[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]
=======================================================================
-----------------------------------------------------------------------
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.
-----------------------------------------------------------------------
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