[Federal Register Volume 67, Number 162 (Wednesday, August 21, 2002)]
[Rules and Regulations]
[Pages 54087-54093]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-21203]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9013]
RIN 1545-AN64


Limitations on Passive Activity Losses and Credits--Treatment of 
Self-Charged Items of Income and Expense

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: These regulations provide guidance on the treatment of self-
charged items of income and expense under section 469. The regulations 
recharacterize a percentage of certain portfolio income and expense as 
passive income and expense (self-charged items) when a taxpayer engages 
in a lending transaction with a partnership or an S corporation 
(passthrough entity) in which the taxpayer owns a direct or indirect 
interest and the loan proceeds are used in a passive activity. Similar 
rules apply to lending transactions between two identically owned 
passthrough entities. These final regulations affect taxpayers subject 
to the limitations on passive activity losses and credits.

DATES: Effective Date: These regulations are effective August 21, 2002.
    Applicability Date: For dates of applicability of these 
regulations, see Sec. 1.469-11 of these regulations.

FOR FURTHER INFORMATION CONTACT: Danielle M. Grimm at (202) 622-3070 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under 
control number 1545-1244. Responses to this collection of information 
are required to obtain the benefit of self-charged treatment of income 
and expense under section 469.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    The estimated annual burden per respondent varies from 5 minutes to 
15 minutes, depending on individual circumstances, with an estimated 
average of 6 minutes.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S 
Washington, DC 20224, and to the Office of Management and Budget, Attn: 
Desk Officer for the Department of the Treasury, Office of Information 
and Regulatory Affairs, Washington, DC 20503.
    Books or records relating to this collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    Section 469(a)(1)(A) of the Internal Revenue Code (Code) provides 
that if aggregate losses from passive activities exceed aggregate 
income from passive activities for the taxable year, the excess losses 
are not allowable for that taxable year. Under section 469(e)(1), 
passive activity income does not include income from interest, 
dividends, annuities, and royalties not derived in the ordinary course 
of a trade or business. However, under the rules of Sec. 1.163-8T, if 
borrowed funds are used in a passive activity, the interest expense is 
treated as a passive activity deduction. Consequently, in certain 
lending transactions, a taxpayer may have interest income that is 
characterized as portfolio income under section 469(e)(1) and interest 
expense that is characterized as a passive activity deduction under 
Sec. 1.163-8T. The legislative history of section 469 indicates that 
this result is inappropriate because the items of interest income and 
expense are essentially ``self-charged'' and thus lack economic 
significance.
    On April 5, 1991, the IRS published in the Federal Register a 
notice of proposed rulemaking (REG-209365-89 at 56 FR 14034) proposing 
amendments to 26 CFR part 1 under section 469 of the Code relating to 
the treatment of self-charged items of income and expense for purposes 
of applying the limitations on passive activity losses and passive 
activity credits.

[[Page 54088]]

    A number of public comments were received and a public hearing was 
held on September 6, 1991. Given the significant period of time that 
had elapsed since the former comment period, additional comments were 
solicited in Notice 2001-47 (2001-36 I.R.B. 212). After consideration 
of all of the comments received, the proposed regulations are adopted, 
as revised by this Treasury decision.

Explanation of Revisions and Summary of Comments

    The proposed regulations provide self-charged treatment for items 
of interest income and interest expense in lending transactions between 
a taxpayer and a passthrough entity in which the taxpayer holds a 
direct or qualifying indirect interest. Several commentators suggested 
that the regulations should also apply to lending transactions between 
related passthrough entities such as brother-sister entities in which 
the taxpayer owns interests because such transactions also may result 
in mismatched income and expense for purposes of section 469. In 
response to the suggestions, the self-charged rules are extended to 
identically owned passthrough entities. This extension is limited to 
identically owned entities because of concerns regarding the difficulty 
of identifying self-charged items in transactions between less closely 
related or unrelated entities.
    Certain commentators requested the removal of the qualifying 
indirect interest rule in the proposed regulations. The qualifying 
indirect interest rule provides that a taxpayer must have at least a 
10-percent indirect interest in a passthrough entity to qualify for 
self-charged treatment. Commentators noted that a taxpayer that owns 
less than a 10 percent interest nevertheless may receive large amounts 
of self-charged income and expense. This suggestion has been adopted. 
Accordingly, the regulations no longer contain the qualifying indirect 
interest rule.
    Noting that Congress authorized the Secretary to identify other 
situations in which self-charged treatment is appropriate, several 
commentators suggested that self-charged treatment be extended to other 
transactions involving rental real estate activities, such as the 
payment of management fees and salaries. After publication of the 
proposed regulations, Congress considered the impact of section 469 on 
rental real estate transactions and enacted specific relief in section 
469(c)(7) for certain real estate professionals for taxable years 
beginning after 1993. There was no indication in the legislative 
history of section 469(c)(7) that Congress considered additional relief 
for real estate transactions necessary or desirable. Moreover, there is 
less justification for the complexity of a self-charged rule in this 
area after the enactment of section 469(c)(7) because that change 
substantially reduced the number of real estate transactions that would 
benefit from a self-charged rule. Accordingly, the regulations do not 
extend the self-charged treatment to other transactions involving 
rental real estate.
    A number of comments suggested that the regulations clarify whether 
the self-charged rules apply to guaranteed payments to a partner for 
the use of capital. Section 1.469-2(e)(2)(ii) of the regulations treats 
these payments as interest income. Accordingly, the regulations clarify 
that lending transactions include guaranteed payments for the use of 
capital under section 707(c).
    Some comments requested clarification on the types of interest 
eligible for self-charged treatment. The comments noted that the 
examples in the regulations may be interpreted as precluding certain 
types of interest because the introductory language states that the 
lending transactions described in the examples do not result in 
foregone interest (within the meaning of section 7872(e)(2)), original 
issue discount (within the meaning of section 1273), or total unstated 
interest (within the meaning of section 483(b)). Accordingly, the 
regulations clarify that the examples assume, solely for purposes of 
simplifying the presentation, that the lending transactions do not 
involve foregone interest, original issue discount, or total unstated 
interest.
    A few comments responded to the notice of proposed rulemaking's 
solicitation for suggestions on the proper treatment of items 
recognized in different taxable years. One comment suggested the use of 
a suspense account. Under this suggestion, in the year in which the 
taxpayer identifies the corresponding item of self-charged income or 
expense, that item would be netted against the self-charged item in the 
suspense account. Another comment suggested that where the recognition 
of passive interest expense precedes the recognition of passive income, 
the taxpayer could elect to treat the income as passive when ultimately 
recognized. Another suggestion was to allow the taxpayer to 
recharacterize interest income or expense equal to the amount 
calculated on a cumulative basis. The commentators recognize that to 
implement the above methods would require more complex regulations.
    After consideration of these comments, the final regulations adopt 
the rule of the proposed regulations that the self-charged rules apply 
only to self-charged items recognized in the same taxable year. This 
rule is consistent with the legislative history and avoids the 
complexity of the other suggested methods. For similar reasons, 
comments suggesting special rules for capitalized expenses are not 
adopted.
    Certain commentators requested that the regulations be extended to 
apply to transactions between taxpayers and their trusts, estates, 
REMICs and housing cooperatives. The regulations address the 
transactions identified by Congress involving S corporations and 
partnerships (including entities classified as partnerships for federal 
tax purposes). Application of the self-charged rules to other types of 
entities would require a significant expansion of the scope of these 
regulations to address broader issues concerning the manner in which 
section 469 applies to those entities.
    The applicability date of the final regulations is consistent with 
the applicability date as proposed. However, certain clarifications 
have been made to the transition rule. In the transition period, a 
taxpayer may use any reasonable method to offset items of interest 
income and interest expense from lending transactions.

Effective Date

    These regulations are applicable for taxable years beginning after 
December 31, 1986. However, for taxable years beginning before June 4, 
1991, a taxpayer that owns an interest in a passthrough entity is not 
required to apply these provisions and may use any reasonable method to 
offset items of interest income and interest expense from lending 
transactions between the passthrough entity and its owners or between 
certain passthrough entities. Items from nonlending transactions cannot 
be offset under the self-charged rules.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12886. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 
6) do not apply to these regulations, and, therefore, a Regulatory 
Flexibility Analysis is not required.

[[Page 54089]]

Pursuant to section 7805(f) of the Code, the notice of proposed 
rulemaking preceding these regulations was submitted to the Small 
Business Administration for comment on its impact on small business.

Drafting Information

    The principal author of these regulations is Danielle M. Grimm, 
Office of the Associate Chief Counsel (Passthroughs and Special 
Industries), Internal Revenue Service. However, personnel from other 
offices of the Internal Revenue Service and Treasury Department 
participated in their development.

List of Subjects

26 CFR Part 1

    Income Taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

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

    Authority: 26 U.S.C. 7805 * * *
    Section 1.469-7 also issued under 26 U.S.C. 469(l). * * *


    Par. 2. Section 1.469-0 is amended by:

    1. Revising the entry for Sec. 1.469-7.
    2. Adding entries for Sec. 1.469-7(a) through (h).
    3. Revising the entries for Sec. 1.469-11(c)(1) and (c)(1)(i).
    4. Adding an entry for Sec. 1.469-11, paragraph (c)(1)(iii).
    The additions and revisions read as follows:


Sec. 1.469-0  Table of contents.

* * * * *


Sec. 1.469-7  Treatment of self-charged items of interest income and 
deduction.

(a) In general.
(1) Applicability and effect of rules.
(2) Priority of rules in this section.
(b) Definitions.
(1) Passthrough entity.
(2) Taxpayer's share.
(3) Taxpayer's indirect interest.
(4) Entity taxable year.
(5) Deductions for a taxable year.
(c) Taxpayer loans to passthrough entity.
(1) Applicability.
(2) General rule.
(3) Applicable percentage.
(d) Passthrough entity loans to taxpayer.
(1) Applicability.
(2) General rule.
(3) Applicable percentage.
(e) Identically-owned passthrough entities.
(1) Applicability.
(2) General rule.
(1) Example.
(f) Identification of properly allocable deductions.
(g) Election to avoid application of the rules of this section.
(1) In general.
(2) Form of election.
(3) Period for which election applies.
(4) Revocation.
(h) Examples.


Sec. 1.469-11  Effective date and transition rules.

* * * * *
(c) * * *
(1) Application of certain income recharacterization rules and self-
charged rules.
(i) Certain recharacterization rules inapplicable in 1987.
* * * * *
(iii) Self-charged rules.
* * * * *


    Par. 3. Section 1.469-7 is amended by:
    (1) Revising the section heading.
    (2) Adding paragraphs (a) through (h).
    The revision and additions read as follows:


Sec. 1.469-7  Treatment of self-charged items of interest income and 
deduction.

    (a) In general--(1) Applicability and effect of rules. This section 
sets forth rules that apply, for purposes of section 469 and the 
regulations thereunder, in the case of a lending transaction (including 
guaranteed payments for the use of capital under section 707(c)) 
between a taxpayer and a passthrough entity in which the taxpayer owns 
a direct or indirect interest, or between certain passthrough entities. 
The rules apply only to items of interest income and interest expense 
that are recognized in the same taxable year. The rules--
    (i) Treat certain interest income resulting from these lending 
transactions as passive activity gross income;
    (ii) Treat certain deductions for interest expense that is properly 
allocable to the interest income as passive activity deductions; and
    (iii) Allocate the passive activity gross income and passive 
activity deductions resulting from this treatment among the taxpayer's 
activities.
    (2) Priority of rules in this section. The character of amounts 
treated under the rules of this section as passive activity gross 
income and passive activity deductions and the activities to which 
these amounts are allocated are determined under the rules of this 
section and not under the rules of Secs. 1.163-8T, 1.469-2(c) and (d), 
and 1.469-2T(c) and (d).
    (b) Definitions. The following definitions set forth the meaning of 
certain terms for purposes of this section:
    (1) Passthrough entity. The term passthrough entity means a 
partnership or an S corporation.
    (2) Taxpayer's share. A taxpayer's share of an item of income or 
deduction of a passthrough entity is the amount treated as an item of 
income or deduction of the taxpayer for the taxable year under section 
702 (relating to the treatment of distributive shares of partnership 
items as items of partners) or section 1366 (relating to the treatment 
of pro rata shares of S corporation items as items of shareholders).
    (3) Taxpayer's indirect interest. The taxpayer has an indirect 
interest in an entity if the interest is held through one or more 
passthrough entities.
    (4) Entity taxable year. In applying this section for a taxable 
year of a taxpayer, the term entity taxable year means the taxable year 
of the passthrough entity for which the entity reports items that are 
taken into account under section 702 or section 1366 for the taxpayer's 
taxable year.
    (5) Deductions for a taxable year. The term deductions for a 
taxable year means deductions that would be allowable for the taxable 
year if the taxpayer's taxable income for all taxable years were 
determined without regard to sections 163(d), 170(b), 469, 613A(d), and 
1211.
    (c) Taxpayer loans to passthrough entity--(1) Applicability. Except 
as provided in paragraph (g) of this section, this paragraph (c) 
applies with respect to a taxpayer's interest in a passthrough entity 
(borrowing entity) for a taxable year if--
    (i) The borrowing entity has deductions for the entity taxable year 
for interest charged to the borrowing entity by persons that own direct 
or indirect interests in the borrowing entity at any time during the 
entity taxable year (the borrowing entity's self-charged interest 
deductions);
    (ii) The taxpayer owns a direct or an indirect interest in the 
borrowing entity at any time during the entity taxable year and has 
gross income for the taxable year from interest charged to the 
borrowing entity by the taxpayer or a passthrough entity through which 
the taxpayer holds an interest in the borrowing entity (the taxpayer's 
income from interest charged to the borrowing entity); and

[[Page 54090]]

    (iii) The taxpayer's share of the borrowing entity's self-charged 
interest deductions includes passive activity deductions.
    (2) General rule. If any of the borrowing entity's self-charged 
interest deductions are allocable to an activity for a taxable year in 
which this paragraph (c) applies, the passive activity gross income and 
passive activity deductions from that activity are determined under the 
following rules--
    (i) The applicable percentage of each item of the taxpayer's income 
for the taxable year from interest charged to the borrowing entity is 
treated as passive activity gross income from the activity; and
    (ii) The applicable percentage of each deduction for the taxable 
year for interest expense that is properly allocable (within the 
meaning of paragraph (f) of this section) to the taxpayer's income from 
the interest charged to the borrowing entity is treated as a passive 
activity deduction from the activity.
    (3) Applicable percentage. In applying this paragraph (c) with 
respect to a taxpayer's interest in a borrowing entity, the applicable 
percentage is separately determined for each of the taxpayer's 
activities. The percentage applicable to an activity for a taxable year 
is obtained by dividing--
    (i) The taxpayer's share for the taxable year of the borrowing 
entity's self-charged interest deductions that are treated as passive 
activity deductions from the activity by
    (ii) The greater of--
    (A) The taxpayer's share for the taxable year of the borrowing 
entity's aggregate self-charged interest deductions for all activities 
(regardless of whether these deductions are treated as passive activity 
deductions); or
    (B) The taxpayer's aggregate income for the taxable year from 
interest charged to the borrowing entity for all activities of the 
borrowing entity.
    (d) Passthrough entity loans to taxpayer--(1) Applicability. Except 
as provided in paragraph (g) of this section, this paragraph (d) 
applies with respect to a taxpayer's interest in a passthrough entity 
(lending entity) for a taxable year if--
    (i) The lending entity has gross income for the entity taxable year 
from interest charged by the lending entity to persons that own direct 
or indirect interests in the lending entity at any time during the 
entity taxable year (the lending entity's self-charged interest 
income);
    (ii) The taxpayer owns a direct or an indirect interest in the 
lending entity at any time during the entity taxable year and has 
deductions for the taxable year for interest charged by the lending 
entity to the taxpayer or a passthrough entity through which the 
taxpayer holds an interest in the lending entity (the taxpayer's 
deductions for interest charged by the lending entity); and
    (iii) The taxpayer's deductions for interest charged by the lending 
entity include passive activity deductions.
    (2) General rule. If any of the taxpayer's deductions for interest 
charged by the lending entity are allocable to an activity for a 
taxable year in which this paragraph (d) applies, the passive activity 
gross income and passive activity deductions from that activity are 
determined under the following rules--
    (i) The applicable percentage of the taxpayer's share for the 
taxable year of each item of the lending entity's self-charged interest 
income is treated as passive activity gross income from the activity.
    (ii) The applicable percentage of the taxpayer's share for the 
taxable year of each deduction for interest expense that is properly 
allocable (within the meaning of paragraph (f) of this section) to the 
lending entity's self-charged interest income is treated as a passive 
activity deduction from the activity.
    (3) Applicable percentage. In applying this paragraph (d) with 
respect to a taxpayer's interest in a lending entity, the applicable 
percentage is separately determined for each of the taxpayer's 
activities. The percentage applicable to an activity for a taxable year 
is obtained by dividing--
    (i) The taxpayer's deductions for the taxable year for interest 
charged by the lending entity, to the extent treated as passive 
activity deductions from the activity; by
    (ii) The greater of--
    (A) The taxpayer's aggregate deductions for all activities for the 
taxable year for interest charged by the lending entity (regardless of 
whether these deductions are treated as passive activity deductions); 
or
    (B) The taxpayer's aggregate share for the taxable year of the 
lending entity's self-charged interest income for all activities of the 
lending entity.
    (e) Identically-owned passthrough entities--(1) Applicability. 
Except as provided in paragraph (g) of this section, this paragraph (e) 
applies with respect to lending transactions between passthrough 
entities if each owner of the borrowing entity has the same 
proportionate ownership interest in the lending entity.
    (2) General rule. To the extent an owner shares in interest income 
from a loan between passthrough entities described in paragraph (e)(1) 
of this section, the owner is treated as having made the loan to the 
borrowing passthrough entity and paragraph (c) of this section applies 
to determine the applicable percentage of portfolio income of properly 
allocable interest expense that is recharacterized as passive.
    (3) Example. The following example illustrates the application of 
this paragraph (e):

    Example. (i) A and B, both calendar year taxpayers, each own a 
50-percent interest in the capital and profits of partnerships RS 
and XY, both calendar year partnerships. Under the partnership 
agreements of RS and XY, A and B are each entitled to a 50-percent 
distributive share of each partnership's income, gain, loss, 
deduction, or credit. RS makes a $20,000 loan to XY and XY pays RS 
$2,000 of interest for the taxable year. A's distributive share of 
interest income attributable to this loan is $1,000 (50 percent  x  
$2,000). XY uses all of the proceeds received from RS is a passive 
activity. A's distributive share of interest expense attributable to 
the loan is $1,000 (50 percent  x  $2,000).
    (ii) This paragraph (e) applies in determining A's passive 
activity gross income because RS and XY are identically-owned 
passthrough entities as described in paragraph (e)(1) of this 
section. Under paragraph (e)(2) of this section, the RS-to-XY loan 
is treated as if A made the loan to XY. Therefore, A must apply 
paragraph (c) of this section to determine the applicable percentage 
of portfolio income that is recharacterized as passive income.
    (iii) Paragraph (c) of this section applies in determining A's 
passive activity gross income because: XY has deductions for 
interest charged to XY by RS for the taxable year (XY's self-charged 
interest deductions); A owns an interest in XY during XY's taxable 
year and has gross income for the taxable year from interest charged 
to XY by RS; and A's share of XY's self-charged interest deductions 
includes passive activity deductions. See paragraph (c)(1) of this 
section.
    (iv) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of A's interest income is recharacterized as passive 
activity gross income from the activity. Paragraph (c)(3) of this 
section provides that the applicable percentage is obtained by 
dividing A's share for the taxable year of XY's self-charged 
interest deductions that are treated as passive activity deductions 
from the activity ($1,000) by the greater of A's share for the 
taxable year of XY's self-charged interest deductions ($1,000), or 
A's income for the year from interest charged to XY ($1,000). Thus, 
A's applicable percentage is 100 percent ($1,000/$1,000), and $1,000 
(100 percent x $1,000) of A's income from interest charged to XY is 
treated as passive activity gross income from the passive activity.

    (f) Identification of properly allocable deductions. For purposes 
of this section, interest expense is properly allocable to

[[Page 54091]]

an item of interest income if the interest expense is allocated under 
Sec. 1.163-8T to an expenditure that--
    (1) Is properly chargeable to capital account with respect to the 
investment producing the item of interest income; or
    (2) May reasonably be taken into account as a cost of producing the 
item of interest income.
    (g) Election to avoid application of the rules of this section--(1) 
In general. Paragraphs (c), (d) and (e) of this section shall not apply 
with respect to any taxpayer's interest in a passthrough entity for a 
taxable year if the passthrough entity has made, under this paragraph 
(g), an election that applies to the entity's taxable year.
    (2) Form of election. A passthrough entity makes an election under 
this paragraph (g) by attaching to its return (or amended return) a 
written statement that includes the name, address, and taxpayer 
identification number of the passthrough entity and a declaration that 
an election is being made under this paragraph (g).
    (3) Period for which election applies. An election under this 
paragraph (g) made with a return (or amended return) for a taxable year 
applies to that taxable year and all subsequent taxable years that end 
before the date on which the election is revoked.
    (4) Revocation. An election under this paragraph (g) may be revoked 
only with the consent of the Commissioner.
    (h) Examples. The following examples illustrate the principles of 
this section. The examples assume for purposes of simplifying the 
presentation, that the lending transactions described do not result in 
foregone interest (within the meaning of section 7872(e)(2)), original 
issue discount (within the meaning of section 1273), or total unstated 
interest (within the meaning of section 483(b)).

    Example 1. (i) A and B, two calendar year individuals, each own 
50-percent interests in the capital, profits and losses of AB, a 
calendar year partnership. AB is engaged in a single rental activity 
within the meaning of Sec. 1.469-1T(e)(3). AB borrows $50,000 from A 
and uses the loan proceeds in the rental activity. AB pays $5,000 of 
interest to A for the taxable year. A and B each incur $2,500 of 
interest expense as their distributive share of AB's interest 
expense.
    (ii) AB has self-charged interest deductions for the taxable 
year (i.e., the deductions for interest charged to AB by A); A owns 
a direct interest in AB during AB's taxable year and has income for 
A's taxable year from interest charged to AB; and A's share of AB's 
self-charged interest deductions includes passive activity 
deductions. Accordingly, paragraph (c) of this section applies in 
determining A's passive activity gross income. See paragraph (c)(1) 
of this section.
    (iii) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of A's interest income is recharacterized as passive 
activity gross income from AB's rental activity. Paragraph (c)(3) of 
this section provides that the applicable percentage is obtained by 
dividing A's share for the taxable year of AB's self-charged 
interest deductions that are treated as passive activity deductions 
from the activity ($2,500) by the greater of A's share for the 
taxable year of AB's self-charged interest deductions ($2,500), or 
A's income for the taxable year from interest charged to AB 
($5,000). Thus, A's applicable percentage is 50 percent ($2,500/
$5,000), and $2,500 (50 percent  x  $5,000) of A's income from 
interest charged to AB is treated as passive activity gross income 
from the passive activity A conducts through AB.
    (iv) Because B does not have any gross income for the year from 
interest charged to AB, this section does not apply to B. See 
paragraph (c)(1)(ii) of this section.
    Example 2. (i) C and D, two calendar year taxpayers, each own 
50-percent interests in the capital and profits of CD, a calendar 
year partnership. CD is engaged in a single rental activity, within 
the meaning of Sec. 1.469-1T(e)(3). C obtains a $10,000 loan from a 
third-party lender, and pays the lender $900 in interest for the 
taxable year. C lends the $10,000 to CD, and receives $1,000 of 
interest income from CD for the taxable year. D lends $20,000 to CD 
and receives $2,000 of interest income from CD for the taxable year. 
CD uses all of the proceeds in the rental activity. C and D are each 
allocated $1,500 (50 percent x $3,000) of interest expense as their 
distributive share of CD's interest expense for the taxable year.
    (ii) CD has self-charged interest deductions for the taxable 
year (i.e., deductions for interest charged to CD by C and D); C and 
D each own direct interests in CD during CD's taxable year and have 
gross income for the taxable year from interest charged to CD; and 
both C's and D's shares of CD's self-charged interest deductions 
include passive activity deductions. Accordingly, paragraph (c) of 
this section applies in determining C's and D's passive activity 
gross income. See paragraph (c)(1) of this section.
    (iii) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of each partner's interest income is recharacterized as 
passive activity gross income from CD's rental activity. Paragraph 
(c)(3) of this section provides that C's applicable percentage is 
obtained by dividing C's share for the taxable year of CD's self-
charged interest deductions that are treated as passive activity 
deductions from the activity ($1,500) by the greater of C's share 
for the taxable year of CD's self-charged interest deductions 
($1,500), or C's income for the taxable year from interest charged 
to CD ($1,000). Thus, C's applicable percentage is 100 percent 
($1,500/$1,500), and all of C's income from interest charged to CD 
($1,000) is treated as passive activity gross income from the 
passive activity C conducts through CD. Similarly, D's applicable 
percentage is obtained by dividing D's share for the taxable year of 
CD's self-charged interest deductions that are treated as passive 
activity deductions from the activity ($1,500) by the greater of D's 
share for the taxable year of CD's self-charged interest deductions 
($1,500), or D's income for the taxable year from interest charged 
to CD ($2,000). Thus, D's applicable percentage is 75 percent 
($1,500/$2,000), and $1,500 (75 percent  x  $2,000) of D's income 
from interest charged to CD is treated as passive activity gross 
income from the rental activity.
    (iv) The $900 of interest expense that C pays to the third-party 
lender is allocated under Sec. 1.163-8T(c)(1) to an expenditure that 
is properly chargeable to capital account with respect to the loan 
to CD. Thus, the expense is properly allocable to the interest 
income C receives from CD (see paragraph (f) of this section). Under 
paragraph (c)(2)(ii) of this section, the applicable percentage of 
C's deductions for the taxable year for interest expense that is 
properly allocable to C's income from interest charged to CD is 
recharacterized as a passive activity deduction from CD's rental 
activity. Accordingly, all of C's $900 interest deduction is treated 
as a passive activity deduction from the rental activity.
    Example 3. (i) E and F, calendar year taxpayers, each own 50 
percent of the stock of X, a calendar year S corporation. E borrows 
$30,000 from X, and pays X $3,000 of interest for the taxable year. 
E uses $15,000 of the loan proceeds to make a personal expenditure 
(as defined in Sec. 1.163-8T(b)(5)), and uses $15,000 of loan 
proceeds to purchase a trade or business activity in which E does 
not materially participate (within the meaning of Sec. 1.469-5T) for 
the taxable year. E and F each receive $1,500 as their pro rata 
share of X's interest income from the loan for the taxable year.
    (ii) X has gross income for X's taxable year from interest 
charged to E (X's self-charged interest income); E owns a direct 
interest in X during X's taxable year and has deductions for the 
taxable year for interest charged by X; and E's deductions for 
interest charged by X include passive activity deductions. 
Accordingly, paragraph (d) of this section applies in determining 
E's passive activity gross income. See paragraph (d)(1) of this 
section.
    (iii) Under the rules in paragraph (d)(2)(i) of this section, 
the applicable percentage of E's share of X's self-charged interest 
income is recharacterized as passive activity gross income from the 
activity. Paragraph (d)(3) of this section provides that the 
applicable percentage is obtained by dividing E's deductions for the 
taxable year for interest charged by X, to the extent treated as 
passive activity deductions from the activity ($1,500), by the 
greater of E's deductions for the taxable year for interest charged 
by X, regardless of whether those deductions are treated as passive 
activity deductions ($3,000), or E's share for the taxable year of 
X's self-charged interest income ($1,500). Thus, E's applicable 
percentage is 50 percent ($1,500/$3,000), and $750 (50 percent  x  
$1,500) of E's share of X's self-charged interest income is treated 
as passive activity gross income.
    (iv) Because F does not have any deductions for the taxable year 
for interest charged by X, this section does not apply to F. See 
paragraph (d)(1)(ii) of this section.
    Example 4. (i) This Example 4 illustrates the application of 
this section to a partner

[[Page 54092]]

that has a different taxable year from the partnership. The facts 
are the same as in Example 1 except as follows: Partnership AB has 
properly adopted a fiscal year ending June 30 for federal tax 
purposes; AB borrows the $50,000 from A on October 1, 1990; and 
under the terms of the loan, AB must pay A $5,000 in interest 
annually, in quarterly installments, for a term of 2 years.
    (ii) For A's taxable years from 1990 through 1993 and AB's 
corresponding entity taxable years (as defined in paragraph (b)(4) 
of this section) A's interest income and AB's interest deductions 
from the loan are as follows:

------------------------------------------------------------------------
                                                    A's          AB's
                                                  interest     interest
                                                   income     deductions
------------------------------------------------------------------------
1990..........................................       $1,250            0
1991..........................................        5,000       $3,750
1992..........................................        3,750        5,000
1993..........................................            0        1,250
------------------------------------------------------------------------

    (iii) For A's taxable year ending December 31, 1990, the 
corresponding entity taxable year is AB's taxable year ending June 
30, 1990. Because AB does not have any deductions for the entity 
taxable year for interest charged to AB by A, paragraph (c) of this 
section does not apply in determining A's passive activity gross 
income for 1990 (see paragraph (c)(1)(i) of this section). 
Accordingly, A reports $1,250 of portfolio income on A's 1990 income 
tax return.
    (iv) For A's taxable year ending December 31, 1991, the 
corresponding entity taxable year ends on June 30, 1991. AB has 
$3,750 of deductions for the entity taxable year for interest 
charged to AB by A (AB's self-charged interest deductions); A owns a 
direct interest in AB during the entity taxable year and has $5,000 
of interest income for A's taxable year from interest charged to AB; 
and A's share of AB's self-charged interest deductions includes 
passive activity deductions. Accordingly, paragraph (c) of this 
section applies in determining A's passive activity gross income.
    (v) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of A's 1991 interest income is recharacterized as passive 
activity gross income from the activity. Paragraph (c)(3) of this 
section provides that the applicable percentage is obtained by 
dividing A's share for A's 1991 taxable year of AB's self-charged 
interest deductions that are treated as passive activity deductions 
from the activity (50 percent  x  $3,750 = $1,875) by the greater of 
A's share for A's taxable year of AB's self-charged interest 
deductions ($1,875), or A's income for A's taxable year from 
interest charged to AB ($5,000). Thus, A's applicable percentage is 
37.5 percent ($1,875/$5,000), and $1,875 (37.5 percent  x  $5,000) 
of A's income from interest charged to AB is treated as passive 
activity gross income from the passive activity A conducts through 
AB.
    (vi) For A's taxable year ending December 31, 1992, the 
corresponding entity taxable year ends on June 30, 1992. AB has 
$5,000 of deductions for the entity taxable year for interest 
charged to AB by A (AB's self-charged interest deductions); A owns a 
direct interest in AB during the entity taxable year and has $3,750 
of gross income for A's taxable year from interest charged to AB; 
and A's share of AB's self-charged interest deductions includes 
passive activity deductions. Accordingly, paragraph (c) of this 
section applies in determining A's passive activity gross income.
    (vii) The applicable percentage for 1992 is obtained by dividing 
A's share for A's 1992 taxable year of AB's self-charged interest 
deductions that are treated as passive activity deductions from the 
activity ($2,500) by the greater of A's share for A's taxable year 
of AB's self-charged interest deductions ($2,500), or A's income for 
A's taxable year from interest charged to AB ($3,750). Thus, A's 
applicable percentage is 66\2/3\ percent ($2,500/$3,750), and $2,500 
(66\2/3\ percent  x  $3,750) of A's income from interest charged to 
AB is treated as passive activity gross income from the passive 
activity A conducts through AB.
    (viii) Paragraph (c) of this section does not apply in 
determining A's passive activity gross income for the taxable year 
ending December 31, 1993, because A has no gross income for the 
taxable year from interest charged to AB (see paragraph (c)(1)(ii) 
of this section). A's share of AB's self-charged interest deductions 
for the entity taxable year ending June 30, 1993 ($625) is taken 
into account as a passive activity deduction on A's 1993 income tax 
return.
    (ix) Because B does not have any gross income from interest 
charged to AB for any of the taxable years, this section does not 
apply to B. See paragraph (c)(1)(ii) of this section.
    Example 5. (i) This Example 5 illustrates the application of the 
rules of this section in the case of a taxpayer who has an indirect 
interest in a partnership. G, a calendar year taxpayer, is an 80-
percent partner in partnership UTP. UTP owns a 25-percent interest 
in the capital and profits of partnership LTP. UTP and LTP are both 
calendar year partnerships. The partners of LTP conduct a single 
passive activity through LTP. UTP obtains a $10,000 loan from a 
bank, and pays the bank $1,000 of interest per year. G's 
distributive share of the interest paid to the bank is $800 (80 
percent  x  $1,000). UTP uses the $10,000 debt proceeds and another 
$10,000 of cash to make a loan to LTP, and LTP pays UTP $2,000 of 
interest for the taxable year. G's distributive share of interest 
income attributable to the UTP-to-LTP loan is $1,600 (80 percent  x  
$2,000). LTP uses all of the proceeds received from UTP in the 
passive activity. UTP's distributive share of interest expense 
attributable to the UTP-to-LTP loan is $500 (25 percent  x  $2,000). 
G's distributive share of interest expense attributable to the UTP-
to-LTP loan is $400 (80 percent  x  $500).
    (ii) LTP has deductions for interest charged to LTP by UTP for 
the taxable year (LTP's self-charged interest deductions); G owns an 
indirect interest in LTP during LTP's taxable year and has gross 
income for the taxable year from interest charged to LTP by a 
passthrough entity (UTP) through which G owns an interest in LTP; 
and G's share of LTP's self-charged interest deductions includes 
passive activity deductions. Accordingly, paragraph (c) of this 
section applies in determining G's passive activity gross income. 
See paragraph (c)(1) of this section.
    (iii) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of G's interest income is recharacterized as passive 
activity gross income from the activity. Paragraph (c)(3) of this 
section provides that the applicable percentage is obtained by 
dividing G's share for the taxable year of LTP's self-charged 
interest deductions that are treated as passive activity deductions 
from the activity ($400) by the greater of G's share for the taxable 
year of LTP's self-charged interest deductions ($400), or G's income 
for the year from interest charged to LTP ($1,600). Thus, G's 
applicable percentage is 25 percent ($400/$1,600), and $400 (25 
percent  x  $1,600) of G's income from interest charged to LTP is 
treated as passive activity gross income from the passive activity 
that G conducts through UTP and LTP.
    (iv) G's $800 distributive share of the interest expense that 
UTP pays to the third-party lender is allocated under Sec. 1.163-
8T(c)(1) to an expenditure that is properly chargeable to capital 
account with respect to the loan to LTP. Thus, the expense is a 
deduction properly allocable to the interest income that G receives 
as a result of the UTP-to-LTP loan (see paragraph (f) of this 
section). Under paragraph (c)(2)(ii) of this section, the applicable 
percentage of G's deductions for the taxable year for interest 
expense that is properly allocable to G's income from interest 
charged by UTP to LTP is recharacterized as a passive activity 
deduction from LTP's passive activity. Accordingly, $200 (25 percent 
x $800) of G's interest deduction is treated as a passive activity 
deduction from LTP's activity.

    Example 6. (i) This Example 6 illustrates the application of the 
rules of this section in the case of a taxpayer who conducts two 
passive activities through a passthrough entity. J, a calendar year 
taxpayer, is the 100-percent shareholder of Y, a calendar year S 
corporation. J conducts two passive activities through Y: a rental 
activity and a trade or business activity in which J does not 
materially participate. Y borrows $80,000 from J, and uses $60,000 
of the loan proceeds in the rental activity and $20,000 of the loan 
proceeds in the passive trade or business activity. Y pays $8,000 of 
interest to J for the taxable year, and J incurs $8,000 of interest 
expense as J's distributive share of Y's interest expense.
    (ii) Y has self-charged interest deductions for the taxable year 
(i.e., the deductions for interest charged to Y by J); J owns a 
direct interest in Y during Y's taxable year and has gross income 
for J's taxable year from interest charged to Y; and J's share of 
Y's self-charged interest deductions includes passive activity 
deductions. Accordingly, paragraph (c) of this section applies in 
determining J's passive activity gross income. See paragraph (c)(1) 
of this section.
    (iii) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of J's interest income is recharacterized as passive 
activity gross income attributable to the rental activity. Paragraph 
(c)(3) of this section provides that the applicable percentage is

[[Page 54093]]

obtained by dividing J's share for the taxable year of Y's self-
charged interest deductions that are treated as passive activity 
deductions from the rental activity ($6,000) by the greater of J's 
share for the taxable year of Y's self-charged interest deductions 
($8,000), or J's income for the taxable year from interest charged 
to Y ($8,000). Thus, J's applicable percentage is 75 percent 
($6,000/$8,000), and $6,000 (75 percent  x  $8,000) of J's income 
from interest charged to Y is treated as passive activity gross 
income from the rental activity J conducts through Y.
    (iv) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of J's interest income is recharacterized as passive 
activity gross income attributable to the passive trade or business 
activity. Paragraph (c)(3) of this section provides that the 
applicable percentage is obtained by dividing J's share for the 
taxable year of Y's self-charged interest deductions that are 
treated as passive activity deductions from the passive trade or 
business activity ($2,000) by the greater of J's share for the 
taxable year of Y's self-charged interest deductions ($8,000), or 
J's income for the taxable year from interest charged to Y ($8,000). 
Thus, J's applicable percentage is 25 percent ($2,000/$8,000), and 
$2,000 of J's income from interest charged to Y is treated as 
passive activity gross income from the passive trade or business 
activity J conducts through Y.


    Par. 4. Section 1.469-11 is amended as follows:
    1. Paragraph (a)(3) is amended by removing the language ``and'' at 
the end of the paragraph.
    2. Paragraph (a)(4) is redesignated as paragraph (a)(5) and a new 
paragraph (a)(4) is added.
    3. The paragraph headings for (c)(1) and (c)(1)(i) are revised.
    4. Paragraph (c)(1)(iii) is added.
    5. The added and revised provisions read as follows:


Sec. 1.469-11  Effective date and transition rules.

    (a) * * *
    (4) The rules contained in Sec. 1.469-7 apply for taxable years 
ending after December 31, 1986; and
* * * * *
    (c) * * *
    (1) Application of certain income recharacterization rules and 
self-charged rules--(i) Certain recharacterization rules inapplicable 
in 1987. * * *
* * * * *
    (iii) Self-charged rules. For taxable years beginning before June 
4, 1991--
    (1) A taxpayer is not required to apply the rules in Sec. 1.469-7 
in computing the taxpayer's passive activity loss and passive activity 
credit; and
    (2) A taxpayer that owns an interest in a passthrough entity may 
use any reasonable method of offsetting items of interest income and 
interest expense from lending transactions between the passthrough 
entity and its owners or between identically-owned passthrough entities 
(as defined in Sec. 1.469-7(e)) to compute the taxpayer's passive 
activity loss and passive activity credit. Items from nonlending 
transactions cannot be offset under the self-charged rules.
* * * * *

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 5. The authority citation for the part 602 continues to read:

    Authority: 26 U.S.C. 7805.

    Par. 6. In Sec. 602.101, paragraph (b) is amended by adding the 
following entry in numerical order to the table to read as follows:


Sec. 602.101  OMB Control Numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                            Current OMB
   CFR part or section where identified and described       control No.
------------------------------------------------------------------------
 
                  *        *        *        *        *
1.469-7.................................................       1545-1244
 
                  *        *        *        *        *
------------------------------------------------------------------------


Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: July 31, 2002.
Pamela F. Olson,
Acting Assistant Secretary of the Treasury.
[FR Doc. 02-21203 Filed 8-20-02; 8:45 am]
BILLING CODE 4830-01-P