determine the income and expense from a rental 
agreement (including the proper allocation of fixed rent under a rental 
agreement).

3. Rental Agreements With Contingent Payments

    The proposed regulations reserve guidance on the section 467 
treatment of contingent rent, indicating that regulations addressing 
this issue would provide rules for contingent rent similar to those 
provided for computing original issue discount for contingent payment 
debt instruments in Sec. 1.1275-4. The final regulations continue to 
reserve on the section 467 treatment of contingent payments. The IRS 
and Treasury Department expect that regulations under Sec. 1.467-6 will 
be separately proposed, and continue to invite comments regarding the 
treatment of contingent rent and the application of

[[Page 26849]]

the Sec. 1.1275-4 rules to section 467 rental agreements.

4. Recapture on Sale or Other Disposition of Property

    Some commentators requested certain modifications and further 
clarification of the recapture rules under section 467(c) in the case 
of dispositions by gift, transfers at death, and certain tax-free 
transactions. In response to these comments, additional rules and 
examples illustrating those rules are provided in the final 
regulations.
    The purpose of the additional rules is to place the transferee in 
the same tax position upon the subsequent disposition of the leased 
property as the transferor would have been in if the transferor had not 
transferred the property to the transferee. For example, if property 
subject to a section 467 rental agreement is transferred in a 
transaction subject to section 351, and if the transferor would have 
recognized section 467(c) recapture upon a taxable disposition of the 
property, the transferee may be subject to recapture upon a subsequent 
taxable disposition of the property. The amount of the recapture upon 
the subsequent taxable disposition will be determined by taking into 
account the section 467 rent and section 467 interest relating to the 
period of the transferor's ownership of the property. Thus, if a 
leaseback or long-term agreement provides for increasing rent but is 
not a disqualified leaseback or long-term agreement, a taxable 
disposition of the property by the transferee on or after the 
expiration of the lease term will not be subject to section 467(c) 
recapture. Alternatively, a taxable disposition of the property by the 
transferee before the expiration of the lease term will be subject to 
the same amount of section 467(c) recapture that would have applied if 
the transferor had continued to own the property.

5. Other Disposition Rules

    The proposed regulations reserve guidance on 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. The IRS and Treasury Department believe, however, that special 
rules are not necessary in the case of nonrecognition transactions. As 
a general matter, because a section 467 loan is treated as indebtedness 
for all purposes of the Internal Revenue Code, the rules that apply to 
each of the nonrecognition provisions in cases where the property 
transferred is encumbered by indebtedness will apply to the transfer of 
property or a leasehold interest subject to a section 467 loan. 
Further, if the section 467 loan represents an additional asset of the 
transferor, it is unlikely that any gain will be realized by the 
transferor because, in most cases, the basis of the loan will be equal 
to the sum of the principal amount of the loan and the accrued interest 
thereon. Thus, the provisions of the proposed regulations relating to 
special rules for transfers in nonrecognition transactions have been 
deleted.

6. Treatment of Modifications

    The proposed regulations provide that, if the lessor and lessee 
agree to a substantial modification of the terms of an existing lease, 
the modified lease is generally treated as a new rental agreement for 
purposes of section 467. Thus, if the modified lease provides for 
increasing or decreasing rent, or deferred or prepaid rent, and the 
rent exceeds $250,000, it is treated under the proposed regulations as 
a section 467 rental agreement, even if the pre-modification lease was 
not a section 467 rental agreement.
    Some commentators requested additional guidance regarding whether a 
substantial modification of a lease has occurred, in view of the 
significant potential consequences of such a modification. In addition, 
the commentators suggested several types of modifications that, in 
their view, should not be treated as a substantial modification.
    Other commentators indicated that the proposed regulations did not 
clarify whether only the remaining portion of the modified lease is to 
be taken into account for purposes of determining the section 467 rent 
and interest for rental periods following the modification.
    The final regulations retain the general rule of the proposed 
regulations under which a rental agreement would be treated as a new 
lease for purposes of section 467 if the parties agreed to a 
substantial modification. Under the final regulations, if a substantial 
modification of a rental agreement occurs after June 3, 1996, the post-
modification agreement is treated as a new agreement for purposes of 
determining whether the agreement is a section 467 rental agreement or 
a disqualified leaseback or long-term agreement and for purposes of 
applying the effective date provisions of the section 467 regulations. 
These rules do not apply, however, to a modification occurring on or 
before May 18, 1999, unless the rental agreement being modified is a 
post-June 3, 1996, disqualified leaseback or long-term agreement or the 
post-modification agreement is a disqualified leaseback or long-term 
agreement.
    In general, in determining whether a modified agreement is a 
section 467 rental agreement, or a disqualified leaseback or long-term 
agreement, the modified agreement is considered to consist only of the 
terms that relate to post-modification items (as described below). 
However, if a principal purpose of the modification is to avoid the 
purpose or intent of section 467 or the regulations thereunder, the 
Commissioner may treat the entire agreement (as modified) as a single 
agreement for purposes of section 467. The final regulations also 
provide that the post-modification agreement, notwithstanding its 
treatment as a new agreement, will be characterized, in certain cases, 
in the same manner as the agreement in effect before the modification. 
For example, if an agreement was a leaseback or was subject to constant 
rental accrual before its modification, the post-modification agreement 
will generally be treated as a leaseback or as subject to constant 
rental accrual. Similarly, if the agreement was a long-term agreement 
before its modification and the entire agreement (as modified) is a 
long-term agreement, the post-modification agreement will be treated as 
a long-term agreement.
    The final regulations also provide rules for accounting for the 
effects of modifications occurring after May 18, 1999. In the case of a 
substantial modification, the lessor and lessee must take pre-
modification items (generally, rent for periods before the 
modification, interest thereon, and payments allocable thereto (whether 
made before or after the modification)) into account under the method 
of accounting used before the modification. In computing section 467 
rent, section 467 interest, and the amount of the section 467 loan with 
respect to post-modification items, only post-modification items are 
taken into account. In addition, the parties to the agreement are 
required to take into account adjustments necessary to prevent 
duplications and omissions resulting from the modification.
    In the case of a modification that is not substantial, section 467 
rent and interest for periods affected by the modification are 
determined under the terms of the entire agreement (as modified). In 
addition, the parties to the agreement are required to recompute the 
balance of the section 467 loan under the new terms and to take into 
account (as either additional rent or a reduction in rent previously 
taken into account) the change in the loan balance resulting from the 
modification. They are also required to take into account any

[[Page 26850]]

amount necessary to prevent duplications or omissions resulting from 
the modification.
    The final regulations also provide additional guidance for 
determining whether a substantial modification of a lease has occurred, 
adopting some of the principles applicable to the modification of debt 
instruments under Sec. 1.1001-3. Under the final regulations, all of 
the facts and circumstances will be examined to determine whether a 
substantial modification has occurred. Because this determination is 
inherently factual, the regulations do not provide more specific 
criteria for making this determination. However, in order to ensure 
that relatively insubstantial changes to the terms of a lease agreement 
and changes that do not implicate the policies of section 467 are not 
treated as substantial modifications under this rule, safe harbor 
provisions have been added.
    In general, the modifications that are likely to affect the 
character of a rental agreement for purposes of section 467 are those 
that change the amount or timing of rent allocated or rent payable for 
the use of the property, or the identity of the taxpayer taking those 
amounts into account. Thus, a substantial modification will not result 
from changes in any provision for the payment of third-party costs or 
any other provision that is ignored for purposes of determining whether 
the agreement provides for contingent rents. In addition, the 
refinancing of a lessor's indebtedness on a leveraged lease will 
generally not be treated as a substantial modification of the lease, 
subject to compliance with certain conditions and limitations. These 
conditions and limitations are intended to permit refinancings to avoid 
classification as a substantial modification in circumstances where the 
primary objective of the lessee is to take advantage of favorable 
changes in interest rates.
    In the case of a transfer of leased property by a lessor or a 
substitution of a lessee, the final regulations provide that the 
transfer or substitution will be treated as a substantial modification 
only if a principal purpose of the transaction is the avoidance of 
Federal income tax. In determining whether a transfer or substitution 
should be treated as a substantial modification, the safe harbors and 
other principles that generally apply in tax avoidance determinations 
are taken into account and the Commissioner may treat the post-
modification agreement as a new agreement or treat the entire agreement 
(as modified) as a single agreement.

7. Definition of Lease Term

    The proposed regulations provide that an option period, whether 
exercisable by the lessor or the lessee, is included in the lease term 
only if it is reasonably expected, as of the agreement date, that the 
option will be exercised. In contrast, Rev. Proc. 75-21 provides a 
comparable rule only for options that are exercisable by the lessee, 
while including the duration of all lessor renewal options in the lease 
term. The IRS and Treasury Department believe that nothing in section 
467 justifies a deviation from the rule of Rev. Proc. 75-21 in this 
instance. Accordingly, for purposes of determining the term of a lease, 
the final regulations retain the rule of the proposed regulations only 
for lessee options, and treat all lessor options as if they had been 
exercised.

8. Effective Dates

    The regulations are applicable for (1) disqualified leasebacks and 
long-term agreements entered into after June 3, 1996, and (2) other 
rental agreements entered into after May 18, 1999. No inference should 
be drawn 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.
    Some commentators requested that the effective date for 
disqualified leasebacks and long-term agreements be deferred so that 
the regulations would apply only to agreements entered into after the 
date on which final regulations are published in the Federal Register. 
The final regulations do not adopt this suggestion. The IRS and 
Treasury Department believe that the additional safe harbors provided 
in these regulations will prevent leasebacks and long-term agreements 
entered into after June 3, 1996, and on or before May 18, 1999 (the 
interim period), from being inappropriately disqualified in cases where 
the increasing or decreasing rents have not been motivated by tax 
avoidance. Some of these commentators also requested that the 
regulations not be applied to rental agreements entered into pursuant 
to a contract that was binding on the applicable effective date. The 
effective dates have been clarified in response to these comments.
    Other commentators requested that taxpayers be permitted to rely on 
the provisions of the proposed regulations in the case of leasebacks 
and long-term agreements entered into during the interim period. 
According to these commentators, the terms of certain leasebacks and 
long-term agreements entered into during the interim period were 
structured so as to comply with the safe harbors and other provisions 
of the proposed regulations in order to ensure that these agreements 
would not be treated as disqualified leasebacks or long-term 
agreements. In the absence of a provision permitting taxpayers to rely 
on the provisions of the proposed regulations in these cases, these 
agreements might lose their safe-harbor protection because of changes 
made in the final regulations. Accordingly, the final regulations 
permit taxpayers to rely on the provisions of the proposed regulations 
in the case of any leaseback or long-term agreement entered into during 
the interim period. No specific election is required in the case of an 
agreement subject to this provision.

9. Special Transitional Rule

    Although the regulations do not apply to any rental agreement 
entered into on or before June 3, 1996, and do not apply to any rental 
agreement other than a disqualified leaseback or long-term agreement 
entered into on or before May 18, 1999, some commentators requested 
that they be allowed to change their method of accounting to the 
constant rental accrual method for rental agreements involving certain 
types of property financed by tax-exempt bonds where the agreements 
were entered into prior to the issuance of the section 467 regulations. 
The special rule was requested because, prior to the issuance of 
regulations, lessees had entered into rental agreements providing for 
disproportionately large payments of rent in the later years of the 
lease term, but without specific allocations of rents. In the view of 
the commentators, the circumstances in which a schedule of rent 
payments would be treated as a rent allocation schedule were not fully 
addressed by the legislative history.
    In response to the comments, the final regulations contain a 
special transitional rule under which lessees may change their method 
of accounting for certain agreements to the constant rental accrual 
method. With respect to this special transitional rule, a lessee's 
change in its method of accounting for a rental agreement does not 
affect the method of accounting used by the lessor for the same 
agreement. In the case of similar rental agreements entered into after 
May 18, 1999, lessees will be able to obtain results comparable to the 
constant rental accrual method only by providing a specific allocation 
schedule that differs from the rent payment schedule.

[[Page 26851]]

10. Issues Not Addressed

    The final regulations do not address the application of section 467 
to payments for services. With respect to the possible application of 
section 467 to transactions sometimes referred to as ``lease strips'' 
or ``stripping transactions'', as described in Notice 95-53 (1995-2 
C.B. 334), regulations under section 7701(l) were proposed after the 
issuance of the proposed regulations under section 467 setting forth 
the treatment of such transactions. Consequently, the IRS and Treasury 
Department believe that no specific guidance on the treatment of such 
transactions under section 467 is necessary.
    The final regulations also do not provide guidance concerning the 
applicability of penalties or additions to tax when the Commissioner 
determines that a section 467 rental agreement should be treated as a 
disqualified leaseback or long-term agreement. No inference should be 
drawn from the failure to address the issue in these regulations 
concerning the Commissioner's authority to impose applicable penalties 
and additions to tax in such circumstances.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
does not apply to these regulations, and, because the regulations do 
not impose a collection of information on small entities, the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. 
Pursuant to section 7805(f) of the Internal Revenue Code, the notice of 
proposed rulemaking preceding these regulations was submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on their impact on small businesses.
    Drafting Information: The principal author of these 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.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

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

    Sec. 1.467-1 is also issued under 26 U.S.C. 467.
    Sec. 1.467-2 is also issued under 26 U.S.C. 467.
    Sec. 1.467-3 is also issued under 26 U.S.C. 467.
    Sec. 1.467-4 is also issued under 26 U.S.C. 467.
    Sec. 1.467-5 is also issued under 26 U.S.C. 467.
    Sec. 1.467-6 is also issued under 26 U.S.C. 467.
    Sec. 1.467-7 is also issued under 26 U.S.C. 467.
    Sec. 1.467-8 is also issued under 26 U.S.C. 467.
    Sec. 1.467-9 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 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 (See Sec. 601.601(b)(2) of this 
chapter), 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. 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 two sentences at the end of the introductory text of 
paragraph (d)(7).
    The 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. 
The examples are as follows:
* * * * *
    Par. 6. Sections 1.467-0 through 1.467-9 are added to read as 
follows:


Sec. 1.467-0  Table of contents.

    This section lists the captions that appear in Secs. 1.467-1 
through 1.467-9.

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

(a) Overview.
    (1) In general.
    (2) Cases in which rules are inapplicable.
    (3) Summary of rules.
    (i) Basic rules.
    (ii) Special rules.
    (4) Scope of rules.
    (5) Application of other authorities.
(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.

[[Page 26852]]

    (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) of this section.
(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) Substantial modification of a rental agreement.
    (1) Treatment as new agreement.
    (i) In general.
    (ii) Limitation.
    (2) Post-modification agreement; in general.
    (3) Other effects of a modification.
    (4) Special rules.
    (i) Carryover of character; leasebacks.
    (ii) Carryover of character; long-term agreements.
    (iii) Carryover of character; disqualified agreements.
    (iv) Allocation of rent.
    (v) Difference between aggregate rent and interest and aggregate 
payments.
    (A) In general.
    (B) Constant rental accrual prior to the modification.
    (C) Agreements described in this paragraph (f)(4)(v)(C).
    (vi) Principal purpose of tax avoidance.
    (5) Definitions.
    (6) Safe harbors.
    (7) Special rules for certain transfers.
    (i) In general.
    (ii) Exception.
(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 agreements 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 rental agreements relating to properties 
having different statutory recovery periods.
(c) Tax avoidance as principal purpose for increasing or decreasing 
rent.
    (1) In general.
    (2) Tax avoidance.
    (i) In general.
    (ii) Significant difference in tax rates.
    (iii) Special circumstances.
    (3) Safe harbors.
    (4) Uneven rent test.
    (i) In general.
    (ii) Special rule for real estate.
    (iii) Operating rules.
(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) Examples.

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), 
(f), or (g).
(b) Principal balance.
    (1) In general.
    (2) Section 467 rental agreements that provide for prepaid fixed 
rent and adequate interest.
    (3) Timing of payments.
(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) Yield for purposes of applying paragraph (a)(4) of this 
section.
    (4) 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) Positive or negative 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 and modifications.

(a) Section 467 recapture.
(b) Recapture amount.
    (1) In general.
    (2) Prior understated inclusion.
    (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.
    (A) In general.
    (B) Transfers to certain tax-exempt organizations.
    (4) Dispositions by transferee.
    (5) Like-kind exchanges and involuntary conversions.
    (6) Installment sales.
    (7) Dispositions covered by section 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) [Reserved]
    (4) Examples.
(f) Treatment of assignments by lessee and lessee-financed renewals.
    (1) Substitute lessee use.
    (2) Treatment of section 467 loan.
    (3) Lessor use.
    (4) Examples.
(g) Application of section 467 following a rental agreement 
modification.
    (1) Substantial modifications.
    (i) Treatment of pre-modification items.
    (ii) Computations with respect to post-modification items.
    (iii) Adjustments.
    (A) Adjustment relating to certain prepayments.
    (B) Adjustment relating to retroactive beginning of lease term.

[[Page 26853]]

    (iv) Coordination with rules relating to dispositions and 
assignments.
    (A) Dispositions.
    (B) Assignments.
    (2) Other modifications.
    (i) Computation of section 467 loan for modified agreement.
    (ii) Change in balance of section 467 loan.
    (iii) Section 467 rent and interest after the modification.
    (iv) Applicable Federal rate.
    (v) Modification effective within a rental period.
    (vi) Other adjustments.
    (vii) Coordination with rules relating to dispositions and 
assignments.
    (viii) Exception for agreements entered into prior to effective 
date of section 467.
    (3) Adjustment by Commissioner.
    (4) Effective date of modification.
    (5) Examples.
(h) Omissions or duplications.
    (1) In general.
    (2) Example.

Sec. 1.467-8  Automatic consent to change to constant rental 
accrual for certain rental agreements.

(a) General rule.
(b) Agreements to which automatic consent applies.

Sec. 1.467-9  Effective dates and automatic method changes for 
certain agreements.

(a) In general.
(b) Automatic consent for certain rental agreements.
(c) Application of regulation project IA-292-84 to certain 
leasebacks and long-term agreements.
(d) Entered into.
(e) Change in method of accounting.
    (1) In general.
    (2) Application of regulation project IA-292-84.
    (3) Automatic change procedures.


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 (and time value of money 
principles) 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 accrual method, pursuant to which the rent is treated 
as accruing 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 1.467-9 (the section 467 regulations), if it 
specifies equal amounts of rent for each month throughout the lease 
term and all payments of rent are due in the calendar year to which the 
rent relates (or in the preceding or succeeding calendar year). In 
addition, the section 467 regulations do not apply to a rental 
agreement that requires total rents of $250,000 or less. For purposes 
of determining whether the agreement has total rents of $250,000 or 
less, certain specified contingent rent is disregarded.
    (3) 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. Paragraph 
(i) of this section is reserved.
    (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 method, including criteria for 
determining whether an agreement is subject to this method. 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). Section 1.467-5 provides rules for applying the section 
467 regulations where a rental agreement requires payments of interest 
at a variable rate. Section 1.467-6, relating to the treatment of 
certain section 467 rental agreements with contingent payments, is 
reserved. 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. Section 
1.467-7 also provides rules for the treatment of modified rental 
agreements. Section 1.467-8 provides special transitional rules 
relating to the method of accounting for certain rental agreements 
entered into on or before May 18, 1999. Finally, Sec. 1.467-9 provides 
the effective date rules for the section 467 regulations.
    (4) Scope of rules. No inference should be drawn from any provision 
of this section or Secs. 1.467-2 through 1.467-9 concerning whether--
    (i) For Federal tax purposes, an arrangement constitutes a lease; 
or
    (ii) For Federal tax purposes, any obligation of the lessee under a 
rental agreement is treated as rent.
    (5) Application of other authorities. Notwithstanding section 467 
and the regulations thereunder, other authorities such as section 
446(b) clear-reflection-of-income principles, section 482, and the 
substance-over-form doctrine, may be applied by the Commissioner to 
determine the income and expense from a rental agreement (including the 
proper allocation of fixed rent under a rental agreement).
    (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 the sum of--
    (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)(12) of this section, that has increasing or decreasing 
rents (as described in paragraph (c)(2) of this section), or deferred 
or prepaid 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 increasing or decreasing rent if the increasing 
or decreasing rent is solely attributable to a rent holiday provision 
allowing reduced rent (or no rent) for a period of three months or less 
at the beginning of the lease term.
    (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.

[[Page 26854]]

    (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 providing for total payments of fixed 
rent equal to the total amount specified, specifically allocates rent. 
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)(2) of this 
section), other than contingent rent described in paragraph 
(c)(2)(iii)(B) of this section.
    (B) Certain contingent rent disregarded. For purposes of this 
paragraph (c)(2)(iii), rent is disregarded to the extent it is 
contingent as the result of one or more of the following provisions--
    (1) A qualified percentage rents provision, as defined in paragraph 
(h)(8) of this section;
    (2) An adjustment based on a reasonable price index, as defined in 
paragraph (h)(10) of this section;
    (3) A provision requiring the lessee to pay third-party costs, as 
defined in paragraph (h)(15) of this section;
    (4) A provision requiring the payment of late payment charges, as 
defined in paragraph (h)(4) of this section;
    (5) A loss payment provision, as defined in paragraph (h)(7) of 
this section;
    (6) A qualified TRAC provision, as defined in paragraph (h)(9) of 
this section;
    (7) A residual condition provision, as defined in paragraph (h)(13) 
of this section;
    (8) A tax indemnity provision, as defined in paragraph (h)(14) of 
this section;
    (9) A variable interest rate provision, as defined in paragraph 
(h)(16) of this section; or
    (10) Any other provision provided in regulations or other published 
guidance issued by the Commissioner, but only if the provision is 
designated as contingent rent to be disregarded for purposes of this 
paragraph (c)(2)(iii).
    (3) Deferred or prepaid rent--(i) Deferred rent. A rental agreement 
has deferred rent under this paragraph (c)(3) if the cumulative amount 
of rent allocated as of the close of a calendar year (determined under 
paragraph (c)(3)(iii) of this section) 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 cumulative amount of rent payable as of the 
close of a calendar year exceeds the cumulative amount of rent 
allocated as of the close of the succeeding calendar year (determined 
under paragraph (c)(3)(iii) of this section).
    (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.
    (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, 2000, and 
end on December 31, 2003. 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 2000, a 
payment of $100,000 is to be made on December 31, 2001, and December 
31, 2002, and a payment of $200,000 is to be made on December 31, 
2003. A and B both select the calendar year as their rental period. 
Thus, 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 2000 ($100,000) does not exceed the 
cumulative rent payable as of December 31, 2001 ($100,000); the rent 
allocated to 2001 and preceding years ($200,000) does not exceed the 
cumulative rent payable as of December 31, 2002 ($200,000); the rent 
allocated to 2002 and preceding years ($300,000) does not exceed the 
cumulative rent payable as of December 31, 2003 ($400,000); and the 
rent allocated to 2003 and preceding years ($400,000) does not 
exceed the cumulative rent payable as of December 31, 2004 
($400,000). Therefore, because the rental agreement does not have 
increasing or decreasing rent and does not have deferred or prepaid 
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 a 10-year lease of personal property, beginning on 
January 1, 2000, and ending on December 31, 2009. 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, 2000.
    (ii) The rental agreement does not have increasing or decreasing 
rent as described in paragraph (c)(2)(i) of this section. The rental 
agreement, however, provides prepaid rent under paragraph (c)(3)(ii) 
of this section because the cumulative amount of rent payable as of 
the close of a calendar year exceeds the cumulative amount of rent 
allocated as of the close of the succeeding calendar year. For 
example, the cumulative amount of rent payable as of the close of 
2000 ($1,200,000 is payable on December 31, 2000) exceeds the 
cumulative amount of rent allocated as of the close of 2001, the 
succeeding calendar year ($240,000). 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, as of the agreement date (as defined in paragraph (h)(1) 
of this section), it is not reasonably expected that the sum of the 
aggregate amount of rental payments under the rental agreement and the 
aggregate value of all other consideration to be received for the use 
of property (taking into account any payments of contingent rent, and 
any other contingent consideration) will exceed $250,000.
    (ii) Special rules in computing amount described in paragraph 
(c)(4)(i) of this section of this section. The following rules apply in 
determining the amount described in paragraph (c)(4)(i) of this 
section:

[[Page 26855]]

    (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 the sum of its remaining principal amount and 
accrued interest (if any) thereon or, in the case of an obligation 
originally issued at a discount, at the sum of its adjusted issue price 
and accrued qualified stated interest (if any), within the meaning of 
Sec. 1.1273-1(c)(1).
    (C) All rental agreements that are part of the same transaction or 
a series of related transactions involving the same lessee (or any 
related person) and the same lessor (or any related person) are treated 
as a single rental agreement. Whether two or more rental agreements are 
part of the same transaction or a series of related transactions 
depends on all the facts and circumstances.
    (D) If an agreement includes a provision increasing or decreasing 
rent payable solely as a result of an adjustment based on a reasonable 
price index, the amount described in paragraph (c)(4)(i) of this 
section must be determined as if the applicable price index did not 
change during the lease term.
    (E) If an agreement includes a variable interest rate provision (as 
defined in paragraph (h)(16) of this section), the amount described in 
paragraph (c)(4)(i) of this section must be determined by using 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 applicable to the lessor's indebtedness.
    (F) Contingent rent described in paragraphs (c)(2)(iii)(B)(3) 
through (8) 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.
    (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 either 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.
    (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 interest stated 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. Section 467 interest is treated as 
interest for all purposes of the Internal Revenue Code.
    (f) Substantial modification of a rental agreement--(1) Treatment 
as new agreement--(i) In general. If a substantial modification of a 
rental agreement occurs after June 3, 1996, the post-modification 
agreement is treated as a new agreement and the date on which the 
modification occurs is treated as the agreement date in applying 
section 467 and the regulations thereunder to the post-modification 
agreement. Thus, for example, the post-modification agreement is 
treated as a new agreement entered into on the date the modification 
occurs for purposes of determining whether it is a section 467 rental 
agreement under this section, whether it is a disqualified leaseback or 
long-term agreement under Sec. 1.467-3, and whether it is entered into 
after the applicable effective date in Sec. 1.467-9.
    (ii) Limitation. In the case of a substantial modification of a 
rental agreement occurring on or before May 18, 1999, this paragraph 
(f) applies only if--
    (A) The rental agreement was a disqualified leaseback or long-term 
agreement before the modification and the agreement date, determined 
without regard to the modification, is after June 3, 1996; or
    (B) The post-modification agreement would, after application of the 
rules in this paragraph (f) (other than the special rule for 
disqualified agreements in paragraph (f)(4)(iii) of this section), be a 
disqualified leaseback or long-term agreement.
    (2) Post-modification agreement; in general. For purposes of 
determining whether a post-modification agreement is a section 467 
rental agreement or a disqualified leaseback or long-term agreement 
under paragraph (f)(1) of this section, the terms of the post-
modification agreement are, except as provided in paragraph (f)(4) of 
this section, only those terms that provide for rights and obligations 
relating to post-modification items (within the meaning of paragraph 
(f)(5)(iv) of this section).
    (3) Other effects of a modification. For rules relating to amounts 
that must be taken into account following certain modifications, see 
Sec. 1.467-7(g).

[[Page 26856]]

    (4) Special rules--(i) Carryover of character; leasebacks. If an 
agreement is a leaseback prior to its modification and the lessee prior 
to the modification (or a related person) is the lessee after the 
modification, the post-modification agreement is a leaseback even if 
the post-modification lessee did not have an interest in the property 
at any time during the two-year period ending on the date on which the 
modification occurs.
    (ii) Carryover of character; long-term agreements. If an agreement 
is a long-term agreement prior to its modification and the entire 
agreement (as modified) would be a long-term agreement, the post-
modification agreement is a long-term agreement.
    (iii) Carryover of character; disqualified agreements. If an 
agreement (as in effect before its modification) is a disqualified 
leaseback or long-term agreement as the result of a determination 
(whether occurring before or after the modification) under Sec. 1.467-
3(b)(1)(ii) and the post-modification agreement is a section 467 rental 
agreement (or the entire agreement (as modified) would be a section 467 
rental agreement), the post-modification agreement will, 
notwithstanding its treatment as a new agreement under paragraph 
(f)(1)(i) of this section, be subject to constant rental accrual unless 
the Commissioner determines that, because of the absence of tax 
avoidance potential, the post-modification agreement should not be 
treated as a disqualified leaseback or long-term agreement.
    (iv) Allocation of rent. If the entire agreement (as modified) 
provides a specific allocation of fixed rent, as described in paragraph 
(c)(2)(ii)(A)(2) of this section, the post-modification agreement is 
treated as an agreement that provides a specific allocation of fixed 
rent. If the entire agreement (as modified) does not provide a specific 
allocation of fixed rent, the fixed rent allocated to rental periods 
during the lease term of the post-modification agreement is determined 
by applying the rules of paragraph (c)(2)(ii)(B) of this section to the 
entire agreement (as modified).
    (v) Difference between aggregate rent and interest and aggregate 
payments--(A) In general. Except as provided in paragraph (f)(4)(v)(B) 
of this section, a post-modification agreement described in paragraph 
(f)(4)(v)(C) of this section is treated as a section 467 rental 
agreement subject to proportional rental accrual (determined under 
Sec. 1.467-2(c)).
    (B) Constant rental accrual prior to the modification. A post-
modification agreement described in paragraph (f)(4)(v)(C) of this 
section is treated as a section 467 rental agreement subject to 
constant rental accrual if--
    (1) Constant rental accrual is required under paragraph (f)(4)(iii) 
of this section; or
    (2) The post-modification agreement involves total payments of more 
than $250,000 (as described in paragraph (c)(4) of this section), and 
the Commissioner determines that the post-modification agreement is a 
disqualified leaseback or long-term agreement.
    (C) Agreements described in this paragraph (f)(4)(v)(C). A post-
modification agreement is described in this paragraph (f)(4)(v)(C) if 
the aggregate amount of fixed rent and stated interest treated as post-
modification items does not equal the aggregate amount of payments 
treated as post-modification items.
    (vi) Principal purpose of tax avoidance. If a principal purpose of 
a substantial modification is to avoid the purpose or intent of section 
467 or the regulations thereunder, the Commissioner may treat the 
entire agreement (as modified) as a single agreement for purposes of 
section 467 and the regulations thereunder.
    (5) Definitions. The following definitions apply for purposes of 
this paragraph (f) and Sec. 1.467-7(g):
    (i) A modification of a rental agreement is any alteration, 
including any deletion or addition, in whole or in part, of a legal 
right or obligation of the lessor or lessee thereunder, whether the 
alteration is evidenced by an express agreement (oral or written), 
conduct of the parties, or otherwise.
    (ii) A modification is substantial only if, based on all of the 
facts and circumstances, the legal rights or obligations that are 
altered and the degree to which they are altered are economically 
substantial. A modification of a rental agreement will not be treated 
as substantial solely because it is not described in paragraph (f)(6) 
of this section.
    (iii) A modification occurs on the earlier of the first date on 
which there is a binding contract that substantially sets forth the 
terms of the modification or the date on which agreement to such terms 
is otherwise evidenced.
    (iv) Post-modification items with respect to any modification of a 
rental agreement are all items (other than pre-modification items) 
provided under the terms of the entire agreement (as modified).
    (v) Pre-modification items with respect to any modification of a 
rental agreement are pre-modification rent, interest thereon, and 
payments allocable thereto (whether payable before or after the 
modification.) For this purpose--
    (A) Pre-modification rent is rent allocable to periods before the 
effective date of the modification, but only to the extent such rent is 
payable under the entire agreement (as modified) at the time such rent 
was due under the agreement in effect before the modification; and
    (B) Pre-modification items are identified by applying payments, in 
the order payable under the entire agreement (as modified) unless the 
agreement specifies otherwise, to rent and interest thereon in the 
order in which amounts accrue.
    (vi) The entire agreement (as modified) with respect to any 
modification is the agreement consisting of pre-modification terms 
providing for rights and obligations that are not affected by the 
modification and post-modification terms providing for rights and 
obligations that differ from the rights and obligations under the 
agreement in effect before the modification. For example, if a 10-year 
rental agreement that provides for rent of $25,000 per year is modified 
at the end of the 5th year to provide for rent of $30,000 per year in 
subsequent years, the entire agreement (as modified) provides for a 10-
year lease term and provides for rent of $25,000 per year in years 1 
through 5 and rent of $30,000 per year in years 6 through 10. The 
result would be the same if the modification provided for both the 
increase in rent and the substitution of a new lessee.
    (6) Safe harbors. Notwithstanding the provisions of paragraph 
(f)(5) of this section, a modification of a rental agreement is not a 
substantial modification if the modification occurs solely as the 
result of one or more of the following--
    (i) The refinancing of any indebtedness incurred by the lessor to 
acquire the property subject to the rental agreement and secured by 
such property (or any refinancing thereof) but only if all of the 
following conditions are met--
    (A) Neither the amount, nor the time for payment, of the principal 
amount of the new indebtedness differs from the amount and time for 
payment of the remaining principal amount of the refinanced 
indebtedness, except for de minimis changes;
    (B) For each of the remaining rental periods, the rent allocation 
schedule, the payments of rent and interest, and the amount accrued 
under section 467 are changed only to the extent necessary to take into 
account the change in financing costs, and such changes are made 
pursuant to the terms of the rental

[[Page 26857]]

agreement in effect before the modification;
    (C) The lessor and the lessee are not related persons to each other 
or to any lender to the lessor with respect to the property (whether 
under the refinanced indebtedness or the new indebtedness); and
    (D) With respect to the indebtedness being refinanced, the lessor 
was granted a unilateral option (within the meaning of Sec. 1.1001-
3(c)(3)) by the creditor to repay the refinanced indebtedness, 
exercisable with or without the lessee's consent;
    (ii) A change in the obligation of the lessee to make any of the 
contingent payments described in paragraphs (c)(2)(iii)(B)(3) through 
(8) of this section; or
    (iii) A change in the amount of fixed rent allocated to a rental 
period that, when combined with all previous changes in the amount of 
fixed rent allocated to the rental period, does not exceed one percent 
of the fixed rent allocated to that rental period prior to the 
modification.
    (7) Special rules for certain transfers--(i) In general. For 
purposes of this paragraph (f), a substitution of a new lessee or a 
sale, exchange, or other disposition by a lessor of property subject to 
a rental agreement will not, by itself, be treated as a substantial 
modification unless a principal purpose of the transaction giving rise 
to the modification is the avoidance of Federal income tax. In 
determining whether a principal purpose of the transaction giving rise 
to the modification is the avoidance of Federal income tax--
    (A) The safe harbors and other principles of Sec. 1.467-3(c) are 
taken into account; and
    (B) The Commissioner may treat the post-modification agreement as a 
new agreement or treat the entire agreement (as modified) as a single 
agreement.
    (ii) Exception. Notwithstanding the provisions of paragraph 
(f)(7)(i) of this section, the continuing lessor and the new lessee (in 
the case of a substitution of a new lessee) or the new lessor and the 
continuing lessee (in the case of a sale, exchange, or other 
disposition by a lessor of property subject to a rental agreement) may, 
in appropriate cases, request the Commissioner to treat the transaction 
as if it were a substantial modification in order to have the 
provisions of paragraph (f)(4)(iii) of this section and Sec. 1.467-
7(g)(1) apply to the transaction.
    (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 1.467-9:
    (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 (as defined in paragraph (h)(10) of this section) or a 
variable interest rate provision (as defined in paragraph (h)(16) of 
this section).
    (3) Fixed rent means any rent to the extent its amount and the time 
at which it is required to be paid are fixed and determinable under the 
terms of the rental agreement as of the lease date. The following rules 
apply for the purpose of determining the extent to which rent is fixed 
rent:
    (i) The possibility of a breach, default, or other early 
termination of the rental agreement and any adjustments based on a 
reasonable price index or a variable interest rate provision are 
disregarded.
    (ii) Rent will not fail to be treated as fixed rent merely because 
of the possibility of impairment by insolvency, bankruptcy, or other 
similar circumstances.
    (iii) If the lease term (as defined in paragraph (h)(6) of this 
section) includes one or more periods as to which either the lessor or 
the lessee has an option to renew or extend the term of the agreement, 
rent will not fail to be treated as fixed rent merely because the 
option has not been exercised.
    (iv) If the lease term includes one or more periods during which a 
substitute lessee or lessor may have use of the property, rent will not 
fail to be treated as fixed rent merely because the contingencies 
relating to the obligation of the lessee (or a related person) to make 
payments in the nature of rent have not occurred.
    (v) If either the lessor or the lessee has an unconditional option 
or options, exercisable on one or more dates during the lease term, 
that, if exercised, require payments of rent to be made under an 
alternative payment schedule or schedules, the amount of fixed rent and 
the dates on which such rent is required to be paid are determined on 
the basis of the payment schedule that, as of the agreement date, is 
most likely to occur. If payments of rent are made under an alternative 
payment schedule that differs from the payment schedule assumed in 
applying the preceding sentence, then, for purposes of paragraph (f) of 
this section, the rental agreement is treated as having been modified 
at the time the option to make payments on such alternative schedule is 
exercised.
    (4) Late payment charge means any amount required to be paid by the 
lessee to the lessor as additional compensation for the lessee's 
failure to make any payment of rent under a rental agreement when due.
    (5) Lease date means the date on which the lessee first has the 
right to use of the property that is the subject of the rental 
agreement.
    (6) Lease term means the period during which the lessee has use of 
the property subject to the rental agreement, including any option to 
renew or extend the term of the agreement other than an option, 
exercisable by the lessee, as to which it is reasonably expected, as of 
the agreement date, that the option will not be exercised. 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 
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 Sec. 1.467-7(f) for 
special rules applicable to the lessee, substitute lessee, and lessor.
    (7) A loss payment provision means a provision that requires the 
lessee to pay the lessor a sum of money (which may be either a 
stipulated amount or an amount determined by reference to a formula or 
other objective measure) if the property subject to the rental 
agreement is lost, stolen, damaged or destroyed, or otherwise rendered 
unsuitable for any use (other than for scrap purposes).
    (8) A qualified percentage rents provision means a provision 
pursuant to which the rent is equal to a fixed percentage of the 
lessee's receipts or sales (whether or not receipts or sales are 
adjusted for returned merchandise or Federal, state, or local sales 
taxes), but only if the percentage does not vary throughout the lease 
term. A provision will not fail to be treated as a qualified percentage 
rents provision solely by reason of one or more of the following 
additional terms:

[[Page 26858]]

    (i) Differing percentages of receipts or sales apply to different 
departments or separate floors of a retail store, but only if the 
percentage applicable to a particular department or floor does not vary 
throughout the lease term.
    (ii) The percentage is applied to receipts or sales in excess of 
determinable dollar amounts, but only if the determinable dollar 
amounts are fixed and do not vary throughout the lease term.
    (9) A qualified TRAC provision means a terminal rental adjustment 
clause (as defined in section 7701(h)(3)) contained in a qualified 
motor vehicle operating agreement (as defined in section 7701(h)(2)), 
but only if the adjustment to the rental price is based on a reasonable 
estimate, determined as of any date between the agreement date and the 
lease date (or, in the event the agreement date is the same as or later 
than the lease date, determined as of the agreement date), of the fair 
market value of the motor vehicle (including any trailer) at the end of 
the lease term.
    (10) 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 a generally 
recognized index for measuring inflation or deflation (for example, the 
non-seasonally adjusted U.S. City Average All Items Consumer Price 
Index for All Urban Consumers (CPI-U), which is published by the Bureau 
of Labor Statistics of the Department of Labor). An adjustment will not 
fail to be treated as one that is based on a reasonable price index 
merely because the adjustment may be limited to a fixed percentage, but 
only if the parties reasonably expect, as of any date between the 
agreement date and the lease date (or, in the event the agreement date 
is the same as the lease date, as of such date), that the fixed 
percentage will actually limit the amount of the rent payable during 
less than 50 percent of the lease term.
    (11) 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). In all other cases, 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).
    (12) 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.
    (13) A residual condition provision means a provision in a rental 
agreement that requires a payment to be made by either the lessor or 
the lessee to the other party based on the difference between the 
actual condition of the property subject to the agreement, determined 
as of the expiration of the lease term, and the expected condition of 
the property at the expiration of the lease term, as set forth in the 
rental agreement. The amount of any such payment may be determined by 
reference to any objective measure relating to the use or condition of 
the property, such as miles, hours or other duration of use, units of 
production, or similar measure. A provision will be treated as a 
residual condition provision only if the payment represents 
compensation for the use of, or wear and tear on, the property in 
excess of, or below, a standard set forth in the rental agreement, and 
the standard is reasonably expected, as of any date between the 
agreement date and the lease date (or, in the event the agreement date 
is the same as or later than the lease date, as of the agreement date), 
to be met at the expiration of the lease term.
    (14) A tax indemnity provision means a provision in a rental 
agreement that may require the lessee to make one or more payments to 
the lessor in the event that the Federal, foreign, state, or local 
income tax consequences actually realized by a lessor from owning the 
property subject to the rental agreement and leasing it to the lessee 
differ from the consequences reasonably expected by the lessor, but 
only if the differences in such consequences result from a 
misrepresentation, act, or failure to act on the part of the lessee, or 
any other factor not within the control of the lessor or any related 
person.
    (15) Third-party costs include any real estate taxes, insurance 
premiums, maintenance costs, and any other costs (excluding a debt 
service cost) that relate to the leased property and are not within the 
control of the lessor or lessee or any person related to the lessor or 
lessee.
    (16) A variable interest rate provision means a provision in a 
rental agreement that requires the rent payable by the lessee to the 
lessor to be adjusted by the dollar amount of changes in the amount of 
interest payable by the lessor on any indebtedness that was incurred to 
acquire the property subject to the rental agreement (or any 
refinancing thereof), but--
    (i) Only to the extent the changes are attributable to changes in 
the interest rate; and
    (ii) Only if the indebtedness provides for interest at one or more 
qualified floating rates (within the meaning of Sec. 1.1275-5(b)), or 
the changes are attributable to a refinancing at a fixed rate or one or 
more qualified floating rates.
    (i) [Reserved].
    (j) Computational rules. For purposes of this section and 
Secs. 1.467-2 through 1.467-9, the following rules apply--
    (1) Counting conventions. Any reasonable counting convention may be 
used (for example, 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 only, 
except as otherwise provided in this section and Secs. 1.467-2 through 
1.467-8--
    (A) 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;
    (D) Any amount payable during the second half of a rental period is 
treated as payable on the last day of the rental period; and
    (E) Any amount payable at the midpoint of a rental period is 
treated, in applying this paragraph (j)(2), as an amount payable during 
the first half 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, a substantial penalty, or other substantial 
detriment (such as giving the lessor the right to terminate the 
agreement, bring an action to enforce payment, or exercise other 
similar remedies under the terms of the agreement or applicable law)).
    (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 the number of periods of the 
rental period's length in a calendar year.

[[Page 26859]]

Thus, if the fixed rent allocated to a rental period is $10,000 and the 
rental period is one month, the annualized fixed rent for that rental 
period is $120,000 ($10,000 times 12).
    (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, may vary in length, and may be 
different as between the lessor and the lessee 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 agreements 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, computed 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 deferred or prepaid rent as 
described in Sec. 1.467-1(c)(3);
    (ii) The rental agreement has deferred or prepaid 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 (within the meaning of 
paragraph (d) of this section) 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 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 all 
stated interest provided by the agreement 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 (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, the present value of any amount is 
determined using a discount rate equal to 110 percent of the applicable 
Federal rate. In general, present values are determined as of the first 
day of the first rental period in the lease term. However, if a section 
467 rental agreement calls for payments of fixed rent prior to the 
lease term, present values are determined as of the first day a fixed 
rent payment is called for by the agreement. 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. 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 1.467-9, 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

[[Page 26860]]

semiannual compounding. The Internal Revenue Service publishes 110 
percent of the applicable Federal rates, based on annual, semiannual, 
quarterly, and monthly compounding, each month in the Internal Revenue 
Bulletin (see Sec. 601.601(d)(2) of this chapter).
    (4) Term of the section 467 rental agreement--(i) In general. For 
purposes of determining 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 deferred or 
prepaid fixed rent, the term of the rental agreement for purposes of 
calculating the applicable Federal rate is the longest period between 
interest rate adjustment dates, or, if the rental agreement provides an 
initial fixed rate of interest on deferred or prepaid 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, 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 the rental 
agreement is not a disqualified leaseback or long-term agreement 
subject to constant rental accrual. The examples are as follows:

    Example 1. (i) C agrees to lease property from D for five years 
beginning on January 1, 2000, and ending on December 31, 2004. 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, 2004. Assume 
that the parties select the calendar year as the rental period and 
that 110 percent of the applicable Federal rate is 10 percent, 
compounded annually.
    (ii) The rental agreement has deferred rent under Sec. 1.467-
1(c)(3)(i) because the fixed rent allocated to calendar years 2000, 
2001, and 2002 is not paid until 2004. 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.
    (iii)(A) Because the rental agreement has deferred fixed rent 
and no prepaid rent, the agreement has adequate interest only if the 
present value test provided in paragraph (b)(1)(iii) of this section 
is met. The present value of all fixed rent and interest payable 
under the rental agreement is $384,971.22, determined as follows: 
$620,000/(1.10) \5\ = $384,971.22. 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] TR18MY99.000

    (B) The rental agreement provides adequate interest on fixed 
rent because the present value of the single amount payable under 
the section 467 rental agreement exceeds the sum of the present 
values of fixed rent allocated.
    (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, 2000, and ending 
on December 31, 2004. 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, 2004, 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.
    (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, 2000, and 
ending on December 31, 2002. The rental agreement provides that rent 
of $800,000 is allocable to 2000, $1,000,000 is allocable to 2001, 
and $1,200,000 is allocable to 2002. Under the rental agreement, Y 
must make a $3,000,000 payment on December 31, 2002. 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.
    (ii) 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.
    (iii)(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, the present value is determined as of 
the first day of the first rental period in the lease term. The 
present value of the single amount payable by the lessee under the 
rental agreement is computed as follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.001

    (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] TR18MY99.002

    (C) Thus, the fraction for determining the proportional rental 
amount is .9297194 ($2,348,724.30/$2,526,272.20). The section 467 
interest for each of the taxable years within the lease term is 
computed and taken into account as provided in Sec. 1.467-4. The 
section 467 rent for each of the taxable years within the lease term 
is as follows:

------------------------------------------------------------------------
           Taxable year                       Section 467 rent
------------------------------------------------------------------------
2000.............................  $743,775.52
                                   ($ 800,000  x  .9297194).
2001.............................  929,719.40
                                   ($1,000,000  x  .9297194).
2002.............................  1,115,663.28
                                   ($1,200,000  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.

[[Page 26861]]

Constant rental accrual may not be used in the absence of a 
determination by the Commissioner, pursuant to paragraph (b)(1)(ii) of 
this section, that the rental agreement is disqualified. Such 
determination may be made either on a case-by-case basis or in 
regulations or other guidance published by the Commissioner (see 
Sec. 601.601(d)(2) of this chapter) providing that a certain type or 
class of leaseback or long-term agreement will be treated as 
disqualified and subject to constant rental accrual.
    (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) A principal purpose for providing increasing or decreasing rent 
is the avoidance of Federal income tax (as described in paragraph (c) 
of this section);
    (ii) The Commissioner determines that, because of the tax avoidance 
purpose, the agreement should be treated as a disqualified leaseback or 
long-term agreement; and
    (iii) 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.
    (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 property's statutory recovery period.
    (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 rental agreements relating to properties 
having different statutory recovery periods. In the case of a rental 
agreement relating to 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 
agreement 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. In determining whether a principal purpose for 
providing increasing or decreasing rent is the avoidance of Federal 
income tax, all relevant facts and circumstances are taken into 
account. However, an agreement will not be treated as a disqualified 
leaseback or long-term agreement if either of the safe harbors set 
forth in paragraph (c)(3) of this section is met. The mere failure of a 
leaseback or long-term agreement to meet one of these safe harbors will 
not, by itself, cause the agreement to be treated as one in which tax 
avoidance was a principal purpose for providing increasing or 
decreasing rent.
    (2) Tax avoidance--(i) In general. If, as of the agreement date, a 
significant difference between the marginal tax rates of the lessor and 
lessee can reasonably be expected at some time during the lease term, 
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. The term 
``marginal tax rate'' means the percentage determined by dividing one 
dollar into the amount of the increase or decrease in the Federal 
income tax liability of the taxpayer that would result from an 
additional dollar of rental income or deduction.
    (ii) Significant difference in tax rates. A significant difference 
between the marginal tax rates of the lessor and lessee is reasonably 
expected if--
    (A) The rental agreement has increasing rents and the lessor's 
marginal tax rate is reasonably expected to exceed the lessee's 
marginal tax rate by more than 10 percentage points during any rental 
period to which the rental agreement allocates annualized fixed rent 
that is less than the average rent allocated to all calendar years 
(determined by taking into account the rules set forth in paragraph 
(c)(4)(iii) of this section); or
    (B) The rental agreement has decreasing rents and the lessee's 
marginal tax rate is reasonably expected to exceed the lessor's 
marginal tax rate by more than 10 percentage points during any rental 
period to which the rental agreement allocates annualized fixed rent 
that is greater than the average rent allocated to all calendar years 
(determined by taking into account the rules set forth in paragraph 
(c)(4)(iii) of this section).
    (iii) Special circumstances. In determining the expected marginal 
tax rates of the lessor and lessee, net operating loss and credit 
carryovers and any other attributes or special circumstances reasonably 
expected to affect the Federal income tax liability of the taxpayer 
(including the alternative minimum tax) are taken into account. For 
example, in the case of a partnership or S corporation, the amount of 
rental income or deduction that would be allocable to the partners or 
shareholders, respectively, is taken into account.
    (3) Safe harbors. Tax avoidance will not be considered a principal 
purpose for providing increasing or decreasing rent if--
    (i) The uneven rent test (as defined in paragraph (c)(4) of this 
section) is met; or
    (ii) The increase or decrease in rent is wholly attributable to one 
or more of the following provisions--
    (A) A contingent rent provision set forth in Sec. 1.467-
1(c)(2)(iii)(B); or
    (B) A single rent holiday provision allowing reduced rent (or no 
rent) for one consecutive period during the lease term, but only if--
    (1) The rent holiday is for a period of three months or less at the 
beginning of the lease term and for no other period; or
    (2) The duration of the rent holiday is reasonable, determined by 
reference to commercial practice (as of the agreement date) in the 
locality where the use of the property occurs, and does not exceed the 
lesser of 24 months or 10 percent of the lease term.
    (4) Uneven rent test--(i) In general. The uneven rent test is met 
if the rent allocated to each calendar year does not vary from the 
average rent allocated to all calendar years (determined in accordance 
with the rules set forth in paragraph (c)(4)(iii) of this section) by 
more than 10 percent.
    (ii) Special rule for real estate. Paragraph (c)(4)(i) of this 
section is applied by substituting ``15 percent'' for ``10 percent'' if 
the rental agreement is a long-term agreement and at least 90 percent 
of the property subject to the agreement (determined on the basis of 
fair market value as of the agreement date) consists of real property 
(as defined in Sec. 1.856-3(d)).
    (iii) Operating rules. In determining whether the uneven rent test 
has been met, the following rules apply:

[[Page 26862]]

    (A) Any contingent rent attributable to a provision set forth in 
Sec. 1.467-1(c)(2)(iii)(B)(3) through (9) is disregarded.
    (B) If the lease term includes one or more partial calendar years 
(a period less than a complete calendar year), the average rent 
allocated to each calendar year is the total rent allocated under the 
rental agreement, divided by the actual length (in years) of the lease 
term. The rent allocated to a partial calendar year is annualized by 
multiplying the allocated rent by the number of periods of the partial 
calendar year's length in a full calendar year and the annualized rent 
is treated as the amount of rent allocated to that year in determining 
whether the uneven rent test is met.
    (C) In the case of a rental agreement not described in paragraph 
(c)(4)(ii) of this section, an initial rent holiday period and any rent 
allocated to such period are disregarded for purposes of this paragraph 
(c)(4) if taking such period and rent into account would cause the 
agreement to fail to meet the uneven rent test. For purposes of this 
paragraph (c)(4), an initial rent holiday period is any period of three 
months or less at the beginning of the lease term during which 
annualized fixed rent (determined by treating such period as a rental 
period for purposes of Sec. 1.467-1(j)(3)) is less than the average 
rent allocated to all calendar years (determined before the application 
of this paragraph (c)(4)(iii)(C)).
    (D) In the case of a rental agreement described in paragraph 
(c)(4)(ii) of this section, one qualified rent holiday period and any 
rent allocated to such period are disregarded for purposes of this 
paragraph (c)(4) if taking such period and rent into account would 
cause the agreement to fail the uneven rent test. For this purpose, a 
qualified rent holiday period is a consecutive period that is an 
initial rent holiday period or that meets the following conditions:
    (1) The period does not exceed the lesser of 24 months or 10 
percent of the lease term (determined before the application of this 
paragraph (c)(4)(iii)(D)).
    (2) Annualized fixed rent during the period (determined by treating 
the period as a rental period for purposes of Sec. 1.467-1(j)(3)) is 
less than the average rent allocated to all calendar years (determined 
before the application of this paragraph (c)(4)(iii)(D)).
    (3) Providing less than average rent for the period is reasonable, 
determined by reference to commercial practice (as of the agreement 
date) in the locality where the use of the property occurs.
    (E) If the rental agreement contains a variable interest rate 
provision, the uneven rent test is applied by treating the rent as 
having been fixed under the terms of the rental agreement for the 
entire lease term using fixed rate substitutes (determined in the same 
manner as Sec. 1.1275-5(e), treating the agreement date as the issue 
date) for the variable rates of interest provided under the terms of 
the lessor's indebtedness.
    (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. 1.467-2(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) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i) K, lessor, and L, lessee, enter into a long-term 
agreement for a 10-year lease of personal property beginning on 
January 1, 2000. K and L are C corporations that use the calendar 
year as their taxable year. K does not have any unused losses or 
credits from taxable years preceding 2000. In addition, as of the 
agreement date, K expects that it will be subject to the maximum 
rate of tax imposed by section 11 in 2000 and that it will not be 
limited in its ability to use any losses or credits. As of the 
agreement date, L expects that it will be subject to the alternative 
minimum tax imposed by section 55 in 2000. The rental agreement 
provides for rent allocations in each year of the lease term, as 
follows:

------------------------------------------------------------------------
                          Year                                Amount
------------------------------------------------------------------------
2000....................................................        $427,500
2001....................................................         442,500
2002....................................................         457,500
2003....................................................         472,500
2004....................................................         487,500
2005....................................................         502,500
2006....................................................         517,500
2007....................................................         532,500
2008....................................................         547,500
2009....................................................         562,500
------------------------------------------------------------------------

    (ii) As described in paragraph (c)(2) of this section, as of the 
agreement date, a significant difference between the marginal tax 
rates of the lessor and lessee can reasonably be expected at some 
time during the lease term. First, the rental agreement has 
increasing rents. Second, the lessor's marginal tax rate exceeds the 
lessee's marginal tax rate by more than 10 percentage points during 
a rental period to which the rental agreement allocates less than a 
ratable portion of the aggregate amount of rent payable under the 
agreement. For example, for the year 2000, the lessor's expected 
marginal tax rate is 35 percent, the percentage determined by 
dividing the increase in the Federal income tax liability of K that 
would result from an additional dollar of rental income ($.35) by 
$1. Because the lessee is subject to the alternative minimum tax, 
the lessee's expected marginal tax rate for 2000 is 20 percent, the 
percentage determined by dividing the decrease in the Federal income 
tax liability (taking into account both the decrease in the lessee's 
regular tax and the increase in the lessee's alternative minimum 
tax) that would result from an additional dollar of rental deduction 
($.20) by $1. Further, for the year 2000, the rent allocated in 
accordance with the rental agreement is $427,500, which is less than 
a ratable portion of the aggregate amount of rental payments, 
$495,000, determined by dividing the total rents payable under the 
agreement ($4,950,000) by the number of years in the lease term 
(10). Thus, because a significant difference between the marginal 
tax rates of the lessor and lessee can reasonably be expected during 
the lease term, the agreement will be closely scrutinized and clear 
and convincing evidence will be required to establish that tax 
avoidance is not

[[Page 26863]]

a principal purpose for providing increasing rent.
    Example 2. (i) A and B enter into a long-term agreement for a 5-
year lease of personal property beginning on July 1, 2000, and 
ending on June 30, 2005. The rental agreement provides that the rent 
is allocated to the calendar years in the lease term in accordance 
with the following schedule and is paid at successive six-month 
intervals (on December 31 and June 30) during the lease term:

------------------------------------------------------------------------
                          Year                                Amount
------------------------------------------------------------------------
2000....................................................        $450,000
2001....................................................         900,000
2002....................................................         900,000
2003....................................................       1,100,000
2004....................................................       1,100,000
2005....................................................         550,000
------------------------------------------------------------------------

    (ii) In determining whether the uneven rent test described in 
paragraph (c)(4)(i) of this section is met, the total amount of rent 
allocated under the rental agreement is $5,000,000, and the lease 
term is five years. The average rent for each year is $1,000,000 
(see paragraph (c)(4)(iii)(B) of this section), and the uneven rent 
test is met if the rent for each year is not less than $900,000 and 
not more than $1,100,000. The test is met for 2000 because the 
annualized rent for that year is $900,000. The test is met for 2005 
because the annualized rent for that year is $1,100,000. The test is 
met for each of the years 2001 through 2004 because the rent for 
each of these years is not less than $900,000 and not more than 
$1,100,000. Accordingly, because the uneven rent test of paragraph 
(c)(4)(i) of this section is met, the long-term agreement will not 
be treated as disqualified.
    Example 3. (i) C and D enter into a long-term agreement for a 
lease of personal property beginning on October 1, 1999, and ending 
on December 31, 2005. The rental agreement provides that the rent is 
allocated to the calendar years in the lease term in accordance with 
the following schedule and is paid at successive six-month intervals 
(on December 31 and June 30) during the lease term:

------------------------------------------------------------------------
                          Year                                Amount
------------------------------------------------------------------------
1999....................................................              $0
2000....................................................         900,000
2001....................................................         900,000
2002....................................................         900,000
2003....................................................       1,100,000
2004....................................................       1,100,000
2005....................................................       1,100,000
------------------------------------------------------------------------

    (ii) The three-month rent holiday period at the beginning of the 
lease term is an initial rent holiday within the meaning of 
paragraph (c)(4)(iii)(C) of this section. Moreover, the agreement 
would fail the uneven rent test if the rent holiday period and the 
rent allocated to the period were taken into account. Thus, under 
paragraph (c)(4)(iii)(C) of this section, the period and the rent 
allocated to the period are disregarded for purposes of applying the 
uneven rent test. In that case, the lease term is six years, and the 
uneven rent test is met because the average rent for each year in 
the lease term is $1,000,000 and the rent for each calendar year in 
the lease term is not less than $900,000 nor more than $1,100,000. 
Accordingly, the long-term agreement will not be treated as 
disqualified.
    Example 4. (i) E and F enter into a long-term agreement for a 6-
year lease of personal property beginning on January 1, 2000, and 
ending on December 31, 2005. The rental agreement provides that the 
rent allocated to the calendar years in the lease term and paid at 
successive six-month intervals (on June 30 and December 31) during 
the lease term is the sum of the interest on the lessor's 
indebtedness, in the amount of $4,637,577, and an amount determined 
in accordance with the following schedule:

------------------------------------------------------------------------
                          Year                                Amount
------------------------------------------------------------------------
2000....................................................        $539,574
2001....................................................         583,603
2002....................................................         631,225
2003....................................................         886,733
2004....................................................         959,090
2005....................................................       1,037,352
------------------------------------------------------------------------

    (ii) Assume further that the lessor's indebtedness bears 
interest at the rate of 2 percent in excess of the 6-month London 
Interbank Offered Rate (LIBOR) in effect on the first day of the 6-
month period for each rental period and that, on the agreement date, 
the interest rate under this formula would be 8 percent. If the 
interest rate remained fixed during the entire lease term, the 
formula for determining the rent payable by the lessee would result 
in payments of rent in the amount of $450,000 for each six-month 
period in 2000, 2001, and 2002, and $550,000 for each six-month 
period in 2003, 2004, and 2005.
    (iii) Under paragraph (c)(4)(iii)(E) of this section, the fixed 
rate substitute for the variable interest rate provision produces a 
schedule of fixed rents that meets the uneven rent test of paragraph 
(c)(4)(i) of this section. Thus, even if the actual rents payable 
under the rental agreement do not meet the uneven rent test because 
of fluctuations in the 6-month LIBOR, the uneven rent test will be 
treated as having been met, and the long-term agreement will not be 
treated as disqualified.
    Example 5. (i) G and H enter into a long-term agreement for a 5-
year lease of personal property beginning on January 1, 2000, and 
ending on December 31, 2004. The rental agreement provides that the 
rent is payable to G at the rate of $40,000 per month in arrears, 
subject to an adjustment based on changes in prevailing interest 
rates during the lease term. Under this adjustment, the lessor is 
entitled to receive an amount equal to the sum of a specified dollar 
amount, which increases each month as payments of rent are made, and 
interest on a notional principal amount (as defined in Sec. 1.446-
3(c)(3)) at a qualified floating rate (as defined in Sec. 1.1275-
5(b)). The notional principal amount is initially established at 80 
percent of the cost of the property. As each payment of rent is 
made, the notional principal amount is reduced (but not below zero) 
to an amount that would represent the outstanding principal balance 
of a loan the payments on which are equal to the monthly payments of 
rent. As of the agreement date, the value of the qualified floating 
rate is 9 percent. Although G did not incur indebtedness 
specifically for the purpose of acquiring the property, the parties 
agreed to the adjustment provisions in order to compensate G for its 
general costs of borrowing.
    (ii) The adjustment provision produces a schedule of rent 
payments that is virtually identical to the schedule that would have 
resulted if G had actually borrowed money in an amount and on terms 
identical to the terms used in determining interest on the notional 
principal amount and the adjustment were based on that indebtedness. 
An adjustment based on actual indebtedness of the lessor would have 
been a variable interest rate provision eligible for a safe harbor 
under paragraph (c)(3)(ii)(A) of this section. Accordingly, based on 
all the facts and circumstances, the adjustment provision did not 
have as one of its principal purposes the avoidance of Federal 
income tax, and thus the long-term agreement will not be treated as 
disqualified.
    Example 6. (i) X and Y enter into a 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)(A) If the Commissioner determines that the leaseback is 
disqualified, the constant rental amount is computed as follows:
    (B) 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] TR18MY99.003

    (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] TR18MY99.004

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 a 
rental period, there is a difference between the amount of fixed rent

[[Page 26864]]

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 Federal tax purposes, 
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 paragraphs (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 (relating to disqualified leasebacks or 
long-term agreements).
    (4) Special rule in applying the provisions of Sec. 1.467-7(e), 
(f), or (g). Notwithstanding the provisions of paragraph (a)(2) of this 
section, section 467 loan balances must be computed for section 467 
rental agreements that are not subject to constant rental accrual under 
Sec. 1.467-3 and that provide adequate interest under Sec. 1.467-
2(b)(1)(i) or (ii), but only for purposes of applying the provisions of 
Sec. 1.467-7(e) (relating to dispositions of property subject to a 
section 467 rental agreement), Sec. 1.467-7(f) (relating to assignments 
by lessees and lessee-financed renewals), and Sec. 1.467-7(g) (relating 
to modifications of rental agreements).
    (b) Principal balance--(1) In general. Except as provided in 
paragraph (b)(2) of this section or in Sec. 1.467-7(e), (f), or (g), 
the principal balance of the section 467 loan at the beginning of a 
rental period equals--
    (i) The fixed rent accrued in preceding rental periods;
    (ii) Increased by the sum of--
    (A) The interest on fixed rent includible in the gross income of 
the lessor for preceding rental periods; and
    (B) Any amount payable by the lessor on or before the first day of 
the rental period as interest on prepaid fixed rent; and
    (iii) Decreased by the sum of--
    (A) The interest on prepaid fixed rent includible in the gross 
income of the lessee for preceding rental periods; and
    (B) 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 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)(i)(B) through (E) and Sec. 1.467-1(j)(2)(ii).
    (c) Yield--(1) In general--(i) Method of determining yield. Except 
as provided in paragraphs (c)(2) and (3) 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 an adjustment to the 
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 
length of the rental period).
    (3) Yield for purposes of applying paragraph (a)(4) of this 
section. For purposes of applying paragraph (a)(4) of this section, the 
yield of the section 467 loan balance of any party, or prior party, to 
a section 467 rental agreement for a period is the same for all parties 
and is the yield that results in the net accrual of positive or 
negative interest for that period equal to the amount of such interest 
that accrues under the terms of the rental agreement for that period. 
For example, if property subject to a section 467 rental agreement is 
sold (transferred) and the beginning section 467 loan balance of the 
transferor (as described in Sec. 1.467-7(e)(2)(i)) is positive and the 
beginning section 467 loan balance of the transferee (as described in 
Sec. 1.467-7(e)(2)(ii)) is negative, the yield on each of these loan 
balances for any period is the same for all parties and is the yield 
that results in the net accrual of positive or negative interest, 
taking into account the aggregate positive or negative interest on the 
section 467 loan balances of both the transferor and transferee, equal 
to the amount of such interest that accrues under the terms of the 
rental agreement for that period.
    (4) 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, 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 is 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 
is 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).

[[Page 26865]]

    (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, 2000, and ending on December 31, 2002. The 
section 467 rental agreement has the following rent allocation 
schedule and payment schedule:

------------------------------------------------------------------------
                                                    Rent
                                                 allocation    Payment
------------------------------------------------------------------------
2000..........................................     $400,000  ...........
2001..........................................      600,000  ...........
2002..........................................      800,000   $1,800,000
------------------------------------------------------------------------

    (B) The rental agreement requires a $1.8 million payment to be 
made on December 31, 2002, but does not provide for interest on 
deferred rent. Assume A and B choose the calendar year as the rental 
period length and that 110 percent of the applicable Federal rate 
based on annual compounding is 10 percent. Assume also that the 
agreement is not a leaseback or long-term agreement and, therefore, 
is not subject to constant rental accrual.
    (ii) 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:

2000.......................................................  $370,370.37
2001.......................................................   555,555.56
2002.......................................................   740,740.73
 

    (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, 
$740,740.73 + $96,296.30, equals $1,800,000). B takes the amounts of 
interest and rent into account as interest and rent expense, 
respectively, and A takes such amounts into account as interest and 
rent income, respectively, for the calendar years identified above, 
regardless of their respective overall methods of accounting.
    Example 2. (i) The facts are the same as in Example 1, 
Sec. 1.467-2(f). C agrees to lease property from D for five years 
beginning on January 1, 2000, and ending on December 31, 2004. 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, 2004. The 
parties select the calendar year as the rental period, and 110 
percent of the applicable Federal rate is 10 percent, compounded 
annually. The rental agreement has deferred rent but provides 
adequate interest on fixed rent.
    (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 2004, 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
----------------------------------------------------------------------------------------------------------------
2000............................................................              $0     $100,000.00     $100,000.00
2001............................................................       10,775.08      100,000.00      210,775.08
2002............................................................       22,711.18      100,000.00      333,486.26
2003............................................................       35,933.41      100,000.00      469,419.67
2004............................................................       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 
overall 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 (a)(4). 
If a section 467 rental agreement provides for interest that is neither 
variable interest nor fixed interest, the agreement provides for 
contingent payments.
    (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 (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 deferred or prepaid 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

[[Page 26866]]

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) Positive or negative 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, 2000, and 
ending on December 31, 2002. The rental agreement allocates $100,000 
of rent to 2000, $200,000 to 2001, and $100,000 to 2002, and 
requires the lessee to pay all $400,000 of rent on December 31, 
2002. 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 2001 and the other for 2002, 
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. Assume also that the 
agreement is not a leaseback or long-term agreement and, therefore, 
is not subject to constant rental accrual.
    (ii) 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 2001 and 2002 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 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        Projected       Cumulative
                                                  Accrued rent      interest         payment           loan
----------------------------------------------------------------------------------------------------------------
2000...........................................        $100,000              $0              $0         $100,000
2001...........................................         200,000          13,630         (10,000)         303,630
2002...........................................         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 2001 and 2002 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) of this 
section are as follows:

------------------------------------------------------------------------
                                            Accrued          Accrued
                                         interest under   interest using
                                             rental         fixed rate
                                           agreement       substitutes
------------------------------------------------------------------------
2000..................................               $0               $0
2001..................................           11,000           10,000
2002..................................           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 2001 and 
is -$3,000 ($42,000-$45,000) for 2002. Thus, under paragraph 
(b)(1)(ii) of this section, the actual interest on fixed rent for 
2001 is $14,630 ($13,630 + $1,000) and for 2002 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:
[GRAPHIC] [TIFF OMITTED] TR18MY99.005

    (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
----------------------------------------------------------------------------------------------------------------
2000...........................................      $98,756.09           $0.00              $0       $98,756.09
2001...........................................      197,512.18       14,813.41         (10,000)      301,081.68
2002...........................................       98,756.09       45,162.23        (445,000)            0.00
----------------------------------------------------------------------------------------------------------------


[[Page 26867]]

    (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 2001 is $15,813.41 
($14,813.41 + $1,000) and for 2002 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 and modifications.

    (a) Section 467 recapture. Notwithstanding any other provision of 
the Internal Revenue Code, except as provided in paragraph (c) of this 
section, a lessor disposing of property in a transaction to which this 
paragraph (a) applies must recognize the recapture amount (determined 
under paragraph (b) of this section) and treat that amount as ordinary 
income. This paragraph (a) 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 inclusion (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 inclusion. The prior understated inclusion is 
the excess (if any) of--
    (i) 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 subject to constant rental accrual 
under Sec. 1.467-3; over
    (ii) The aggregate amount of section 467 rent and section 467 
interest accrued by the lessor during that period.
    (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 Internal Revenue Code other than 
section 467(c) (for example, section 1245 or 1250).
    (ii) Certain dispositions. In the case of a disposition that is not 
a sale or exchange, 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. If a disposition is in 
part a sale or exchange and in part a gift, paragraph (a) of this 
section applies to the disposition but the prior understated inclusion 
is determined by taking into account only section 467 rent and section 
467 interest properly allocable to the portion of the property not 
disposed of by gift.
    (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). This paragraph (c)(2) 
does not apply to property which constitutes a right to receive an item 
of income in respect of a decedent. See sections 691 and 1014(c).
    (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 Internal 
Revenue Code other than section 467(c). However, see paragraph (c)(4) 
of this section for dispositions by transferees.
    (ii) Dispositions covered--(A) In general. Except as provided in 
paragraph (c)(3)(ii)(B) of this section, 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.
    (B) Transfers to certain tax-exempt organizations. This paragraph 
(c)(3) does not apply to a disposition to an organization (other than a 
cooperative described in section 521) which is exempt from tax imposed 
by chapter 1, subtitle A of the Internal Revenue Code (a tax-exempt 
entity) except to the extent the property is used in an activity the 
income from which is subject to tax under section 511(a) (a section 
511(a) activity). However, if assets used to any extent in a section 
511(a) activity are disposed of by the tax-exempt entity, then, 
notwithstanding any other provision of law (except section 1031 or 
section 1033) the recapture amount with respect to such disposition, to 
the extent attributable under paragraph (c)(4) of this section to the 
period of the transferor's ownership of the property prior to the first 
disposition, shall be included in the tax-exempt entity's unrelated 
business taxable income. To the extent that the tax-exempt entity 
ceases to use the property in a section 511(a) activity, the entity 
will be treated for purposes of this paragraph (c)(3) and paragraph 
(c)(4) of this section as having disposed of the property to such 
extent on the date of the cessation.
    (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 
paragraph (a) of this section applies, the prior understated inclusion 
determined under paragraph (b)(2) of this section is computed by taking 
into account the amounts attributable to the period of the transferor's 
ownership of the property prior to the first disposition. Thus, for 
example, the section 467 rent and section 467 interest that would have 
been taken into account by the transferee if the section 467 rental 
agreement were a disqualified leaseback or long-term agreement subject 
to constant rental accrual include the amounts that would have been 
taken into account by the transferor, and the aggregate amount of 
section 467 rent and section 467 interest accrued by the transferee 
includes the aggregate amount of section 467 rent and section 467 
interest that was taken into account by the transferor. The prior 
understated inclusion determined under this paragraph (c)(4) must be 
reduced by any recapture amount taken into account under paragraph (a) 
of this section by the transferor.
    (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); and
    (ii) The fair market value of property acquired that is not subject 
to the same section 467 rental agreement and that is

[[Page 26868]]

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 is reported under 
the installment method of accounting if and to the extent that method 
is otherwise available under section 453.
    (7) Dispositions covered by section 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 
paragraphs (a), (b), and (c) of this section. In each of these examples 
the transferor of property subject to a section 467 rental agreement is 
entitled to the rent for the day of the disposition. The examples are 
as follows:

    Example 1. (i)(A) X and Y enter into a section 467 rental 
agreement for a 5-year lease of personal property beginning on 
January 1, 2000, and ending on December 31, 2004. The rental 
agreement provides that the calendar year will be the rental period 
and that rents accrue and are paid in the following pattern:

------------------------------------------------------------------------
                                            Allocation        Payment
------------------------------------------------------------------------
2000....................................              $0              $0
2001....................................          87,500               0
2002....................................          87,500         175,000
2003....................................          87,500         175,000
2004....................................          87,500               0
------------------------------------------------------------------------

    (B) 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 also that the rental agreement is a 
long-term agreement (as defined in Sec. 1.467-3(b)(3)), but it is 
not a disqualified leaseback or long-term agreement. Further, 
because the agreement does not provide prepaid or deferred rent, 
proportional rental accrual is not applicable. (See Sec. 1.467-
2(b)(1)(i)). Therefore, the rent taken into account under 
Sec. 1.467-1(d)(2) is the fixed rent allocated to the rental periods 
under Sec. 1.467-1(c)(2)(ii).
    (ii) On December 31, 2000, X sells the property subject to the 
section 467 rental agreement to an unrelated person for $575,000. At 
the time of the sale, X's adjusted basis in the property is 
$175,000. Thus, X's gain on the sale of the property is $400,000. 
Assume that $175,000 of this gain would be treated as ordinary 
income under provisions 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 inclusion or the section 467 gain.
    (iii)(A) In computing the prior understated inclusion under 
paragraph (b)(2) of this section, 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
------------------------------------------------------------------------
2000...................................      $65,812.55              $0
2001...................................       65,812.55        7,239.38
2002...................................       65,812.55       15,275.09
2003...................................       65,812.55        4,944.73
2004...................................       65,812.55       (6,521.95)
------------------------------------------------------------------------

    (B) The total amount of section 467 rent and section 467 
interest for 2000, based on constant rental accrual, is $65,812.55. 
Since X did not take any section 467 rent or section 467 interest 
into account in 2000, the prior understated inclusion is also 
$65,812.55. X's section 467 gain is $225,000, which is the excess of 
the gain realized ($400,000) over the amount of that gain treated as 
ordinary income under non-section 467 provisions ($175,000). 
Accordingly, the recapture amount (the lesser of the prior 
understated inclusion or the section 467 gain) treated as ordinary 
income is $65,812.55.
    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
------------------------------------------------------------------------
2000....................................         $60,000              $0
2001....................................          65,000               0
2002....................................          70,000         175,000
2003....................................          75,000         175,000
2004....................................          80,000               0
------------------------------------------------------------------------

    (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). Under Sec. 1.467-2(c), the following 
amounts would be required to be taken into account:

------------------------------------------------------------------------
                                           Section 467     Section 467
                                              rent           interest
------------------------------------------------------------------------
2000...................................      $57,260.43             $ 0
2001...................................       62,032.13        6,298.65
2002...................................       66,803.83       13,815.03
2003...................................       71,575.53        3,433.11
2004...................................       76,347.23       (7,565.94)
------------------------------------------------------------------------

    (B) The amount of section 467 rent and section 467 interest 
taken into account by X for 2000 is $57,260.43. Thus, the prior 
understated inclusion is $8,552.12 (the excess of the amount of 
section 467 rent and section 467 interest based on constant rental 
accrual for 2000, $65,812.55, over the amount of section 467 rent 
and section 467 interest actually taken into account, $57,260.43). 
Since the prior understated inclusion is less than the section 467 
gain ($225,000, as determined in Example 1(iii)(B)), the recapture 
amount treated as ordinary income is also $8,552.12.
    Example 3. (i) The facts are the same as in Example 1, except 
that, instead of selling the property, X transfers the property to S 
on December 31, 2002, in exchange for stock of S in a transaction 
that meets the requirements of section 351(a). Under paragraph 
(c)(3) of this section, because of the application of section 351, X 
is not required to take into account any section 467 recapture.
    (ii) On December 31, 2003, S sells the property subject to the 
section 467 rental agreement to an unrelated person for $450,000. At 
the time of the sale, S's adjusted basis in the property is 
$105,000. Thus, S's gain on the sale of the property is $345,000. 
Assume that $245,000 of this gain would be treated as ordinary 
income under provisions of the Internal Revenue Code other than 
section 467(c). Under paragraph (a) of this section, S is required 
to take the recapture amount into account as ordinary income which, 
under paragraph (b) of this section, is the lesser of the prior 
understated inclusion or the section 467 gain.
    (iii) S owned the property in 2003 and, under paragraph (c)(4) 
of this section, for purposes of determining S's prior understated 
inclusion, S is treated as if it had owned the property during the 
years 2000 through 2002. In computing S's prior understated 
inclusion under paragraph (b)(2) of this section, the section 467 
rent and section 467 interest based on constant rental accrual are 
the same as the amounts set forth in the schedule in Example 
1(iii)(A). Thus, the constant rental amount for 2000, 2001, 2002, 
and 2003 is $290,709.40 ((4  x  $65,812.55) + $7,239.38 + $15,275.09 
+ $4,944.73). The section 467 rent and section 467 interest actually 
taken into account prior to the disposition is $262,500. Thus, S's 
prior understated inclusion is $28,209.40 ($290,709.40 minus 
$262,500 (3  x  $87,500)). S's section 467 gain is $100,000, the 
difference between the gain realized on the disposition ($345,000) 
and the amount of gain that is treated as ordinary income under non-
section 467 Code provisions ($245,000). Accordingly, S's recapture 
amount, the lesser of the prior understated inclusion or the section 
467 gain, is $28,209.40.

    (e) Other rules relating to dispositions--(1) In general. If there 
is a sale, exchange, or other disposition of property subject to a 
section 467 rental agreement (the transfer), the section 467 rent and, 
if applicable, section 467 interest for a period are taken into account 
by the owner of the property during the period. The following rules 
apply in determining the section 467 rent and section 467 interest for 
the portion of the rental period ending immediately prior to the 
transfer:
    (i) The section 467 rent and section 467 interest for the portion 
of the rental period ending immediately prior to the transfer are a pro 
rata portion of the section 467 rent and the section 467

[[Page 26869]]

interest, respectively, for the rental period. Such amounts are also 
taken into account in determining the transferor's section 467 loan 
balance, prior to any adjustment thereof that may be required under 
paragraph (h) of this section, immediately before the transfer.
    (ii) If the transferor of the property is entitled to the rent for 
the day of transfer, the transfer is treated as occurring at the end of 
the day of the transfer.
    (iii) If the transferee of the property is entitled to the rent for 
the day of transfer, the transfer is treated as occurring at the 
beginning of the day of the transfer.
    (2) Treatment of section 467 loan. If there is a transfer described 
in paragraph (e)(1) of this section, the following rules apply in 
determining the transferor's and the transferee's section 467 loans 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 (but after 
giving effect to 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 transferor's 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) [Reserved].
    (4) Examples. The following examples illustrate the application of 
this paragraph (e). In each of these examples the transferor of 
property subject to a section 467 rental agreement is entitled to the 
rent for the day of the transfer. The examples are as follows:

    Example 1. (i) Q and R enter into a section 467 rental agreement 
for a 5-year lease of personal property beginning on January 1, 
2000, and ending on December 31, 2004. The rental agreement provides 
that $0 of rent is allocated to 2000, 2001, and 2002, and $1,750,000 
is allocated to each of the years 2003 and 2004. 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 Q and R 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 disqualified long-term agreement (as 
defined in Sec. 1.467-3(b)(3)) and that the section 467 rent, the 
section 467 interest, and the section 467 loan balance would be the 
following amounts:

----------------------------------------------------------------------------------------------------------------
                                                            Section 467                         Section 467 loan
            Calendar year                  Payment            interest       Section 467 rent       balance
----------------------------------------------------------------------------------------------------------------
2000................................                 $0                 $0        $592,905.87        $592,905.87
2001................................                  0          65,219.65         592,905.87       1,251,031.39
2002................................                  0         137,613.45         592,905.87       1,981,550.71
2003................................       1,750,000.00         217,970.58         592,905.87       1,042,427.16
2004................................       1,750,000.00         114,666.97         592,905.87                  0
----------------------------------------------------------------------------------------------------------------

    (ii) On December 31, 2002, Q sells the property subject to the 
section 467 rental agreement to P, an unrelated person, for 
$3,000,000. Q does not retain the right to receive any amounts 
payable by R under the rental agreement after the date of sale, but 
the agreement is not otherwise modified. At the time of the sale, 
Q's adjusted basis in the property is $975,000. Assume that, under 
Sec. 1.467-1(f)(7), the disposition is not a substantial 
modification. Further, the Commissioner does not determine that the 
treatment of the agreement as a disqualified long-term agreement 
should be changed and, under Sec. 1.467-1(f)(4)(iii), the agreement 
remains subject to constant rental accrual. Thus, under paragraph 
(g)(2)(iii) of this section, section 467 rent and section 467 
interest for periods after the disposition will be taken into 
account on the basis of constant rental accrual applied to the terms 
of the entire agreement (as modified).
    (iii) Under paragraph (e)(2)(ii) of this section, the beginning 
balance of P's section 467 loan is $1,981,550.71. P's section 467 
loan balance is computed by reducing the balance of the section 467 
loan immediately before the transfer ($1,981,550.71) by the 
beginning balance of the transferor's section 467 loan ($0 because Q 
does not retain the right to receive any amounts payable under the 
rental agreement subsequent to the transfer).
    (iv) Q will be treated as if it had received $1,981,550.71 from 
the disposition of the section 467 loan and $1,018,449.29 from the 
sale of the property subject to the rental agreement. Thus, Q's gain 
on the sale of the property is $43,449.29 ($1,018,449.29 amount 
realized less $975,000 adjusted basis). Q's gain is not subject to 
the recapture provisions of section 467(c) and paragraph (a) of this 
section because the rental agreement was disqualified under 
Sec. 1.467-3(b)(1) and, thus, the requirement of paragraph (a)(2) of 
this section is not met. Q recognizes no gain on the disposition of 
the section 467 loan because Q's basis in the loan equals the amount 
considered received for the loan. Further, Q does not take into 
account any of the section 467 rent or section 467 interest 
attributable to periods after the transfer of the property.
    (v) P is treated as if it had acquired the property and the 
positive balance in the transferee's section 467 loan. P's cost 
basis in the property is $1,018,449.29, and its cost basis in the 
section 467 loan immediately following the transfer is 
$1,981,550.71. P takes section 467 rent and section 467 interest 
into account for the calendar years 2002 and 2003 under the constant 
rental accrual method and, accordingly, treats payments received 
under the rental agreement as recoveries of the principal balance of 
the section 467 loan (as adjusted from time to time).
    Example 2. (i) The facts are the same as Example 1, except that 
on December 31, 2002, Q transfers the property to P in exchange for 
stock of P having a fair market value of $3,000,000 and the 
transaction meets the requirements of section 351(a).
    (ii) Q is treated as having transferred two assets to P, the 
property subject to the rental agreement and the positive balance of 
the section 467 loan. Under section 351(a), because only stock of P 
is received by Q, Q does not recognize any of the gain realized on 
the transaction. Pursuant to section

[[Page 26870]]

358(a), the basis of Q in the P stock received in the exchange is 
the same as the aggregate basis of the property exchanged, or 
$2,956,550.71 (the sum of the balance of the section 467 loan, 
$1,981,550.71, and the adjusted basis of the property, $975,000). Q 
does not take into account any of the section 467 rent or section 
467 interest attributable to periods after the transfer of the 
property.
    (iii) P is treated as if it had acquired the property and the 
positive balance in the transferee's section 467 loan in the 
transaction. Pursuant to section 362(a), P's basis in each asset is 
the same as the basis of Q immediately preceding the transfer. Thus, 
the basis of P in the property subject to the rental agreement is 
$975,000, and the basis of P in the section 467 loan immediately 
following the transfer is $1,981,550.71. P takes section 467 rent 
and section 467 interest into account for the calendar years 2003 
and 2004 under the constant rental accrual method and, accordingly, 
treats payments received under the rental agreement as recoveries of 
the principal balance of the section 467 loan (as adjusted from time 
to time).
    (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 if a 
period when a substitute lessee has the use of property subject to a 
section 467 rental agreement is otherwise included in the lease term 
under Sec. 1.467-1(h)(6), the section 467 rent for a period is taken 
into account by the person having the use of the property during the 
period. The following rules apply in determining the section 467 rent 
and section 467 interest for the portion of the rental period ending 
immediately prior to the assignment:
    (i) The section 467 rent and section 467 interest for the portion 
of the rental period ending immediately prior to the assignment are a 
pro rata portion of the section 467 rent and the section 467 interest, 
respectively, for the rental period. Such amounts are also taken into 
account in determining the lessee's section 467 loan balance, prior to 
any adjustment thereof that may be required under paragraph (h) of this 
section, immediately before the substitute lessee first has use of the 
property.
    (ii) If the lessee is liable for the rent for the day that the 
substitute lessee first has use of the property, the substitute 
lessee's use shall be treated as beginning at the end of that day.
    (iii) If the substitute lessee is liable for the rent for the day 
that the substitute lessee first has use of the property, the 
substitute lessee's use shall be treated as beginning at the beginning 
of that day.
    (2) Treatment of section 467 loan. If, as described in paragraph 
(f)(1) of this section, 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 section 467 rental 
agreement is otherwise included in the lease term under Sec. 1.467-
1(h)(6), the following rules apply in determining the amount of the 
lessee's and the substitute lessee's section 467 loans 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 time the substitute lessee first 
has use of the property (but after giving effect to the transfer of the 
right to use 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 is not 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 lessee's 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 receipts 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, the following rules apply:
    (A) If the principal balance of the lessee's section 467 loan 
immediately before the substitute lessee first has use of the property 
was negative, any consideration paid by the substitute lessee to the 
lessee in conjunction with the transfer of the use of the property 
shall be treated as a nontaxable return of capital to the lessee to the 
extent that--
    (1) The consideration does not exceed the amount owed to the lessee 
under the lessee's section 467 loan balance immediately before the 
substitute lessee first has use of the property; and
    (2) The lessee has basis in the principal balance of the lessee's 
section 467 loan immediately before the substitute lessee first has use 
of the property.
    (B) Except as provided in paragraph (f)(2)(iv)(D) of this section, 
the excess, if any, of the beginning balance of the amount owed to the 
substitute lessee under the section 467 loan, over any consideration 
paid by the substitute lessee to the lessee in conjunction with the 
transfer of the use of the property, is treated as an amount incurred 
by the lessee for the taxable year in which the substitute lessee first 
has use of the property.
    (C) To the extent the beginning balance of the amount owed to the 
substitute lessee under the section 467 loan exceeds any consideration 
paid by the substitute lessee to the lessee in conjunction with the 
transfer of the use of the property, repayments of the beginning 
balance are items of gross income of the substitute lessee in the 
taxable year in which repayment occurs (determined by applying any 
repayment first to the beginning balance of the substitute lessee's 
section 467 loan).
    (D) Any amount incurred by the lessee under paragraph (f)(2)(iv)(B) 
of this section with respect to a transfer of the use of property (the 
current transfer) shall be reduced (but not below zero) to the extent 
that the lessee, in its capacity, if any, as a substitute lessee with 
respect to an earlier transfer of the use of the property would have 
recognized additional gross income under paragraph (f)(2)(iv)(C) of 
this section if the current transfer had not occurred.
    (v) For purposes of paragraph (f)(2)(iv)(C) of this section, 
repayments occur as the negative balance is amortized through the net 
accrual of rent and negative interest.
    (3) 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)(6), the section 467 rent for the period is not 
taken into account and the lessor is treated as a substitute lessee for 
purposes of this paragraph (f).
    (4) Examples. The following examples illustrate the application of 
this paragraph (f). In each of these examples,

[[Page 26871]]

the substitute lessee is liable for the rent for the day on which the 
substitute lessee first has use of the property subject to the section 
467 rental agreement. Further, assume that in each example the lessee 
assignment is not a substantial modification under Sec. 1.467-1(f). The 
examples are as follows:

    Example 1. (i) The facts are the same as in Example 1 of 
paragraph (e)(4) of this section, except that on December 31, 2001, 
R, the lessee, contracts to assign its entire remaining interest in 
the leasehold to S, a calendar year taxpayer. The assignment becomes 
effective at the beginning of January 1, 2002. Pursuant to the terms 
of the assignment, R agrees with S that R will make $1,400,000 of 
the $1,750,000 rental payment required on December 31, 2003.
    (ii) Under paragraph (f)(2)(i) of this section, R's section 467 
loan balance as of the beginning of January 1, 2002, the time S 
first has use of the property, is $1,136,271.41 ($1,400,000/
(1.11)2). Under paragraph (f)(2)(ii) of this section, S's section 
467 loan balance as of the beginning of January 1, 2002, is 
$114,759.98 (the principal balance of R's section 467 loan 
immediately before S has use of the property ($1,251,031.39), less 
R's section 467 loan balance at the beginning of January 1, 2002 
($1,136,271.41)).
    (iii) Because S's $114,759.98 section 467 loan balance is 
positive, under paragraph (f)(2)(iii)(A) of this section, such 
amount is treated as gross receipts of R for 2002, R's taxable year 
in which S first has use of the property. R will treat the 
$114,759.98 as an amount received in exchange for the transfer of 
the leasehold interest. Under paragraph (f)(2)(iii)(B) of this 
section, S will treat that amount as a liability assumed in 
acquiring the leasehold interest. Thus, S's cost basis in the 
leasehold interest is $114,759.98.
    (iv) Under paragraph (f)(1) of this section, S takes the section 
467 rent attributable to the property into account for the period 
beginning on January 1, 2002. For 2002, S takes section 467 interest 
into account based on S's section 467 loan balance at the beginning 
of 2002. S's amounts payable, section 467 rent, section 467 
interest, and end-of-year section 467 loan balances for calendar 
years 2002 through 2004 are as follows:

----------------------------------------------------------------------------------------------------------------
                                                            Section 467                         Section 467 loan
            Calendar year                  Payment            interest       Section 467 rent       balance
----------------------------------------------------------------------------------------------------------------
Beginning...........................  .................  .................  .................        $114,759.98
2002................................                 $0         $12,623.60        $592,905.87         720,289.45
2003................................         350,000.00          79,231.83         592,905.87       1,042,427.15
2004................................       1,750,000.00         114,666.98         592,905.87                  0
----------------------------------------------------------------------------------------------------------------

    (v) Under paragraph (f)(2)(i) of this section, R must continue 
to take into account section 467 interest on R's section 467 loan 
balance after S first has use of the property. R's section 467 loan 
balance beginning when S first has use of the property is 
$1,136,271.41. R's section 467 interest and end-of-year section 467 
loan balances for calendar years 2002 through 2003 are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                               Section 467      Section 467 loan
                     Calendar year                            Payment            interest           balance
----------------------------------------------------------------------------------------------------------------
Beginning..............................................  .................  .................      $1,136,271.41
2002...................................................                 $0        $124,989.85       1,261,261.26
2003...................................................       1,400,000.00         138,738.74                  0
----------------------------------------------------------------------------------------------------------------

    Example 2. (i) On January 1, 2000, B leases tangible personal 
property from C for a period of five years. The rental agreement 
provides that the rental period is the calendar year and that rent 
payments are due at the end of the calendar year. The rental 
agreement does not provide for interest on prepaid rent. Assume that 
B and C are both calendar year taxpayers and that 110 percent of the 
applicable Federal rate is 10 percent, compounded annually. The 
rental agreement allocates rents and provides for payments of rent 
as follows:

------------------------------------------------------------------------
              Calendar year                    Rent          Payments
------------------------------------------------------------------------
2000....................................        $200,000        $400,000
2001....................................         200,000         300,000
2002....................................         200,000         200,000
2003....................................         200,000         100,000
2004....................................         200,000               0
------------------------------------------------------------------------

    (ii) The rental agreement has prepaid rent within the meaning of 
Sec. 1.467-1(c)(3)(ii) because the cumulative amount of rent payable 
through the end of 2001 ($700,000) exceeds the cumulative amount of 
rent allocated to calendar years 2000 through 2002 ($600,000). 
Because the rental agreement does not provide for adequate interest 
on prepaid fixed rent, the rent for each calendar year during the 
lease term is the proportional rental amount, as described in 
Sec. 1.467-2(c). The amounts payable, section 467 rent, section 467 
interest, and end-of-year section 467 loan balances for each 
calendar year are as follows:

----------------------------------------------------------------------------------------------------------------
                                                           Section 467                         Section 467 loan
           Calendar year                 Payment            interest        Section 467 rent        balance
----------------------------------------------------------------------------------------------------------------
2000..............................           $400,000                 $0         $218,987.40       ($181,012.60)
2001..............................            300,000         (18,101.26)         218,987.40        (280,126.46)
2002..............................            200,000         (28,012.64)         218,987.40        (289,151.70)
2003..............................            100,000         (28,915.17)         218,987.40        (199,079.47)
2004..............................                  0         (19,907.93)         218,987.40                  0
----------------------------------------------------------------------------------------------------------------

    (iii) On December 31, 2001, B contracts to assign its entire 
remaining interest in the leasehold to D, a calendar year taxpayer. 
The assignment becomes effective at the beginning of January 1, 
2002. D pays B $278,000 on January 1, 2002, in conjunction with the 
assignment of the leasehold interest. Under the terms of the 
assignment, B is not obligated to make any rental payments due after 
the assignment.
    (iv) Under paragraph (f)(2)(i) of this section, B's section 467 
loan balance as of the beginning of January 1, 2002, the time D 
first has use of the property, is zero because D is obligated to 
make all rent payments due after the assignment of the leasehold 
interest. Under paragraph (f)(2)(ii) of this section, D's section 
467 loan balance as of the beginning of January 1, 2002, is negative 
$280,126.46 (the principal balance of B's section 467 loan 
immediately before D has use of the property (negative $280,126.46), 
less B's section 467 loan balance when D first has use of the 
property (zero)). Because D's beginning section 467 loan balance is 
negative, paragraph (f)(2)(iv) of this section applies.
    (v) Because B's $280,126.46 section 467 loan balance at the end 
of 2001 (that is, immediately before D has use of the property) is 
negative, paragraph (f)(2)(iv)(A) of this section applies. B's loan 
balance is the amount owed to B under the section 467 loan

[[Page 26872]]

and consists of the excess of B's payments to C over the net amount 
of rent and negative interest B has taken into account through the 
end of 2001. Thus, B's basis in the negative section 467 loan 
balance at the end of 2001 is $280,126.46. Because the $278,000 paid 
by D to B in conjunction with the transfer of the leasehold interest 
does not exceed the amount owed to B under the section 467 loan at 
the end of 2001, and does not exceed B's basis in that loan balance, 
under paragraph (f)(2)(iv)(A) of this section B treats the $278,000 
payment from D as a nontaxable return of capital.
    (vi) The beginning balance of the amount owed to D under the 
section 467 loan ($280,126.46) exceeds by $2,126.46 the $278,000 
paid by D to B in conjunction with the transfer of the leasehold 
interest. Paragraph (f)(2)(iv)(B) of this section treats the 
$2,126.46 as an amount incurred by B in 2002, B's taxable year in 
which D first has use of the property. Paragraph (f)(2)(iv)(D) of 
this section does not apply to reduce the amount incurred by B 
because B is the original lessee under the section 467 rental 
agreement.
    (vii) Under paragraph (f)(1) of this section, D takes the 
section 467 rent into account for the period beginning when D first 
has use of the property. D takes section 467 interest into account 
based on a beginning section 467 loan balance of negative 
$280,126.46.
    (viii) The beginning balance of the amount owed to D under the 
section 467 loan ($280,126.46) exceeds by $2,126.46 the $278,000 
paid by D to B in conjunction with the transfer of the leasehold 
interest. Under paragraph (f)(2)(iv)(C) of this section, D must 
include this amount in gross income in 2002, the year in which this 
amount of D's beginning section 467 loan balance is paid through the 
net accrual of rent and negative interest. This inclusion in gross 
income ensures that the reductions in D's taxable income 
attributable to the section 467 rental agreement will not exceed the 
actual amount of D's expenditures.

    (g) Application of section 467 following a rental agreement 
modification--(1) Substantial modifications. The following rules apply 
to any substantial modification of a rental agreement occurring after 
May 18, 1999 unless the entire agreement (as modified) is treated as a 
single agreement under Sec. 1.467-1(f)(4)(vi):
    (i) Treatment of pre-modification items. The lessor and lessee must 
take pre-modification items (within the meaning of Sec. 1.467-
1(f)(5)(v)) into account under their method of accounting used before 
the modification to report income and expense attributable to the 
rental agreement.
    (ii) Computations with respect to post-modification items. In 
computing section 467 rent, section 467 interest, and the amount of the 
section 467 loan with respect to post-modification items--
    (A) Post-modification items are treated as provided under a rental 
agreement (the post-modification agreement) separate from the agreement 
under which pre-modification items are provided;
    (B) The lease term of the post-modification agreement begins at the 
beginning of the first period for which rent other than pre-
modification rent is provided; and
    (C) The applicable Federal rate for the post-modification agreement 
is the applicable Federal rate in effect on the day on which the 
modification occurs.
    (iii) Adjustments--(A) Adjustment relating to certain prepayments. 
If any payments before the beginning of the lease term of the post-
modification agreement are post-modification items, the lessor and 
lessee must take into account, in the taxable year in which the 
modification occurs, any adjustment necessary to prevent duplication 
with respect to such payments or the omission of interest thereon for 
periods before the beginning of the lease term.
    (B) Adjustment relating to retroactive beginning of lease term. If 
the lease term of a post-modification agreement begins before the date 
on which the modification occurs, the lessor and lessee must take into 
account in the taxable year in which the modification occurs any amount 
necessary to prevent the duplication or omission of rent or interest 
for the period after the beginning of the lease term of the post-
modification agreement and before the beginning of the taxable year in 
which the modification occurs. For this purpose, the amount necessary 
to prevent duplication or omission is determined after taking into 
account any adjustments required by the Commissioner for taxable years 
ending prior to the beginning of the taxable year in which the 
modification occurs. In determining any adjustments required by the 
Commissioner for taxable years ending prior to the beginning of the 
taxable year in which the modification occurs, the Commissioner will 
disregard the modification.
    (iv) Coordination with rules relating to dispositions and 
assignments--(A) Dispositions. If the modification involves a sale, 
exchange, or other disposition of the property subject to the rental 
agreement--
    (1) Adjustments required under this paragraph (g) are taken into 
account before applying paragraphs (a), (b), (c), and (e) of this 
section;
    (2) The prior understated inclusion for purposes of paragraph (b) 
of this section is the sum of the prior understated inclusion with 
respect to pre-modification items and the prior understated inclusion 
with respect to post-modification items; and
    (3) Paragraph (e) of this section applies separately with respect 
to pre-modification items and post-modification items.
    (B) Assignments. If the modification involves an assignment of the 
lessee's interest in the rental agreement to a substitute lessee or a 
substitute lessee having use of the property during a period otherwise 
included in the lease term--
    (1) Adjustments required under this paragraph (g) are taken into 
account before applying paragraph (f) of this section; and
    (2) Paragraph (f) of this section applies separately with respect 
to pre-modification items and post-modification items.
    (2) Other modifications. The following rules apply to a 
modification (other than a substantial modification) of a rental 
agreement occurring after May 18, 1999:
    (i) Computation of section 467 loan for modified agreement. The 
amount of the section 467 loan relating to the agreement is computed as 
of the effective date of the modification. The section 467 rent and 
section 467 interest for periods before the effective date of the 
modification are determined, solely for purposes of computing the 
amount of the section 467 loan, under the terms of the entire agreement 
(as modified).
    (ii) Change in balance of section 467 loan. (A) If the balance of 
the section 467 loan determined under paragraph (g)(2)(i) of this 
section is greater than the balance of the section 467 loan immediately 
before the effective date of the modification, the difference is taken 
into account, in the taxable year in which the modification occurs, as 
additional rent.
    (B) If the balance of the section 467 loan determined under 
paragraph (g)(2)(i) of this section is less than the balance of the 
section 467 loan immediately before the effective date of the 
modification, the difference is taken into account, in the taxable year 
in which the modification occurs, as a reduction of the rent previously 
taken into account by the lessor and lessee.
    (C) For purposes of this paragraph (g)(2)(ii), a negative balance 
is less than a positive balance, a zero balance, or any other negative 
balance that is closer to a zero balance.
    (iii) Section 467 rent and interest after the modification. The 
section 467 rent and section 467 interest for periods after the 
effective date of the modification are determined under the terms of 
the entire agreement (as modified).
    (iv) Applicable Federal rate. The applicable Federal rate for the

[[Page 26873]]

agreement does not change as a result of the modification.
    (v) Modification effective within a rental period. If the effective 
date of a modification does not coincide with the beginning or end of a 
rental period under the agreement in effect before the modification, 
the section 467 rent and section 467 interest for the portion of the 
rental period ending immediately prior to the effective date of the 
modification are a pro rata portion of the section 467 rent and the 
section 467 interest, respectively, for the rental period. Such amounts 
are also taken into account in determining the section 467 loan 
balance, prior to any adjustment thereof that may be required under 
paragraph (h) of this section, immediately before the effective date of 
the modification. Similar rules apply with respect to the section 467 
rent and section 467 interest determined under the terms of the entire 
agreement (as modified) for purposes of computing the amount of the 
section 467 loan under paragraph (g)(2)(i) of this section and the 
section 467 rent and section 467 interest for a partial rental period 
beginning on the effective date of the modification.
    (vi) Other adjustments. The lessor and lessee must take into 
account, in the taxable year in which a retroactive modification 
occurs, any amount necessary to prevent the duplication or omission of 
rent or interest for the period before the beginning of the taxable 
year in which the modification occurs.
    (vii) Coordination with rules relating to dispositions and 
assignments. If the modification involves a sale, exchange, or other 
disposition of the property subject to the rental agreement, an 
assignment of the lessee's interest in the rental agreement to a 
substitute lessee or a substitute lessee having use of the property 
during a period otherwise included in the lease term, adjustments 
required under this paragraph (g) are taken into account before 
applying paragraphs (a), (b), (c), (e), and (f) of this section.
    (viii) Exception for agreements entered into prior to effective 
date of section 467. This paragraph (g)(2) does not apply to a 
modification of a rental agreement that is not subject to section 467 
because of the effective date provisions of section 92(c) of the Tax 
Reform Act of 1984 (Public Law 98-369 (98 Stat. 612)).
    (3) Adjustment by Commissioner. If the entire agreement (as 
modified) is treated as a single agreement under Sec. 1.467-
1(f)(4)(vi), the Commissioner may require adjustments to taxable income 
to reflect the effect of the modification, including adjustments that 
are similar to those required under paragraph (g)(2) of this section.
    (4) Effective date of modification. The effective date of a 
modification of a rental agreement occurs at the earliest of--
    (i) The date on which the modification occurs;
    (ii) The beginning of the first period for which the amount of rent 
or interest provided under the entire agreement (as modified) differs 
from the amount of rent or interest provided under the agreement in 
effect before the modification;
    (iii) The due date of the first payment, under either the entire 
agreement (as modified) or the agreement in effect before the 
modification, that is not identical, in due date and amount, under both 
such agreements;
    (iv) The date, in the case of a modification involving the 
substitution of a new lessor, on which the property subject to the 
rental agreement is transferred; or
    (v) The date, in the case of a modification involving the 
substitution of a new lessee, on which the substitute lessee first has 
use of the property subject to the rental agreement.
    (5) Examples. The following examples illustrate the application of 
this paragraph (g):

    Example 1. (i) F, a cash method lessor, and G, an accrual method 
lessee, agree to a 7-year lease of tangible personal property for 
the period beginning on January 1, 1998, and ending on December 31, 
2004. The rental agreement allocates $100,000 of rent to each 
calendar year during the lease term, such rent to be paid December 
31 following the close of the calendar year to which it is 
allocated. Because the rental agreement does not provide for 
increasing rent, or deferred rent within the meaning of section 
467(d)(1)(A), section 467 does not apply to the rental agreement.
    (ii) Prior to January 1, 2001, G timely makes the $100,000 
rental payments required as of December 31, 1999, and December 31, 
2000. On January 1, 2001, F and G modify the rental agreement 
payment schedule to provide for a single final payment of $500,000 
on December 31, 2004. Assume that the change is a substantial 
modification within the meaning of Sec. 1.467-1(f)(5)(ii). Because 
the modification occurs after May 18, 1999, the post-modification 
agreement is treated, under Sec. 1.467-1(f)(1), as a new agreement 
for purposes of determining whether it is a section 467 rental 
agreement.
    (iii) Under Sec. 1.467-1(f)(5)(v), the $200,000 of rent 
allocated to calendar years 1998 and 1999 (periods prior to the 
modification) constitutes pre-modification rent, and the $100,000 
rent payments made on December 31, 1999, and December 31, 2000, 
constitute pre-modification payments. Although calendar year 2000 is 
also prior to the modification, the rent allocated to calendar year 
2000 is not pre-modification rent and the related payment is not a 
pre-modification payment because the modification changed the time 
at which that rent is payable. See Sec. 1.467-1(f)(5)(v)(A).
    (iv) Under paragraph (g)(1)(i) of this section, F and G take 
pre-modification rent and pre-modification payments into account 
under the method of accounting they used to report income and 
deductions attributable to the pre-modification agreement.
    (v) Under Sec. 1.467-1(f)(1)(i), the post-modification agreement 
providing rent for the period beginning on January 1, 2000, and 
ending on December 31, 2004, is treated as a new rental agreement. 
This rental agreement allocates $100,000 of rent to each of the 
calendar years 2000 through 2004 and provides for a single rental 
payment of $500,000 on December 31, 2004. Because the post-
modification agreement provides for deferred rent under Sec. 1.467-
1(c)(3)(i), section 467 applies. Further, the post-modification 
agreement does not provide for adequate interest on fixed rent, and 
therefore F and G must account for fixed rent and interest on fixed 
rent using proportional rental accrual. Under paragraph (g)(1)(iii) 
of this section, for their taxable years which include January 1, 
2001, F and G must adjust reported rent for the difference between 
the rent taken into account for the calendar year 2000 under the 
unmodified agreement and the proportional rental amount for that 
year under the post-modification agreement.
    Example 2. (i) On January 1, 2000, X, lessee, and Y, lessor, 
enter into a rental agreement for a 6-year lease of tangible 
personal property beginning January 1, 2000, and endingDecember 31, 
2005. The agreement provides that the calendar year is the rental 
period and all rent payments are due on July 15 of all years in 
which a payment is required. Assume the agreement is not a 
disqualified leaseback or long-term agreement within the meaning of 
Sec. 1.467-3(b), and has the following allocation schedule and 
payment schedule:

------------------------------------------------------------------------
                  Year                      Allocation        Payment
------------------------------------------------------------------------
2000....................................        $800,000              $0
2001....................................         900,000               0
2002....................................       1,000,000       1,500,000
2003....................................       1,000,000       1,500,000
2004....................................       1,100,000       1,500,000
2005....................................       1,200,000       1,500,000
------------------------------------------------------------------------

    (ii) The rental agreement has deferred rent within the meaning 
of Sec. 1.467-1(c)(3)(i) because the rent allocated to 2000 is not 
payable until 2002 and some of the rent allocable to 2001 is not 
payable until 2003. Further, the rental agreement does not provide 
adequate interest on fixed rent within the meaning of Sec. 1.467-
2(b). Therefore, the rent amount to be accrued by X and Y for each 
rental period is the proportional rental amount, as described in 
Sec. 1.467-2(c). Assuming 110 percent of the applicableFederal rate 
is 10 percent compounded annually, the section 467 rent, interest, 
and loan balances are as follows:

[[Page 26874]]



----------------------------------------------------------------------------------------------------------------
                          Year                                  Rent             Interest         Loan balance
----------------------------------------------------------------------------------------------------------------
2000...................................................        $736,949.55                 $0        $736,949.55
2001...................................................         829,068.24          73,694.96       1,639,712.75
2002...................................................         921,186.94         163,971.28       1,224,870.97
2003...................................................         921,186.94         122,487.10         768,545.01
2004...................................................       1,013,305.63          76,854.50         358,705.14
2005...................................................       1,105,424.33          35,870.53                  0
----------------------------------------------------------------------------------------------------------------

    (iii)(A) On January 1, 2004, X and Y agree that the $1,500,000 
payment scheduled for July 15, 2005, will be made in three equal 
installments on June 15, 2005, July 15, 2005, and August 15, 2005. 
Under Sec. 1.467-1(j)(2)(i)(C) (relating to timing conventions), the 
payment to be made on June 15, 2005, is treated as if it were 
payable on December 31, 2004, for purposes of determining present 
values and yield of the section 467 loan. Assume that this change, 
which results in the following allocation schedule and payment 
schedule, is not a substantial modification within the meaning of 
Sec. 1.467-1(f)(5)(ii):

------------------------------------------------------------------------
                  Year                      Allocation        Payment
------------------------------------------------------------------------
2000....................................        $800,000              $0
2001....................................         900,000               0
2002....................................       1,000,000       1,500,000
2003....................................       1,000,000       1,500,000
2004....................................       1,100,000       2,000,000
2005....................................       1,200,000       1,000,000
------------------------------------------------------------------------

    (B) The agreement remains subject to proportional rental accrual 
after the modification because it has deferred rent and does not 
provide adequate interest on fixed rent within the meaning of 
Sec. 1.467-2(b).
    (iv) Because the modification occurs after May 18, 1999, and is 
not substantial within the meaning of Sec. 1.467-1(f)(5)(ii), 
paragraph (g)(2) of this section applies. Under paragraph (g)(2)(i) 
of this section, the amount of the section 467 loan relating to the 
modified agreement is computed as of the effective date of the 
modification, and, solely for purposes of recomputing the amount of 
the section 467 loan, the section 467 rent and section 467 interest 
for periods before the modification are determined under the terms 
of the entire agreement (as modified). In addition, the applicable 
Federal rate does not change as a result of the modification. Thus, 
the recomputed section 467 rent, interest, and loan balances are as 
follows:

----------------------------------------------------------------------------------------------------------------
                         Year                                 Rent             Interest          Loan balance
----------------------------------------------------------------------------------------------------------------
2000.................................................       $ 742,242.59                $ 0        $ 742,242.59
2001.................................................         835,022.91          74,224.26        1,651,489.76
2002.................................................         927,803.24         165,148.98        1,244,441.98
2003.................................................         927,803.24         124,444.20          796,689.42
2004.................................................       1,020,583.56          79,668.94         (103,058.08)
2005.................................................       1,113,363.88         (10,305.80)                  0
----------------------------------------------------------------------------------------------------------------

    (v) Under paragraph (g)(2)(ii) of this section, the difference 
between the section 467 loan balance immediately before the 
effective date of the modification and the recomputed section 467 
loan balance as of the effective date of the modification is taken 
into account. In this example, the loan balance immediately before 
the effective date of the modification is $768,545.01 and the 
recomputed loan balance as of the effective date of the modification 
is $796,689.42. Thus, because the recomputed loan balance exceeds 
the original loan balance, the difference ($28,144.41) is taken into 
account, in the taxable year in which the modification occurs, as 
additional rent. Beginning on January 1, 2004, section 467 rent and 
interest are taken into account by X and Y in accordance with the 
recomputed rent schedule set forth in paragraph (iv) of this 
example.

    (h) Omissions or duplications--(1) In general. In applying the 
rules of this section in conjunction with the rules of Secs. 1.467-1 
through 1.467-5, adjustments must be made to the extent necessary to 
prevent the omission or duplication of items of income, deduction, 
gain, or loss. For example, if a transferee lessor acquires property 
subject to a section 467 rental agreement at other than the beginning 
or end of a rental period, and the transferee lessor's beginning 
section 467 loan balance differs from the transferor lessor's section 
467 loan balance immediately prior to the transfer, it will be 
necessary to treat the rental period that includes the day of transfer 
as consisting of two rental periods, one beginning at the beginning of 
the rental period that includes the day of transfer and ending with or 
immediately prior to the transfer and one beginning with or immediately 
after the transfer and ending immediately prior to the beginning of the 
succeeding rental period. Because the substitution of two rental 
periods for one rental period may change the proportional rental amount 
or constant rental amount, the change in rental periods should be 
treated as a modification of the rental agreement that occurs 
immediately prior to the transfer. The change in rental periods, by 
itself, is not treated as a substantial modification of the rental 
agreement although the substitution of a new lessor may constitute a 
substantial modification of the rental agreement. Likewise, Sec. 1.467-
1(j)(2), which provides rules regarding when amounts are treated as 
payable, is designed to simplify calculations of present values, 
section 467 loan balances, and proportional and constant rental 
amounts. These simplifying conventions assume that there will be no 
change in the lessor or lessee under a section 467 rental agreement and 
that the terms of the section 467 rental agreement will not be 
modified. Therefore, as illustrated in the example in paragraph (h)(2) 
of this section, when actual events do not reflect these assumptions, 
it may be necessary to alter the application of these rules to properly 
reflect taxable income.
    (2) Example. The following example illustrates an application of 
this paragraph (h):

    Example. (i) J leases tangible personal property from K for five 
years beginning on January 1, 2000, and ending on December 31, 2004. 
Under the rental agreement, rent is payable on July 15 of the 
calendar year to which it is allocated. Both J and K treat the 
calendar year as the rental period. The allocation of rent and 
payments of rent required under the rental agreement are as follows:

------------------------------------------------------------------------
              Calendar year                    Rent          Payments
------------------------------------------------------------------------
2000....................................        $200,000        $450,000
2001....................................         200,000         250,000
2002....................................         200,000         200,000
2003....................................         200,000         100,000
2004....................................         200,000               0
------------------------------------------------------------------------

    (ii) The rental agreement does not provide for interest on 
prepaid rent. The rental

[[Page 26875]]

agreement has prepaid rent under Sec. 1.467-1(c)(3)(ii) because the 
rent payable at the end of 2000 exceeds the cumulative amount of 
rent allocated to 2000 and 2001. Therefore, J and K must take 
section 467 rent into account under the proportional rental method 
of Sec. 1.467-2(c). Assume that 110 percent of the applicable 
Federal rate is 10 percent, compounded annually. The section 467 
rent, section 467 interest, amounts payable, and section 467 loan 
balances for each of the calendar years under the terms of the 
rental agreement are as follows:

----------------------------------------------------------------------------------------------------------------
                                                           Section 467                         Section 467 loan
           Calendar Year             Section 467 rent       interest            Payments            balance
----------------------------------------------------------------------------------------------------------------
2000..............................        $220,077.48                 $0            $450,000       $(229,922.52)
2001..............................         220,077.48         (22,992.25)            250,000        (282,837.29)
2002..............................         220,077.48         (28,283.73)            200,000        (291,043.54)
2003..............................         220,077.48         (29,104.35)            100,000        (200,070.41)
2004..............................         220,077.48         (20,007.07)                  0                  0
----------------------------------------------------------------------------------------------------------------

    (iii) On January 1, 2002, J and K amend the terms of the rental 
agreement to advance the due date of the $200,000 payment originally 
due on July 15, 2002, to June 15, 2002. This change in the payment 
schedule constitutes a modification of the terms of the rental 
agreement within the meaning of Sec. 1.467-1(f)(5)(i). Assume, 
however, that the change is not a substantial modification within 
the meaning of Sec. 1.467-1(f)(5)(ii). Because the modification 
occurs after May 18, 1999, and is not substantial, paragraph (g)(2) 
of this section applies. Thus, the section 467 loan balance at the 
beginning of 2002 must be recomputed as if the June 15, 2002, 
payment date had been included in the terms of the pre-modification 
rental agreement. If this had been the case, the section 467 rent, 
section 467 interest, amounts payable, and section 467 loan balances 
for each of the calendar years under the terms of the rental 
agreement would have been as follows:

----------------------------------------------------------------------------------------------------------------
                                                           Section 467                         Section 467 loan
             Calendar                Section 467 rent       interest            Payments            balance
----------------------------------------------------------------------------------------------------------------
2000..............................        $224,041.38                 $0            $450,000       $(225,958.62)
2001..............................         224,041.38         (22,595.86)            450,000        (474,513.10)
2002..............................         224,041.38         (47,451.31)                  0        (297,923.03)
2003..............................         224,041.38         (29,792.30)            100,000        (203,673.95)
2004..............................         224,041.38         (20,367.43)                  0                  0
----------------------------------------------------------------------------------------------------------------

    (iv) Section 1.467-4(b)(3) incorporates the conventions of 
Sec. 1.467-1(j)(2) in determining when amounts are treated as 
payable for purposes of determining the section 467 loan balance. 
Section 1.467-1(j)(2)(i)(C) treats amounts payable during the first 
half of any rental period except the first rental period as payable 
on the last day of the preceding rental period. Therefore, because 
June 15, 2002, occurs in the first half of 2002, in determining the 
section 467 loan balance at the beginning of 2002 under the amended 
terms of the rental agreement, the $200,000 payment due on June 15, 
2002, is treated as payable on December 31, 2001.
    (v) Under paragraph (g)(2)(ii)(B) of this section, if the 
recomputed section 467 loan balance is less than the section 467 
loan balance immediately before the modification, the difference is 
taken into account as a reduction of the rent previously taken into 
account by the lessor and the lessee. In this example, the 
recomputed section 467 loan balance immediately after the 
modification is negative $474,513.10 and the section 467 loan 
balance immediately before the modification is negative $282,837.29. 
However, the section 467 loan balance immediately before the 
modification does not take into account the $200,000 payment 
originally payable on July 15, 2002, whereas, under the conventions 
of Sec. 1.467-1(j)(2)(i)(C), the recomputed section 467 loan balance 
immediately after the modification takes into account that $200,000 
payment because it is now payable in the first half of the rental 
period (June 15). Under these circumstances, if the recomputed 
section 467 loan balance immediately after the modification is 
treated as negative $474,513.10 for purposes of applying paragraph 
(g)(2)(ii)(B) of this section, K's gross income and J's deductions 
attributable to the section 467 rental agreement will be understated 
by $200,000. Therefore, under paragraph (h)(1) of this section, only 
for purposes of applying paragraph (g)(2)(ii)(B) of this section, 
the $200,000 payment due on June 15, 2002, should not be taken into 
account in determining the recomputed section 467 loan balance 
immediately after the modification.


Sec. 1.467-8  Automatic consent to change to constant rental accrual 
for certain rental agreements.

    (a) General rule. For the first taxable year ending after May 18, 
1999, a taxpayer may change to the constant rental accrual method, as 
described in Sec. 1.467-3, for all of its section 467 rental agreements 
described in paragraph (b) of this section. A change to the constant 
rental accrual method is a change in method of accounting to which the 
provisions of sections 446 and 481 and the regulations thereunder 
apply. A taxpayer changing its method of accounting in accordance with 
this section must follow the automatic change in accounting method 
provisions of Rev. Proc. 98-60 (see Sec. 601.601(d)(2) of this chapter) 
except, for purposes of this paragraph (a), the scope limitations in 
section 4.02 of Rev. Proc. 98-60 are not applicable. Taxpayers changing 
their method of accounting in accordance with this section must do so 
for all of their section 467 rental agreements described in paragraph 
(b) of this section.
    (b) Agreements to which automatic consent applies. A section 467 
rental agreement is described in this paragraph (b) if--
    (1) The property subject to the section 467 rental agreement is 
financed with an ``exempt facility bond'' within the meaning of section 
142;
    (2) The facility subject to the section 467 rental agreement is 
described in section 142(a)(1), (2), (3), or (12);
    (3) The section 467 rental agreement does not include a specific 
allocation of fixed rent within the meaning of Sec. 1.467-
1(c)(2)(ii)(A)(2); and
    (4) The section 467 rental agreement was entered into on or before 
May 18, 1999.


Sec. 1.467-9  Effective dates and automatic method changes for certain 
agreements.

    (a) In general. Sections 1.467-1 through 1.467-7 are applicable 
for--
    (1) Disqualified leasebacks and long-term agreements entered into 
after June 3, 1996; and
    (2) Rental agreements not described in paragraph (a)(1) of this 
section that are entered into after May 18, 1999.
    (b) Automatic consent for certain rental agreements. Section 1.467-
8 applies only to rental agreements described in Sec. 1.467-8.
    (c) Application of regulation project IA-292-84 to certain 
leasebacks and

[[Page 26876]]

long-term agreements. In the case of any leaseback or long-term 
agreement (other than a disqualified leaseback or long-term agreement) 
entered into after June 3, 1996, and on or before May 18, 1999, a 
taxpayer may choose to apply the provisions of regulation project IA-
292-84 (1996-2 C.B. 462)(see Sec. 601.601(d)(2) of this chapter).
    (d) Entered into. For purposes of this section and Sec. 1.467-8, a 
rental agreement is entered into on its agreement date (within the 
meaning of Sec. 1.467-1(h)(1) and, if applicable, Sec. 1.467-
1(f)(1)(i)).
    (e) Change in method of accounting--(1) In general. For the first 
taxable year ending after May 18, 1999, a taxpayer is granted consent 
of the Commissioner to change its method of accounting for rental 
agreements described in paragraph (a)(2) of this section to comply with 
the provisions of Secs. 1.467-1 through 1.467-7.
    (2) Application of regulation project IA-292-84. For the first 
taxable year ending after May 18, 1999, a taxpayer is granted consent 
of the Commissioner to change its method of accounting for any rental 
agreement described in paragraph (c) of this section to comply with the 
provisions of regulation project IA-292-84 (1996-2 C.B. 462) (see 
Sec. 601.601(d)(2) of this chapter).
    (3) Automatic change procedures. A taxpayer changing its method of 
accounting in accordance with this paragraph (e) must follow the 
automatic change in accounting method provisions of Rev. Proc. 98-60 
(see Sec. 601.601(d)(2) of this chapter) except, for purposes of this 
paragraph (e), the scope limitations in section 4.02 of Rev. Proc. 98-
60 are not applicable. A method change in accordance with paragraph 
(e)(1) of this section is made on a cut-off basis so no adjustment 
under section 481(a) is required.
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
Approved: May 5, 1999.
Donald C. Lubick,
Assistant Secretary of the Treasury.
[FR Doc. 99-11891 Filed 5-17-99; 8:45 am]
BILLING CODE 4830-01-U