[Federal Register Volume 68, Number 52 (Tuesday, March 18, 2003)]
[Rules and Regulations]
[Pages 12817-12825]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-6221]


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

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9047]
RIN 1545-BA36 and 1545-AW92


Certain Transfers of Property to Regulated Investment Companies 
[RICs] and Real Estate Investment Trusts [REITs]

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations and removal of temporary regulations.

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

SUMMARY: This document contains final regulations that apply to certain 
transactions or events that result in a Regulated Investment Company 
[RIC] or a Real Estate Investment Trust [REIT] owning property that has 
a basis determined by reference to a C corporation's basis in the 
property. These regulations affect RICs, REITs, and C corporations and 
clarify the tax treatment of transfers of C corporation property to a 
RIC or REIT.

DATES: Effective Date: These regulations are effective March 18, 2003.
    Applicability Dates: For dates of applicability, see Sec. Sec.  
1.337(d)-5(d), 1.337(d)-6(e) and 1.337(d)-7(f).

FOR FURTHER INFORMATION CONTACT: Jennifer D. Sledge, (202) 622-7750 
(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 of 1995 (44 U.S.C. 
3507(d)) under control number 1545-1672. This information is required 
to obtain a benefit, i.e., to elect to recognize gain as if the C 
corporation had sold the property at fair market value or to elect 
section 1374 treatment.
    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 is 30 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:T:T:SP, 
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 a collection of information must be 
retained as long as their contents might 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

    This document contains amendments to 26 CFR part 1. On February 7, 
2000, temporary regulations [TD 8872] (the 2000 temporary regulations) 
relating to certain transactions or events that result in a RIC or REIT 
owning property that has a basis determined by reference to a C 
corporation's basis in the property were published in the Federal 
Register (65 FR 5775). A notice of proposed rulemaking (REG-209135-88) 
cross-referencing the temporary regulations was published in the 
Federal Register for the same day (65 FR 5805). The 2000 temporary 
regulations were intended to carry out the purposes of the repeal of 
the General Utilities doctrine as enacted in the Tax Reform Act of 1986 
(the 1986 Act)(Public Law 99-514, 100 Stat. 2085), as amended by the 
Technical and Miscellaneous Revenue Act of 1988 (Public Law 100-647, 
102 Stat. 3342).
    The 1986 Act amended sections 336 and 337 to require corporations 
to recognize gain or loss on the distribution of property in connection 
with complete liquidations other than certain subsidiary liquidations. 
Section 337(d) directs the Secretary to prescribe regulations as may be 
necessary to carry out the purposes of the General Utilities repeal, 
including rules to ``ensure that such purposes may not be circumvented 
* * * through the use of a regulated investment company, a real estate 
investment trust, or tax-exempt entity * * *.''
    The 2000 temporary regulations also reflected the principles set 
forth in Notice 88-19 (1988-1 C.B. 486), in which the IRS announced its 
intention to promulgate regulations under the authority of section 
337(d) with respect to transactions or events that result in a RIC or 
REIT owning property that has a basis determined by reference to a C 
corporation's basis (a carryover basis). Notice 88-19 provided that the 
regulations would apply with respect to the net built-in gain of C 
corporation assets that become assets of a RIC or REIT by the 
qualification of a C corporation as a RIC or REIT or by the transfer of 
assets of a C corporation to a RIC or REIT (a conversion transaction). 
The Notice further provided that, where the regulations apply, the C 
corporation would be treated, for all purposes, as if it had sold all 
of its assets at their respective fair market values and immediately 
liquidated. The Notice provided, however, that the regulations would 
not allow the recognition of a net loss and that immediate gain 
recognition could be avoided if the C corporation that qualified as a 
RIC or REIT or the transferee RIC or REIT, as the case may have been, 
elected to be subject to tax under section 1374 with respect to the C 
corporation property. Notice 88-19 also indicated that the regulations 
would apply retroactively to June 10, 1987.
    A public hearing on the cross-referenced notice of proposed 
rulemaking was held on May 10, 2000. Written or electronic comments 
responding to the notice of proposed rulemaking were received. After 
consideration of these comments, Treasury and the IRS decided to issue 
two new sets of temporary regulations. On January 2, 2002, temporary 
regulations [TD 8975] (the 2002 temporary regulations) were published 
in the Federal Register (67 FR 8). The regulations under Sec.  
1.337(d)-6T apply to conversion transactions occurring on or after June 
10, 1987 and before January 2, 2002, and the regulations under Sec.  
1.337(d)-7T apply to conversion transactions occurring on or after 
January 2, 2002. A notice of proposed

[[Page 12818]]

rulemaking (REG-142299-01 and REG-209135-88) cross-referencing the 
temporary regulations was published in the Federal Register for the 
same day (67 FR 48).
    The regulations under Sec.  1.337(d)-6T provide that, if property 
of a C corporation that is not a RIC or REIT becomes the property of a 
RIC or REIT in a conversion transaction, then the C corporation is 
subject to deemed sale treatment, unless the RIC or REIT elects to be 
subject to section 1374 treatment. Thus, the C corporation generally 
recognizes gain and loss as if it sold the property converted to RIC or 
REIT property or transferred to the RIC or REIT (the converted 
property) to an unrelated party at fair market value immediately before 
the conversion transaction. If the C corporation recognizes net gain on 
the deemed sale, then the basis of the converted property in the hands 
of the RIC or REIT is adjusted to its fair market value immediately 
before the conversion transaction. The regulations under Sec.  
1.337(d)-6T do not permit a C corporation to recognize a net loss on 
the deemed sale. Where there is a net loss, the C corporation 
recognizes no gain or loss on the deemed sale, and the C corporation's 
basis in the converted property carries over to the RIC or REIT.
    The regulations under Sec.  1.337(d)-7T provide that, if property 
of a C corporation that is not a RIC or REIT becomes the property of a 
RIC or REIT in a conversion transaction, then the RIC or REIT will be 
subject to tax on the net built-in gain in the converted property under 
the rules of section 1374 and the regulations thereunder, unless the C 
corporation that qualifies as a RIC or REIT or transfers property to a 
RIC or REIT elects deemed sale treatment. In most other respects, the 
regulations under Sec.  1.337(d)-7T follow the regulations under Sec.  
1.337(d)-6T.
    No public hearing was requested or held on the 2002 temporary 
regulations. Written or electronic comments responding to the notice of 
proposed rulemaking were received. After consideration of all the 
comments, the proposed regulations are adopted as amended (the final 
regulations) by this Treasury decision, and the corresponding temporary 
regulations are removed. The revisions are discussed below.

Explanation and Summary of Comments

    This preamble first discusses a change in the time for making the 
section 1374 election under Sec.  1.337(d)-6. This preamble then 
discusses the clarification of the rules concerning the use of loss 
carryforwards, credits and credit carryforwards found in the 
regulations under both Sec.  1.337(d)-6 and Sec.  1.337(d)-7. Finally, 
this preamble discusses the clarification of certain issues related to 
the special rule for partnerships found in Sec.  1.337(d)-7.

Time for Making Section 1374 Election Under Sec.  1.337(d)-6

    As explained above, the regulations under Sec.  1.337(d)-6T provide 
that, if property of a C corporation that is not a RIC or REIT becomes 
the property of a RIC or REIT in a conversion transaction, then the C 
corporation is subject to deemed sale treatment, unless the RIC or REIT 
elects to be subject to section 1374 treatment. Under Sec.  1.337(d)-
6T(c)(4)(ii), the section 1374 election may be filed by the RIC or REIT 
with any Federal income tax return filed by the RIC or REIT on or 
before March 15, 2003, provided that the RIC or REIT has reported 
consistently with such election for all periods. Commentators expressed 
concern that, in the case of a conversion transaction occurring on 
January 1, 2002 (the last date of applicability of Sec.  1.337(d)-6T), 
the time limit for making a section 1374 election could preclude a RIC 
or REIT from extending the due date of its Federal income tax return 
beyond March 15, 2003. In response to this comment, the final 
regulations under Sec.  1.337(d)-6 extend the time for making the 
section 1374 election to September 15, 2003.

Use of Loss Carryforwards, Credits and Credit Carryforwards

    Under the 2002 temporary regulations, recognized built-in gains and 
recognized built-in losses that have been taxed in accordance with 
these regulations are treated like other gains and losses of RICs and 
REITs that are not subject to tax under these regulations. Thus, they 
are included in computing investment company taxable income for 
purposes of section 852(b)(2), real estate investment trust taxable 
income for purposes of section 857(b)(2), net capital gain for purposes 
of sections 852(b)(3) and 857(b)(3), gross income derived from sources 
within any foreign country or possession of the United States for 
purposes of section 853, and the dividends paid deduction for purposes 
of sections 852(b)(2)(D), 852(b)(3)(A), 857(b)(2)(B), and 857(b)(3)(A).
    In addition, consistent with section 1374, the 2002 temporary 
regulations generally allow RICs and REITs to use loss carryforwards 
and credits and credit carryforwards arising in taxable years for which 
the corporation that generated the attribute was a C corporation (and 
not a RIC or REIT) to reduce net recognized built-in gain and the tax 
thereon, subject to the limitations imposed by sections 1374(b)(2) and 
(b)(3) and Sec. Sec.  1.1374-5 and 1.1374-6. The 2002 temporary 
regulations also provide an ordering rule for applying loss 
carryforwards, credits, and credit carryforwards to reduce net 
recognized built-in gain (and the tax thereon) and RIC or REIT taxable 
income (and the tax thereon). Under this ordering rule, loss 
carryforwards of a RIC or REIT must be used to reduce net recognized 
built-in gain for a taxable year to the greatest extent possible before 
such losses can be used to reduce investment company taxable income for 
purposes of section 852(b) or real estate investment trust taxable 
income for purposes of section 857(b). A similar rule applies to the 
use of credits and credit carryforwards.
    A commentator asked whether the use of loss carryforwards, credits 
and credit carryforwards for purposes of section 1374 affected the use 
of loss carryforwards, credits and credit carryforwards for purposes of 
subchapter M. In response to this comment, the final regulations under 
Sec. Sec.  1.337(d)-6 and 1.337(d)-7 clarify that the use of loss 
carryforwards, credits and credit carryforwards for purposes of the 
section 1374 tax does not change the extent to which such loss 
carryforwards, credits and credit carryforwards can be used for 
purposes of subchapter M.

Special Rule for Partnerships Under Sec.  1.337(d)-7

    Section Sec.  1.337(d)-7T applies to property transferred by a 
partnership to a RIC or REIT to the extent of any C corporation 
partner's proportionate share of the transferred property (the 
partnership rule). The regulations state that, if the partnership 
elects deemed sale treatment with respect to such transfer, then any 
gain recognized by the partnership on the deemed sale must be specially 
allocated to the C corporation partner.
    In response to comments, the regulations have been revised to 
clarify that the principles of section 704(b) and (c) apply in 
determining the C corporation partner's share of the transferred 
property. As revised, the regulations provide that the principles of 
these regulations apply to property transferred by a partnership to a 
RIC or REIT to the extent of any C corporation partner's distributive 
share of the gain or loss in the transferred property. The following 
sections highlight other specific comments received with respect to 
this rule.

[[Page 12819]]

Partnerships With Multiple Corporate Partners

    A commentator expressed concern that the partnership rule does not 
specify whether the C corporation partner or the partnership is 
considered the transferor for purposes of making the deemed sale 
election. Further, the commentator asserted that in the case of a 
partnership with multiple corporate partners, each corporate partner 
should be allowed to make (or not make) a deemed sale election.
    Treasury and the IRS believe that requiring each corporate partner 
to make a deemed sale election would be inconsistent with section 
703(b) (which generally requires that elections be made at the 
partnership level) and would create unnecessary administrative 
complexity. Therefore, the final regulations under Sec.  1.337(d)-7 
retain the rule under section 703(b) that the deemed sale election is 
made at the partnership level.

Contribution of Loss Assets by Partnership

    Under the partnership rule, if a partnership were to elect deemed 
sale treatment under Sec.  1.337(d)-7T, any gain recognized by the 
partnership on the deemed sale is allocated to the C corporation 
partner. A commentator expressed concern that if the contribution by 
the partnership to a RIC or REIT includes multiple assets, the deemed 
sale may generate losses on certain assets and gain on others even 
though there is an overall net built-in gain. The commentator suggested 
that losses recognized by the partnership must also be allocated to the 
C corporation partner.
    Under Sec.  1.337(d)-7T, when a partnership elects deemed sale 
treatment, only net gains are recognized. If a net gain is recognized, 
the C corporation partner will receive the benefit of offsetting losses 
(as a result of the reduction in net gain). The final regulations under 
Sec.  1.337(d)-7 have been modified to clarify that the gain allocated 
to the C corporation partner on a deemed sale transaction is the C 
corporation partner's distributive share of the net gain in the assets 
transferred to the RIC or REIT by the partnership.

Allocation of Gain or Loss on Subsequent Sale of RIC or REIT Stock

    Under section 358, a partnership that elects deemed sale treatment 
under Sec.  1.337(d)-7T(c) with respect to a conversion transaction 
increases its basis in the RIC or REIT stock by the net gain recognized 
on such transaction. A commentator suggested that the C corporation 
partner should be allowed to use this basis increase to offset any gain 
or loss recognized by the partnership on the eventual sale of the RIC 
or REIT stock.
    Treasury and the IRS agree with this comment. Accordingly, the 
final regulations under Sec.  1.337(d)-7 provide that any adjustment to 
the basis of the RIC or REIT stock held by the partnership as a result 
of electing deemed sale treatment will constitute an adjustment to the 
basis of that stock with respect to the C corporation partner only.

Partnerships With Tax-Exempt Partners

    A commentator expressed concern that the partnership rule in Sec.  
1.337(d)-7T may have an unintended punitive effect when the C 
corporation partner is a tax-exempt entity. Tax-exempt entities that 
are partners in a partnership that holds debt financed property are 
subject to tax under the unrelated business income tax (UBIT) rules 
unless certain criteria are satisfied. One of these criteria (the 
fractions rule) requires that: (1) the tax-exempt partner's share of 
overall partnership income for any tax year is no greater than its 
smallest share of partnership loss in any tax year; and (2) each 
allocation with respect to the partnership has substantial economic 
effect within the meaning of section 704(b)(2). The commentator 
expressed concern that the special allocation of gain to the tax-exempt 
partner that is required by ``1.337(d)-7T when the partnership makes a 
deemed sale election may violate the fractions rule, tainting all 
income from the partnership for UBIT purposes.
    In response to this comment, Treasury and the IRS have amended the 
regulations under section 514 to provide that allocations that are 
mandated by statute or regulation (other than subchapter K of chapter 1 
of the Internal Revenue Code and the regulations thereunder) are not 
considered for purposes of determining qualification under the 
fractions rule. This rule applies to partnership allocations made in 
taxable years beginning on or after January 1, 2002.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 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. Therefore, a Regulatory Flexibility Analysis is not required. 
Pursuant to section 7805(f) of the Code, these final regulations will 
be submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on their impact on small business.

Drafting Information

    The principal author of these regulations is Jennifer D. Sledge of 
the Office of Associate Chief Counsel (Corporate). Other personnel from 
Treasury Department and the IRS 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 
removing the entries for ``Section 1.337(d)-5T'', ``Section 1.337(d)-
6T'', and ``Section 1.337(d)-7T'' and adding entries in numerical order 
to read in part as follows:

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

Section 1.337(d)-5 also issued under 26 U.S.C. 337.
Section 1.337(d)-6 also issued under 26 U.S.C. 337.
Section 1.337(d)-7 also issued under 26 U.S.C. 337. * * *


Sec.  1.337(d)-5T  [Redesignated as Sec.  1.337(d)-5]

    Par. 2. Section 1.337(d)-5T is redesignated as Sec.  1.337(d)-5 and 
the language ``(temporary)'' is removed from the end of the section 
heading.

    Par. 3. Newly designated Sec.  1.337(d)-5 is amended as follows:

    1. In paragraph (b)(3), first sentence, the reference to ``Sec.  
1.337(d)-5T(b)'' is removed and ``paragraph (b) of this section'' is 
added in its place.
    2. In paragraph (d), third sentence, the references to ``Sec.  
1.337(d)-5T(b)(1)'' and ``Sec.  1.337(d)-6T'' are removed and 
``paragraph (b)(1) of this section'' and ``Sec.  1.337(d)-6'' are added 
in their places, respectively.

    3. In paragraph (d), fourth sentence, the reference to ``Sec.  
1.337(d)-6T'' is

[[Page 12820]]

removed and ``Sec.  1.337(d)-6'' is added in its place.
    4. In paragraph (d), last sentence, the reference to ``Sec.  
1.337(d)-7T'' is removed and ``Sec.  1.337(d)-7'' is added in its 
place.

    Par. 4. Section 1.337(d)-6 is added to read as follows:


Sec.  1.337(d)-6  New transitional rules imposing tax on property owned 
by a C corporation that becomes property of a RIC or REIT.

    (a) General rule--(1) Property owned by a C corporation that 
becomes property of a RIC or REIT. If property owned by a C corporation 
(as defined in paragraph (a)(2)(i) of this section) becomes the 
property of a RIC or REIT (the converted property) in a conversion 
transaction (as defined in paragraph (a)(2)(ii) of this section), then 
deemed sale treatment will apply as described in paragraph (b) of this 
section, unless the RIC or REIT elects section 1374 treatment with 
respect to the conversion transaction as provided in paragraph (c) of 
this section. See paragraph (d) of this section for exceptions to this 
paragraph (a).
    (2) Definitions--(i) C corporation. For purposes of this section, 
the term C corporation has the meaning provided in section 1361(a)(2) 
except that the term does not include a RIC or REIT.
    (ii) Conversion transaction. For purposes of this section, the term 
conversion transaction means the qualification of a C corporation as a 
RIC or REIT or the transfer of property owned by a C corporation to a 
RIC or REIT.
    (b) Deemed sale treatment--(1) In general. If property owned by a C 
corporation becomes the property of a RIC or REIT in a conversion 
transaction, then the C corporation recognizes gain and loss as if it 
sold the converted property to an unrelated party at fair market value 
on the deemed sale date (as defined in paragraph (b)(3) of this 
section). This paragraph (b) does not apply if its application would 
result in the recognition of a net loss. For this purpose, net loss is 
the excess of aggregate losses over aggregate gains (including items of 
income), without regard to character.
    (2) Basis adjustment. If a corporation recognizes a net gain under 
paragraph (b)(1) of this section, then the converted property has a 
basis in the hands of the RIC or REIT equal to the fair market value of 
such property on the deemed sale date.
    (3) Deemed sale date--(i) RIC or REIT qualifications. If the 
conversion transaction is a qualification of a C corporation as a RIC 
or REIT, then the deemed sale date is the end of the last day of the C 
corporation's last taxable year before the first taxable year in which 
it qualifies to be taxed as a RIC or REIT.
    (ii) Other conversion transactions. If the conversion transaction 
is a transfer of property owned by a C corporation to a RIC or REIT, 
then the deemed sale date is the end of the day before the day of the 
transfer.
    (4) Example. The rules of this paragraph (b) are illustrated by the 
following example:

    Example. Deemed sale treatment on merger into RIC. (i) X, a 
calendar-year taxpayer, has qualified as a RIC since January 1, 
1991. On May 31, 1994, Y, a C corporation and calendar-year 
taxpayer, transfers all of its property to X in a transaction that 
qualifies as a reorganization under section 368(a)(1)(C). X does not 
elect section 1374 treatment under paragraph (c) of this section and 
chooses not to rely on Sec.  1.337(d)-5. As a result of the 
transfer, Y is subject to deemed sale treatment under this paragraph 
(b) on its tax return for the short taxable year ending May 31, 
1994. On May 31, 1994, Y's only assets are Capital Asset, which has 
a fair market value of $100,000 and a basis of $40,000 as of the end 
of May 30, 1994, and $50,000 cash. Y also has an unrestricted net 
operating loss carryforward of $12,000 and accumulated earnings and 
profits of $50,000. Y has no taxable income for the short taxable 
year ending May 31, 1994, other than gain recognized under this 
paragraph (b). In 1997, X sells Capital Asset for $110,000. Assume 
the applicable corporate tax rate is 35%.
    (ii) Under this paragraph (b), Y is treated as if it sold the 
converted property (Capital Asset and $50,000 cash) at fair market 
value on May 30, 1994, recognizing $60,000 of gain ($150,000 amount 
realized--$90,000 basis). Y must report the gain on its tax return 
for the short taxable year ending May 31, 1994. Y may offset this 
gain with its $12,000 net operating loss carryforward and will pay 
tax of $16,800 (35% of $48,000).
    (iii) Under section 381, X succeeds to Y's accumulated earnings 
and profits. Y's accumulated earnings and profits of $50,000 
increase by $60,000 and decrease by $16,800 as a result of the 
deemed sale. Thus, the aggregate amount of subchapter C earnings and 
profits that must be distributed to satisfy section 852(a)(2)(B) is 
$93,200 ($50,000 + $60,000 - $16,800). X's basis in Capital Asset is 
$100,000. On X's sale of Capital Asset in 1997, X recognizes $10,000 
of gain, which is taken into account in computing X's net capital 
gain for purposes of section 852(b)(3).
    (c) Election of section 1374 treatment--(1) In general--(i) 
Property owned by a C corporation that becomes property of a RIC or 
REIT. Paragraph (b) of this section does not apply if the RIC or REIT 
that was formerly a C corporation or that acquired property from a C 
corporation makes the election described in paragraph (c)(4) of this 
section. A RIC or REIT that makes such an election will be subject to 
tax on the net built-in gain in the converted property under the rules 
of section 1374 and the regulations thereunder, as modified by this 
paragraph (c), as if the RIC or REIT were an S corporation.
    (ii) Property subject to the rules of section 1374 owned by a RIC, 
REIT, or S corporation that becomes property of a RIC or REIT. If 
property subject to the rules of section 1374 owned by a RIC, a REIT, 
or an S corporation (the predecessor) becomes the property of a RIC or 
REIT (the successor) in a continuation transaction, the rules of 
section 1374 apply to the successor to the same extent that the 
predecessor was subject to the rules of section 1374 with respect to 
such property, and the 10-year recognition period of the successor with 
respect to such property is reduced by the portion of the 10-year 
recognition period of the predecessor that expired before the date of 
the continuation transaction. For this purpose, a continuation 
transaction means the qualification of the predecessor as a RIC or REIT 
or the transfer of property from the predecessor to the successor in a 
transaction in which the successor's basis in the transferred property 
is determined, in whole or in part, by reference to the predecessor's 
basis in that property.
    (2) Modification of section 1374 treatment--(i) Net recognized 
built-in gain for REITs--(A) Prelimitation amount. The prelimitation 
amount determined as provided in Sec.  1.1374-2(a)(1) is reduced by the 
portion of such amount, if any, that is subject to tax under section 
857(b)(4), (5), (6), or (7). For this purpose, the amount of a REIT's 
recognized built-in gain that is subject to tax under section 857(b)(5) 
is computed as follows:
    (1) Where the tax under section 857(b)(5) is computed by reference 
to section 857(b)(5)(A), the amount of a REIT's recognized built-in 
gain that is subject to tax under section 857(b)(5) is the tax imposed 
by section 857(b)(5) multiplied by a fraction the numerator of which is 
the amount of recognized built-in gain (without regard to recognized 
built-in loss and recognized built-in gain from prohibited 
transactions) that is not derived from sources referred to in section 
856(c)(2) and the denominator of which is the gross income (without 
regard to gross income from prohibited transactions) of the REIT that 
is not derived from sources referred to in section 856(c)(2).
    (2) Where the tax under section 857(b)(5) is computed by reference 
to section 857(b)(5)(B), the amount of a REIT's recognized built-in 
gain that is subject to tax under section 857(b)(5) is

[[Page 12821]]

the tax imposed by section 857(b)(5) multiplied by a fraction the 
numerator of which is the amount of recognized built-in gain (without 
regard to recognized built-in loss and recognized built-in gain from 
prohibited transactions) that is not derived from sources referred to 
in section 856(c)(3) and the denominator of which is the gross income 
(without regard to gross income from prohibited transactions) of the 
REIT that is not derived from sources referred to in section 856(c)(3).
    (B) Taxable income limitation. The taxable income limitation 
determined as provided in Sec.  1.1374-2(a)(2) is reduced by an amount 
equal to the tax imposed under sections 857(b)(5), (6), and (7).
    (ii) Loss carryforwards, credits and credit carryforwards--(A) Loss 
carryforwards. Consistent with paragraph (c)(1)(i) of this section, net 
operating loss carryforwards and capital loss carryforwards arising in 
taxable years for which the corporation that generated the loss was not 
subject to subchapter M of chapter 1 of the Internal Revenue Code are 
allowed as a deduction against net recognized built-in gain to the 
extent allowed under section 1374 and the regulations thereunder. Such 
loss carryforwards must be used as a deduction against net recognized 
built-in gain for a taxable year to the greatest extent possible before 
such losses can be used to reduce other investment company taxable 
income for purposes of section 852(b) or other real estate investment 
trust taxable income for purposes of section 857(b) for that taxable 
year.
    (B) Credits and credit carryforwards. Consistent with paragraph 
(c)(1)(i) of this section, minimum tax credits and business credit 
carryforwards arising in taxable years for which the corporation that 
generated the credit was not subject to subchapter M of chapter 1 of 
the Internal Revenue Code are allowed to reduce the tax imposed on net 
recognized built-in gain under this paragraph (c) to the extent allowed 
under section 1374 and the regulations thereunder. Such credits and 
credit carryforwards must be used to reduce the tax imposed under this 
paragraph (c) on net recognized built-in gain for a taxable year to the 
greatest extent possible before such credits and credit carryforwards 
can be used to reduce the tax, if any, on other investment company 
taxable income for purposes of section 852(b) or on other real estate 
investment trust taxable income for purposes of section 857(b) for that 
taxable year.
    (iii) 10-year recognition period. In the case of a conversion 
transaction that is a qualification of a C corporation as a RIC or 
REIT, the 10-year recognition period described in section 1374(d)(7) 
begins on the first day of the RIC's or REIT's first taxable year. In 
the case of other conversion transactions, the 10-year recognition 
period begins on the day the property is acquired by the RIC or REIT.
    (3) Coordination with subchapter M rules--(i) Recognized built-in 
gains and losses subject to subchapter M. Recognized built-in gains and 
losses of a RIC or REIT are included in computing investment company 
taxable income for purposes of section 852(b)(2), real estate 
investment trust taxable income for purposes of section 857(b)(2), 
capital gains for purposes of sections 852(b)(3) and 857(b)(3), gross 
income derived from sources within any foreign country or possession of 
the United States for purposes of section 853, and the dividends paid 
deduction for purposes of sections 852(b)(2)(D), 852(b)(3)(A), 
857(b)(2)(B), and 857(b)(3)(A). In computing such income and deduction 
items, capital loss carryforwards and net operating loss carryforwards 
that are used by the RIC or REIT to reduce recognized built-in gains 
are allowed as a deduction, but only to the extent that they are 
otherwise allowable as a deduction against such income under the 
Internal Revenue Code (including section 852(b)(2)(B)).
    (ii) Treatment of tax imposed. The amount of tax imposed under this 
paragraph (c) on net recognized built-in gain for a taxable year is 
treated as a loss sustained by the RIC or the REIT during such taxable 
year. The character of the loss is determined by allocating the tax 
proportionately (based on recognized built-in gain) among the items of 
recognized built-in gain included in net recognized built-in gain. With 
respect to RICs, the tax imposed under this paragraph (c) on net 
recognized built-in gain is treated as attributable to the portion of 
the RIC's taxable year occurring after October 31.
    (4) Making the section 1374 election--(i) In general. A RIC or REIT 
makes a section 1374 election with the following statement: ``[Insert 
name and employer identification number of electing RIC or REIT] elects 
under Sec.  1.337-6(c) to be subject to the rules of section 1374 and 
the regulations thereunder with respect to its property that formerly 
was held by a C corporation, [insert name and employer identification 
number of the C corporation, if different from name and employer 
identification number of the RIC or REIT].'' However, a RIC or REIT 
need not file an election under this paragraph (c), but will be deemed 
to have made such an election if it can demonstrate that it informed 
the Internal Revenue Service prior to January 2, 2002 of its intent to 
make a section 1374 election. An election under this paragraph (c) is 
irrevocable.
    (ii) Time for making the election. An election under this paragraph 
(c) may be filed by the RIC or REIT with any Federal income tax return 
filed by the RIC or REIT on or before September 15, 2003, provided that 
the RIC or REIT has reported consistently with such election for all 
periods.
    (5) Example. The rules of this paragraph (c) are illustrated by the 
following example:

    Example. Section 1374 treatment on REIT election. (i) X, a C 
corporation that is a calendar-year taxpayer, elects to be taxed as 
a REIT on its 1994 tax return, which it files on March 15, 1995. As 
a result, X is a REIT for its 1994 taxable year and would be subject 
to deemed sale treatment under paragraph (b) of this section but for 
X's timely election of section 1374 treatment under this paragraph 
(c). X chooses not to rely on Sec.  1.337(d)-5. As of the beginning 
of the 1994 taxable year, X's property consisted of Real Property, 
which is not section 1221(a)(1) property and which had a fair market 
value of $100,000 and an adjusted basis of $80,000, and $25,000 
cash. X also had accumulated earnings and profits of $25,000, 
unrestricted capital loss carryforwards of $3,000, and unrestricted 
business credit carryforwards of $2,000. On July 1, 1997, X sells 
Real Property for $110,000. For its 1997 taxable year, X has no 
other income or deduction items. Assume the highest corporate tax 
rate is 35%.
    (ii) Upon its election to be taxed as a REIT, X retains its 
$80,000 basis in Real Property and its $25,000 accumulated earnings 
and profits. X retains its $3,000 of capital loss carryforwards and 
its $2,000 of business credit carryforwards. To satisfy section 
857(a)(2)(B), X must distribute $25,000, an amount equal to its 
earnings and profits accumulated in non-REIT years, to its 
shareholders by the end of its 1994 taxable year.
    (iii) Upon X's sale of Real Property in 1997, X recognizes gain 
of $30,000 ($110,000--$80,000). X's recognized built-in gain for 
purposes of applying section 1374 is $20,000 ($100,000 fair market 
value as of the beginning of X's first taxable year as a REIT--
$80,000 basis). Because X's $30,000 of net income for the 1997 
taxable year exceeds the net recognized built-in gain of $20,000, 
the taxable income limitation does not apply. X, therefore, has 
$20,000 net recognized built-in gain for the year. Assuming that X 
has not used its $3,000 of capital loss carryforwards in a prior 
taxable year and that their use is allowed under section 1374(b)(2) 
and Sec.  1.1374-5, X is allowed a $3,000 deduction against the 
$20,000 net recognized built-in gain. X would owe tax of $5,950 (35% 
of $17,000) on its net recognized built-in gain, except that X may 
use its $2,000 of business credit carryforwards to reduce this tax, 
assuming that X has not used the credit carryforwards in a prior 
taxable year and that their use is allowed under section 1374(b)(3)

[[Page 12822]]

and Sec.  1.1374-6. Thus, X owes tax of $3,950 under this paragraph 
(c).
    (iv) For purposes of subchapter M of chapter 1 of the Internal 
Revenue Code, X's earnings and profits for the year increase by 
$26,050 ($30,000 capital gain on the sale of Real Property--$3,950 
tax under this paragraph (c)). For purposes of section 857(b)(2) and 
(b)(3), X's net capital gain for the year is $23,050 ($30,000 
capital gain reduced by $3,000 capital loss carryforward and further 
reduced by $3,950 tax).

    (d) Exceptions--(1) Gain otherwise recognized. Paragraph (a) of 
this section does not apply to any conversion transaction to the extent 
that gain or loss otherwise is recognized on such conversion 
transaction. See, for example, sections 336, 351(b), 351(e), 356, 
357(c), 367, 368(a)(2)(F), and 1001.
    (2) Re-election of RIC or REIT status--(i) Generally. Except as 
provided in paragraphs (d)(2)(ii) and (iii) of this section, paragraph 
(a)(1) of this section does not apply to any corporation that--
    (A) Immediately prior to qualifying to be taxed as a RIC or REIT 
was subject to tax as a C corporation for a period not exceeding two 
taxable years; and
    (B) Immediately prior to being subject to tax as a C corporation 
was subject to tax as a RIC or REIT for a period of at least one 
taxable year.
    (ii) Property acquired from another corporation while a C 
corporation. The exception described in paragraph (d)(2)(i) of this 
section does not apply to property acquired by the corporation while it 
was subject to tax as a C corporation from any person in a transaction 
that results in the acquirer's basis in the property being determined 
by reference to a C corporation's basis in the property.
    (iii) RICs and REITs previously subject to section 1374 treatment. 
If the RIC or REIT had property subject to paragraph (c) of this 
section before the RIC or REIT became subject to tax as a C corporation 
as described in paragraph (d)(2)(i) of this section, then paragraph (c) 
of this section applies to the RIC or REIT upon its requalification as 
a RIC or REIT, except that the 10-year recognition period with respect 
to such property is reduced by the portion of the 10-year recognition 
period that expired before the RIC or REIT became subject to tax as a C 
corporation and by the period of time that the corporation was subject 
to tax as a C corporation.
    (e) Effective date. This section applies to conversion transactions 
that occur on or after June 10, 1987, and before January 2, 2002. In 
lieu of applying this section, taxpayers generally may apply Sec.  
1.337(d)-5 to determine the tax consequences (for all taxable years) of 
any conversion transaction that occurs on or after June 10, 1987 and 
before January 2, 2002, except that RICs and REITs that are subject to 
section 1374 treatment with respect to a conversion transaction may not 
rely on Sec.  1.337(d)-5(b)(1), but must apply paragraphs (c)(1)(i), 
(c)(2)(i), (c)(2)(ii), and (c)(3) of this section, with respect to 
built-in gains and losses recognized in taxable years beginning on or 
after January 2, 2002. Taxpayers are not prevented from relying on 
Sec.  1.337(d)-5 merely because they elect section 1374 treatment in 
the manner described in paragraph (c)(4) of this section instead of in 
the manner described in Sec.  1.337(d)-5(b)(3) and (c). For conversion 
transactions that occur on or after January 2, 2002, see Sec.  
1.337(d)-7.


Sec.  1.337(d)-6T  [Removed]

    Par. 5. Section 1.337(d)-6T is removed.

    Par. 6. Section 1.337(d)-7 is added to read as follows:


Sec.  1.337(d)-7  Tax on property owned by a C corporation that becomes 
property of a RIC or REIT.

    (a) General rule--(1) Property owned by a C corporation that 
becomes property of a RIC or REIT. If property owned by a C corporation 
(as defined in paragraph (a)(2)(i) of this section) becomes the 
property of a RIC or REIT (the converted property) in a conversion 
transaction (as defined in paragraph (a)(2)(ii) of this section), then 
section 1374 treatment will apply as described in paragraph (b) of this 
section, unless the C corporation elects deemed sale treatment with 
respect to the conversion transaction as provided in paragraph (c) of 
this section. See paragraph (d) of this section for exceptions to this 
paragraph (a).
    (2) Definitions--(i) C corporation. For purposes of this section, 
the term C corporation has the meaning provided in section 1361(a)(2) 
except that the term does not include a RIC or REIT.
    (ii) Conversion transaction. For purposes of this section, the term 
conversion transaction means the qualification of a C corporation as a 
RIC or REIT or the transfer of property owned by a C corporation to a 
RIC or REIT.
    (b) Section 1374 treatment--(1) In general--(i) Property owned by a 
C corporation that becomes property of a RIC or REIT. If property owned 
by a C corporation becomes the property of a RIC or REIT in a 
conversion transaction, then the RIC or REIT will be subject to tax on 
the net built-in gain in the converted property under the rules of 
section 1374 and the regulations thereunder, as modified by this 
paragraph (b), as if the RIC or REIT were an S corporation.
    (ii) Property subject to the rules of section 1374 owned by a RIC, 
REIT, or S corporation that becomes property of a RIC or REIT. If 
property subject to the rules of section 1374 owned by a RIC, a REIT, 
or an S corporation (the predecessor) becomes the property of a RIC or 
REIT (the successor) in a continuation transaction, the rules of 
section 1374 apply to the successor to the same extent that the 
predecessor was subject to the rules of section 1374 with respect to 
such property, and the 10-year recognition period of the successor with 
respect to such property is reduced by the portion of the 10-year 
recognition period of the predecessor that expired before the date of 
the continuation transaction. For this purpose, a continuation 
transaction means the qualification of the predecessor as a RIC or REIT 
or the transfer of property from the predecessor to the successor in a 
transaction in which the successor's basis in the transferred property 
is determined, in whole or in part, by reference to the predecessor's 
basis in that property.
    (2) Modification of section 1374 treatment--(i) Net recognized 
built-in gain for REITs--(A) Prelimitation amount. The prelimitation 
amount determined as provided in Sec.  1.1374-2(a)(1) is reduced by the 
portion of such amount, if any, that is subject to tax under section 
857(b)(4), (5), (6), or (7). For this purpose, the amount of a REIT's 
recognized built-in gain that is subject to tax under section 857(b)(5) 
is computed as follows:
    (1) Where the tax under section 857(b)(5) is computed by reference 
to section 857(b)(5)(A), the amount of a REIT's recognized built-in 
gain that is subject to tax under section 857(b)(5) is the tax imposed 
by section 857(b)(5) multiplied by a fraction the numerator of which is 
the amount of recognized built-in gain (without regard to recognized 
built-in loss and recognized built-in gain from prohibited 
transactions) that is not derived from sources referred to in section 
856(c)(2) and the denominator of which is the gross income (without 
regard to gross income from prohibited transactions) of the REIT that 
is not derived from sources referred to in section 856(c)(2).
    (2) Where the tax under section 857(b)(5) is computed by reference 
to section 857(b)(5)(B), the amount of a REIT's recognized built-in 
gain that is subject to tax under section 857(b)(5) is the tax imposed 
by section 857(b)(5) multiplied by a fraction the numerator of which is 
the amount of recognized

[[Page 12823]]

built-in gain (without regard to recognized built-in loss and 
recognized built-in gain from prohibited transactions) that is not 
derived from sources referred to in section 856(c)(3) and the 
denominator of which is the gross income (without regard to gross 
income from prohibited transactions) of the REIT that is not derived 
from sources referred to in section 856(c)(3).
    (B) Taxable income limitation. The taxable income limitation 
determined as provided in Sec.  1.1374-2(a)(2) is reduced by an amount 
equal to the tax imposed under section 857(b)(5), (6), and (7).
    (ii) Loss carryforwards, credits and credit carryforwards --(A) 
Loss carryforwards. Consistent with paragraph (b)(1)(i) of this 
section, net operating loss carryforwards and capital loss 
carryforwards arising in taxable years for which the corporation that 
generated the loss was not subject to subchapter M of chapter 1 of the 
Internal Revenue Code are allowed as a deduction against net recognized 
built-in gain to the extent allowed under section 1374 and the 
regulations thereunder. Such loss carryforwards must be used as a 
deduction against net recognized built-in gain for a taxable year to 
the greatest extent possible before such losses can be used to reduce 
other investment company taxable income for purposes of section 852(b) 
or other real estate investment trust taxable income for purposes of 
section 857(b) for that taxable year.
    (B) Credits and credit carryforwards. Consistent with paragraph 
(b)(1)(i) of this section, minimum tax credits and business credit 
carryforwards arising in taxable years for which the corporation that 
generated the credit was not subject to subchapter M of chapter 1 of 
the Internal Revenue Code are allowed to reduce the tax imposed on net 
recognized built-in gain under this paragraph (b) to the extent allowed 
under section 1374 and the regulations thereunder. Such credits and 
credit carryforwards must be used to reduce the tax imposed under this 
paragraph (b) on net recognized built-in gain for a taxable year to the 
greatest extent possible before such credits and credit carryforwards 
can be used to reduce the tax, if any, on other investment company 
taxable income for purposes of section 852(b) or on other real estate 
investment trust taxable income for purposes of section 857(b) for that 
taxable year.
    (iii) 10-year recognition period. In the case of a conversion 
transaction that is a qualification of a C corporation as a RIC or 
REIT, the 10-year recognition period described in section 1374(d)(7) 
begins on the first day of the RIC's or REIT's first taxable year. In 
the case of other conversion transactions, the 10-year recognition 
period begins on the day the property is acquired by the RIC or REIT.
    (3) Coordination with subchapter M rules--(i) Recognized built-in 
gains and losses subject to subchapter M. Recognized built-in gains and 
losses of a RIC or REIT are included in computing investment company 
taxable income for purposes of section 852(b)(2), real estate 
investment trust taxable income for purposes of section 857(b)(2), 
capital gains for purposes of sections 852(b)(3) and 857(b)(3), gross 
income derived from sources within any foreign country or possession of 
the United States for purposes of section 853, and the dividends paid 
deduction for purposes of sections 852(b)(2)(D), 852(b)(3)(A), 
857(b)(2)(B), and 857(b)(3)(A). In computing such income and deduction 
items, capital loss carryforwards and net operating loss carryforwards 
that are used by the RIC or REIT to reduce recognized built-in gains 
are allowed as a deduction, but only to the extent that they are 
otherwise allowable as a deduction against such income under the 
Internal Revenue Code (including section 852(b)(2)(B)).
    (ii) Treatment of tax imposed. The amount of tax imposed under this 
paragraph (b) on net recognized built-in gain for a taxable year is 
treated as a loss sustained by the RIC or the REIT during such taxable 
year. The character of the loss is determined by allocating the tax 
proportionately (based on recognized built-in gain) among the items of 
recognized built-in gain included in net recognized built-in gain. With 
respect to RICs, the tax imposed under this paragraph (b) on net 
recognized built-in gain is treated as attributable to the portion of 
the RIC's taxable year occurring after October 31.
    (4) Example. The rules of this paragraph (b) are illustrated by the 
following example:

    Example. Section 1374 treatment on REIT election. (i) X, a C 
corporation that is a calendar-year taxpayer, elects to be taxed as 
a REIT on its 2004 tax return, which it files on March 15, 2005. As 
a result, X is a REIT for its 2004 taxable year and is subject to 
section 1374 treatment under this paragraph (b). X does not elect 
deemed sale treatment under paragraph (c) of this section. As of the 
beginning of the 2004 taxable year, X's property consisted of Real 
Property, which is not section 1221(a)(1) property and which had a 
fair market value of $100,000 and an adjusted basis of $80,000, and 
$25,000 cash. X also had accumulated earnings and profits of 
$25,000, unrestricted capital loss carryforwards of $3,000, and 
unrestricted business credit carryforwards of $2,000. On July 1, 
2007, X sells Real Property for $110,000. For its 2007 taxable year, 
X has no other income or deduction items. Assume the highest 
corporate tax rate is 35%.
    (ii) Upon its election to be taxed as a REIT, X retains its 
$80,000 basis in Real Property and its $25,000 accumulated earnings 
and profits. X retains its $3,000 of capital loss carryforwards and 
its $2,000 of business credit carryforwards. To satisfy section 
857(a)(2)(B), X must distribute $25,000, an amount equal to its 
earnings and profits accumulated in non-REIT years, to its 
shareholders by the end of its 2004 taxable year.
    (iii) Upon X's sale of Real Property in 2007, X recognizes gain 
of $30,000 ($110,000--$80,000). X's recognized built-in gain for 
purposes of applying section 1374 is $20,000 ($100,000 fair market 
value as of the beginning of X's first taxable year as a REIT--
$80,000 basis). Because X's $30,000 of net income for the 2007 
taxable year exceeds the net recognized built-in gain of $20,000, 
the taxable income limitation does not apply. X, therefore, has 
$20,000 net recognized built-in gain for the year. Assuming that X 
has not used its $3,000 of capital loss carryforwards in a prior 
taxable year and that their use is allowed under section 1374(b)(2) 
and Sec.  1.1374-5, X is allowed a $3,000 deduction against the 
$20,000 net recognized built-in gain. X would owe tax of $5,950 (35% 
of $17,000) on its net recognized built-in gain, except that X may 
use its $2,000 of business credit carryforwards to reduce the tax, 
assuming that X has not used the credit carryforwards in a prior 
taxable year and that their use is allowed under section 1374(b)(3) 
and Sec.  1.1374-6. Thus, X owes tax of $3,950 under this paragraph 
(b).
    (iv) For purposes of subchapter M of chapter 1 of the Internal 
Revenue Code, X's earnings and profits for the year increase by 
$26,050 ($30,000 capital gain on the sale of Real Property--$3,950 
tax under this paragraph (b)). For purposes of section 857(b)(2) and 
(b)(3), X's net capital gain for the year is $23,050 ($30,000 
capital gain reduced by $3,000 capital loss carryforward and further 
reduced by $3,950 tax).

    (c) Election of deemed sale treatment--(1) In general. Paragraph 
(b) of this section does not apply if the C corporation that qualifies 
as a RIC or REIT or transfers property to a RIC or REIT makes the 
election described in paragraph (c)(5) of this section. A C corporation 
that makes such an election recognizes gain and loss as if it sold the 
converted property to an unrelated party at fair market value on the 
deemed sale date (as defined in paragraph (c)(3) of this section). See 
paragraph (c)(4) of this section concerning limitations on the use of 
loss in computing gain. This paragraph (c) does not apply if its 
application would result in the recognition of a net loss. For this 
purpose, net loss is the excess of aggregate losses over aggregate 
gains (including items of income), without regard to character.

[[Page 12824]]

    (2) Basis adjustment. If a corporation recognizes a net gain under 
paragraph (c)(1) of this section, then the converted property has a 
basis in the hands of the RIC or REIT equal to the fair market value of 
such property on the deemed sale date.
    (3) Deemed sale date--(i) RIC or REIT qualifications. If the 
conversion transaction is a qualification of a C corporation as a RIC 
or REIT, then the deemed sale date is the end of the last day of the C 
corporation's last taxable year before the first taxable year in which 
it qualifies to be taxed as a RIC or REIT.
    (ii) Other conversion transactions. If the conversion transaction 
is a transfer of property owned by a C corporation to a RIC or REIT, 
then the deemed sale date is the end of the day before the day of the 
transfer.
    (4) Anti-stuffing rule. A C corporation must disregard converted 
property in computing gain or loss recognized on the conversion 
transaction under this paragraph (c), if--
    (i) The converted property was acquired by the C corporation in a 
transaction to which section 351 applied or as a contribution to 
capital;
    (ii) Such converted property had an adjusted basis immediately 
after its acquisition by the C corporation in excess of its fair market 
value on the date of acquisition; and
    (iii) The acquisition of such converted property by the C 
corporation was part of a plan a principal purpose of which was to 
reduce gain recognized by the C corporation in connection with the 
conversion transaction. For purposes of this paragraph (c)(4), the 
principles of section 336(d)(2) apply.
    (5) Making the deemed sale election. A C corporation (or a 
partnership to which the principles of this section apply under 
paragraph (e) of this section) makes the deemed sale election with the 
following statement: ``[Insert name and employer identification number 
of electing corporation or partnership] elects deemed sale treatment 
under Sec.  1.337(d)-7(c) with respect to its property that was 
converted to property of, or transferred to, a RIC or REIT, [insert 
name and employer identification number of the RIC or REIT, if 
different from the name and employer identification number of the C 
corporation or partnership].'' This statement must be attached to the 
Federal income tax return of the C corporation or partnership for the 
taxable year in which the deemed sale occurs. An election under this 
paragraph (c) is irrevocable.
    (6) Examples. The rules of this paragraph (c) are illustrated by 
the following examples:

    Example 1. Deemed sale treatment on merger into RIC. (i) X, a 
calendar-year taxpayer, has qualified as a RIC since January 1, 
2001. On May 31, 2004, Y, a C corporation and calendar-year 
taxpayer, transfers all of its property to X in a transaction that 
qualifies as a reorganization under section 368(a)(1)(C). As a 
result of the transfer, Y would be subject to section 1374 treatment 
under paragraph (b) of this section but for its timely election of 
deemed sale treatment under this paragraph (c). As a result of such 
election, Y is subject to deemed sale treatment on its tax return 
for the short taxable year ending May 31, 2004. On May 31, 2004, Y's 
only assets are Capital Asset, which has a fair market value of 
$100,000 and a basis of $40,000 as of the end of May 30, 2004, and 
$50,000 cash. Y also has an unrestricted net operating loss 
carryforward of $12,000 and accumulated earnings and profits of 
$50,000. Y has no taxable income for the short taxable year ending 
May 31, 2004, other than gain recognized under this paragraph (c). 
In 2007, X sells Capital Asset for $110,000. Assume the applicable 
corporate tax rate is 35%.
    (ii) Under this paragraph (c), Y is treated as if it sold the 
converted property (Capital Asset and $50,000 cash) at fair market 
value on May 30, 2004, recognizing $60,000 of gain ($150,000 amount 
realized--$90,000 basis). Y must report the gain on its tax return 
for the short taxable year ending May 31, 2004. Y may offset this 
gain with its $12,000 net operating loss carryforward and will pay 
tax of $16,800 (35% of $48,000).
    (iii) Under section 381, X succeeds to Y's accumulated earnings 
and profits. Y's accumulated earnings and profits of $50,000 
increase by $60,000 and decrease by $16,800 as a result of the 
deemed sale. Thus, the aggregate amount of subchapter C earnings and 
profits that must be distributed to satisfy section 852(a)(2)(B) is 
$93,200 ($50,000 + $60,000-$16,800). X's basis in Capital Asset is 
$100,000. On X's sale of Capital Asset in 2007, X recognizes $10,000 
of gain which is taken into account in computing X's net capital 
gain for purposes of section 852(b)(3).
    Example 2. Loss limitation. (i) Assume the facts are the same as 
those described in Example 1, but that, prior to the reorganization, 
a shareholder of Y contributed to Y a capital asset, Capital Asset 
2, which has a fair market value of $10,000 and a basis of $20,000, 
in a section 351 transaction.
    (ii) Assuming that Y's acquisition of Capital Asset 2 was made 
pursuant to a plan a principal purpose of which was to reduce the 
amount of gain that Y would recognize in connection with the 
conversion transaction, Capital Asset 2 would be disregarded in 
computing the amount of Y's net gain on the conversion transaction.

    (d) Exceptions--(1) Gain otherwise recognized. Paragraph (a) of 
this section does not apply to any conversion transaction to the extent 
that gain or loss otherwise is recognized on such conversion 
transaction. See, for example, sections 336, 351(b), 351(e), 356, 
357(c), 367, 368(a)(2)(F), and 1001.
    (2) Re-election of RIC or REIT status--(i) Generally. Except as 
provided in paragraphs (d)(2)(ii) and (iii) of this section, paragraph 
(a)(1) of this section does not apply to any corporation that--
    (A) Immediately prior to qualifying to be taxed as a RIC or REIT 
was subject to tax as a C corporation for a period not exceeding two 
taxable years; and
    (B) Immediately prior to being subject to tax as a C corporation 
was subject to tax as a RIC or REIT for a period of at least one 
taxable year.
    (ii) Property acquired from another corporation while a C 
corporation. The exception described in paragraph (d)(2)(i) of this 
section does not apply to property acquired by the corporation while it 
was subject to tax as a C corporation from any person in a transaction 
that results in the acquirer's basis in the property being determined 
by reference to a C corporation's basis in the property.
    (iii) RICs and REITs previously subject to section 1374 treatment. 
If the RIC or REIT had property subject to paragraph (b) of this 
section before the RIC or REIT became subject to tax as a C corporation 
as described in paragraph (d)(2)(i) of this section, then paragraph (b) 
of this section applies to the RIC or REIT upon its requalification as 
a RIC or REIT, except that the 10-year recognition period with respect 
to such property is reduced by the portion of the 10-year recognition 
period that expired before the RIC or REIT became subject to tax as a C 
corporation and by the period of time that the corporation was subject 
to tax as a C corporation.
    (e) Special rule for partnerships. The principles of this section 
apply to property transferred by a partnership to a RIC or REIT to the 
extent of any C corporation partner's distributive share of the gain or 
loss in the transferred property. If the partnership were to elect 
deemed sale treatment under paragraph (c) of this section in lieu of 
section 1374 treatment under paragraph (b) of this section with respect 
to such transfer, then any net gain recognized by the partnership on 
the deemed sale must be allocated to the C corporation partner, but 
does not increase the capital account of any partner. Any adjustment to 
the partnership's basis in the RIC or REIT stock as a result of deemed 
sale treatment under paragraph (c) of this section shall constitute an 
adjustment to the basis of that stock with respect to the C corporation 
partner only. The principles of section 743 apply to such basis 
adjustment.

[[Page 12825]]

    (f) Effective date. This section applies to conversion transactions 
that occur on or after January 2, 2002. For conversion transactions 
that occurred on or after June 10, 1987, and before January 2, 2002, 
see Sec. Sec.  1.337(d)-5 and 1.337(d)-6.


Sec.  1.337(d)-7T  [Removed]

    Par. 7. Section 1.337(d)-7T is removed.

    Par. 8. In Sec.  1.514(c)-2, paragraph (e)(1)(v) is added to read 
as follows:


Sec.  1.514(c)-2  Permitted allocations under section 514(c)(9)(E).

* * * * *
    (e) * * *
    (1) * * *
    (v) Allocations made in taxable years beginning on or after January 
1, 2002, that are mandated by statute or regulation other than 
subchapter K of chapter 1 of the Internal Revenue Code and the 
regulations thereunder.

PART 602--[AMENDED]

    Par. 9. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 10. In Sec.  602.101, paragraph (b) is amended by removing the 
entries for ``1.337(d)-5T'', ``1.337(d)-6T'', and ``1.337-7T'' and 
adding entries 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 or described       control No.
------------------------------------------------------------------------
 
                                * * * * *
1.337(d)-5..............................................       1545-1672
1.337(d)-6..............................................       1545-1672
1.337(d)-7..............................................       1545-1672
 
                                * * * * *
------------------------------------------------------------------------


David A. Mader,
Assistant Deputy Commissioner of Internal Revenue.
    Approved: March 7, 2003.
Pamela F. Olson,
Assistant Secretary of the Treasury.
[FR Doc. 03-6221 Filed 3-13-03; 1:16 pm]
BILLING CODE 4830-01-P